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

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5 Delivering growth: how the options compare

Chapter Summary

  • The motivation for fiscal reform in Scotland is to create a fiscal framework which will give Scotland greater ability to increase sustainable economic growth.
  • The Scottish Government believes that the best fiscal structure for Scotland's future is one that will lead to the establishment of a fiscal policy making environment which is best placed to meet the challenges of ensuring long-term competitiveness and responsiveness.
  • To deliver this, options for reform are assessed against three key criteria:
  • enhanced efficiency;
  • greater accountability and transparency; and
  • sustainability.
  • The Scottish Government believes that the only option which will deliver the framework to support the levels of higher long-term sustainable economic growth that Scotland should enjoy is full fiscal autonomy in an independent Scotland.

Introduction

5.1 This chapter considers the options for reform and reviews them against a number of key criteria to establish how effective each option would be in achieving the Scottish Government's Purpose and enabling Scotland to realise its full potential.

Assessment of Options for Reform

5.2 The Scottish Government's core Purpose is to create a more successful country, with opportunities for all of Scotland to flourish through increasing sustainable economic growth. Any changes to the fiscal framework for Scotland must contribute to the delivery of the Purpose.

5.3 Economic growth is the key driver of prosperity and sustainability over the long-term. Faster economic growth means more resources can be devoted to public services and/or cuts in taxation.

5.4 The Scottish Government believes that the best fiscal structure to achieve this is one that will lead to the creation of a fiscal policy making environment which is best placed to meet the challenges of ensuring:

  • long-term competitiveness - maximising opportunities to raise productivity, competitiveness and economic growth over the long-term; and
  • responsiveness - maximising opportunities to respond swiftly and effectively to changes in circumstances.

Criteria for Comparing Options for Reform

5.5 To deliver a fiscal framework for Scotland that best meets these two objectives there are three key criteria against which each of the options outlined in Chapter 4 are compared. The three criteria are:

  • Enhanced Efficiency - A fiscal framework that encourages economic efficiency is vital to ensuring that Scotland becomes a richer society and economy. Changes to the fiscal framework should create opportunities for raising efficiency and enhancing Scotland's competitive advantage.
  • Greater Accountability and Transparency - Accountability and transparency are vital in ensuring public support and trust in the political system and incentivising best practice, better governance and policy actions. Changes to the fiscal framework should enhance accountability and transparency and create incentives for delivering best practice.
  • Sustainability - Changes to the fiscal framework should show the cost effectiveness of the funding mechanism and at the same time ensure affordability of tax and spending policies both in the short and long-term.

Comparing the Options for Reform

5.6 The following section examines how each option for reform demonstrates the ability to meet these key criteria and the extent to which it assists in the delivery of increased sustainable economic growth. The concluding chapter presents a summary of the options for reform and sets out the preferred position of the Scottish Government.

Enhanced Efficiency

Enhanced Efficiency - A fiscal framework that encourages efficiency is vital to ensuring Scotland becomes a richer society and economy. Changes to the fiscal framework should create opportunities for raising efficiency and enhancing Scotland's competitive advantage.

5.7 In order to promote long-term growth and short-term flexibility there are three critical elements to be considered in relation to enhanced economic efficiency:

  • greater autonomy to tailor policies to match preferences;
  • opportunities to extend competitive advantages; and
  • efficiency in delivery of public services.

Greater autonomy to tailor policies

5.8 A basic principle underlying the economic theory of optimal public finance is the belief that devolved governments are best placed to tailor policies to match the particular preferences and needs of their constituents 45. By matching policy instruments to the location which captures the benefits and costs of each policy instrument, optimal efficiency in policy setting can be achieved. In contrast, a 'one-size-fits-all' fiscal policy strategy is unable to take full advantage of differences between countries or regions.

5.9 We believe that enabling the Scottish Parliament to have greater autonomy to tailor policies to match the particular preferences and needs of the Scottish people can generate a more efficient allocation of spending and taxation and hence lead to an improvement in welfare. Indeed to date, devolution has enabled policies on business rates, prescription charges and hospital car park charges to be different in Scotland from those in England. Further devolution could extend these policy differences into other areas, such as increasing the state pension in Scotland or halting the introduction of identity cards. Where the Scottish people believed that there were shared benefits and costs of certain policies between Scotland and other parts of the UK, there could be an advantage from the establishment of appropriate economic and fiscal partnerships.

5.10 This view has some support in the academic literature. For example, Brueckner (2006) has assessed the merits of policy differentials within a centralised economy and found that (on the assumption that there are already differences between regions), regions have the potential to grow faster with appropriately targeted policies arising from greater decentralisation than under a 'one-size fits all' centralised policy 46.

5.11 As highlighted in Chapter 3, within the current framework of devolved powers, the Scottish Parliament has significant autonomy over devolved policies and flexibility to decide the allocation of programme spending.

5.12 However a range of policies, particularly in respect of taxation and in key areas of spending and economic policy, remain reserved to Westminster. In addition, the lack of significant revenue autonomy means that the Scottish Government only has limited opportunities to vary the overall size of the Scottish Budget in a meaningful way - such as via tax cuts or increased levels of investment in public services or infrastructure - without corresponding cuts elsewhere.

5.13 Under assigned revenues, there would be no additional opportunity for distinctive policies to be pursued in Scotland compared with the rest of the UK and, in this regard, there would be no material increase in the freedom to tailor policies to match the preferences of the Scottish people or particular circumstances unique to Scotland.

5.14 The specific design of an enhanced devolution framework would determine whether there was an improved range of options available to the Scottish Parliament. In general, greater tax devolution would, at the margin, increase the range of revenue policy options open to the Scottish Parliament. Similarly, provided authority to change policy on any shared taxes was devolved, a degree of autonomy would be achieved under tax sharing.

5.15 The 'type' of taxes devolved in any revised framework would be an important determinant of the degree of 'real' autonomy. Clearly some elements of government expenditure and taxation, such as income tax and the welfare state, have greater implications for the people of Scotland and the Scottish economy than others. Overall however, the opportunities for the Scottish Government to set policies specifically for the benefit of the Scottish economy and the people of Scotland would remain constrained.

5.16 Devolution max would provide significant autonomy in the setting of fiscal policies to match the preferences and circumstances of the people of Scotland and would represent a significant step forward. However, as highlighted in Chapter 4, this is still likely to be subject to constraints. Negotiation of a revised fiscal settlement within the UK, coupled with EU rules and regulations governing tax and spending policies of sub-central governments, would impose limitations on the autonomy to vary policy. Furthermore, while devolution of fiscal policy would be at a near maximum, many other aspects of economic, employment and regulatory policy may remain reserved unless devolved separately.

5.17 Independence however, would put Scotland in the same position as other countries and allow the full range of fiscal and economic policies to be set to meet the objectives and needs of the people of Scotland and the Scottish economy. We believe that this would allow maximum opportunity to take advantage of the economic efficiency gains that could be made from tailoring policies solely in the best interests of Scotland.

Opportunities to extend competitive advantages

5.18 Public policies have an important role to play in boosting sustainable economic growth. Investments in capital, both physical and human, and research and development are essential drivers of Scottish productivity, competitiveness and sustainable economic growth.

5.19 Greater decentralisation has the potential to boost sustainable economic growth by creating the opportunity for the Scottish Parliament to shape the regulatory framework, the taxation environment and the supply side of the economy, to make the most of Scotland's comparative advantages, to address any specific skills shortages and to build upon and correct any infrastructure strengths and weaknesses.

5.20 The establishment of clusters and key sectors is also vital to sustainable economic growth. The Nobel laureate Paul Krugman, in his theory of New Economic Geography 47, has stressed the importance of the growth and development of clusters and key sectors in developing networks, enhancing economies of scale, creating spill-overs and ultimately boosting economic growth. Once again, government policy has an important role to play in ensuring that regions and countries are well placed to take advantage of such opportunities.

5.21 Under the current framework, the Scottish Government has extensive but not complete responsibility for a number of key elements of supply-side economic policy, including education, skills and infrastructure, which are believed to be important determinants of competitiveness and long-term economic growth. The Government Economic Strategy sets out how the Government intends to use these levers to boost Scotland's economic growth. Already a number of policies have been put in place such as the Small Business Bonus Scheme and the abolition of tolls on the Forth and Tay Road Bridges. However, responsibility for a number of critical elements of policy which determine Scotland's competitiveness, such as establishing the competition, regulatory and business tax environment, remain reserved to the UK Government.

5.22 Assigned revenues, where the Scottish Government would simply be allocated UK taxes raised in Scotland, would offer no opportunities to enhance Scotland's competitive advantage. The actual levers of competitiveness, that is the ability to change tax and economic policy, would remain reserved.

5.23 Enhanced devolution would, at the margin, increase the range of policy options available to boost Scotland's competitive advantage, provided that any revised fiscal settlement involved an element of real policy autonomy of important taxes and key areas of economic policy. However, this is not guaranteed and key elements of competitiveness could well remain reserved to the UK Government. For example, the UK Government has, despite widespread support, chosen to reject recommendations to lower the rate of corporation tax in Northern Ireland to a level that is comparable with that levied in the Republic of Ireland 48.

5.24 Devolution max and independence would increase the policy opportunities available to the Scottish Government. Both would allow fiscal policies to be set more efficiently by building on any strengths and addressing any weaknesses in the Scottish economy. Opportunities to improve competitiveness would therefore be greater.

5.25 However, short of full independence there may well be constraints in the ability to set a tax structure that differed significantly from that of the rest of the UK. With devolution max, policy opportunities and choices would be subject to constraints. For example, in Spain the 'economic agreement' between the Basque Country and Madrid contains a number of general principles which the Basque Country must adhere to, which are designed to ensure a degree of harmonisation between the Basque tax system and that in the rest of Spain. In addition, monetary policy would continue to be set at the UK level.

5.26 Once again, we believe that only independence would offer the Scottish Government the widest set of fiscal and economic policy levers to enhance Scotland's competitive edge and deliver increased and sustainable economic growth. Enhancing Scotland's competitive advantage would be the responsibility of the Scottish Parliament and Scottish Government, and policies and strategies could be tailored to grow the Scottish economy. In this scenario, Scotland would also have the opportunity to contribute to the shaping of policy at the European level as an independent member of the EU. Scotland would also be free to choose an appropriate framework for monetary policy within the wider context of a revised economic strategy for Scotland.

Efficient delivery of public services

5.27 In addition to dictating the range of policy options available to decision makers, economic theory predicts that the fiscal framework also determines the environment in which policy is set and the efficiency with which it is delivered.

5.28 A key principle for efficient policy delivery is the belief that economically rational decisions are more likely to be adopted when decision-makers are required to balance the marginal benefits of particular spending decisions with their respective marginal costs, and vice versa. The creation of a 'hard' budget constraint is essential in ensuring efficient delivery of public services by making policy makers responsible for balancing the benefits and costs.

5.29 Furthermore, it has been argued that greater devolution can lead to further efficiencies in policy setting by encouraging competition between governments - Brennan and Buchannan (1980) 49. 'Competitive federalism' whereby governments compete with one another for outside investment, business and jobs can lead to more efficient policy delivery and policy innovations. Taking an example from another policy area, the introduction of the Smoking Ban in Scotland has been adopted elsewhere in the UK - a clear example of a successful policy innovation which has led to benefits not just in Scotland but elsewhere. With greater autonomy, this principle could be extended into areas of economic and tax policy and there are examples of US states clearly competing with each other for business, by capitalising on their particular strengths and trying to create the most attractive environments for both indigenous and outside businesses.

5.30 Some economists have stated that too much competition between governments may create issues for efficient delivery of public services. If under greater fiscal autonomy policies set in Scotland and other parts of the UK (or even other EU countries) diverged significantly, then coordination and dialogue through shared institutions, such as the Joint Ministerial Committee, may be appropriate.

5.31 It has also been claimed that where regulations, tax rates and subsidies differed between Scotland and the UK, this may have implications for efficiency, for example by limiting opportunities to take advantage of economies of scale arising from centralised service provision. However, on the other hand, a heavily centralised administration of fiscal policy may itself carry significant costs and decentralised systems may be more efficient.

5.32 Examples from Ireland suggest that government services can be provided more efficiently than in the UK, when factors such as the high costs in London are taken into account. It is also important to bear in mind that Scotland already pays a full share of the running costs of UK-wide Departments which operate in Westminster. Under greater fiscal autonomy the Scottish Parliament would have greater authority and influence over how these resources were spent.

5.33 A new system of tax administration may impose adjustment costs on firms and individuals as they undertake business in a new tax environment. However, one reform that could be taken under greater devolution would be to move toward a more simplified tax system. The UK system, particularly for business taxation, is regarded by some as complex and administratively burdensome - CBI (2008) 50. In contrast, a joint study by PWC and the World Bank conducted in 2009 noted that Ireland was one of the highest ranked countries for ease of paying business taxes 51. This serves to further enhance its competitiveness and attractiveness as a place for conducting business. An absolute priority in undertaking relevant procedures for tax administration in a more fiscally autonomous Scotland would be to minimise the costs involved.

5.34 Under the current framework, a balance has to be struck when making decisions on the appropriate policy mix ( i.e. increases in a particular element of spending have to be financed by cuts elsewhere). This provides a 'hard' budget constraint for spending but the Scottish Parliament has no real authority to determine the overall size of the budget in Scotland. For example, full use of the SVR is estimated to raise approximately £1.2 billion in 2009/10 relative to a budget of over £30 billion. Instead, the amount available to be spent on public services in Scotland is determined principally by changes in spending in England and relevant Barnett 'consequentials' and is not necessarily set at a level that maximises efficiency. There is little incentive to spend less than that determined by the block grant and few opportunities to spend more.

Assigned revenues, whereby the Scottish Government would have no authority to increase the level of tax raised, would be unlikely to provide any material change in the incentives for efficient policy delivery as changes in devolved spending would not be directly comparable with costs in terms of increased (or decreased) tax rates. Furthermore, opportunities for the Scottish Government to put in place innovative competitive policies would be prevented.

5.35 Enhanced devolution would, at the margin, increase the efficiency of the funding settlement provided that choices could be made between increased or decreased spending and higher or lower taxes. Devolution of particular taxes by offering limited opportunities to vary the level of spending, would provide an improvement in this regard - benefits of spending decisions on devolved policies could be directly linked to additional costs (or reductions) in devolved taxes. By design however, as the full range of policies and choices would not be devolved, the overall scope to deliver maximum efficiencies and innovative policies would be constrained.

5.36 Devolution max would have the potential to raise efficiency by providing a 'hard budget' constraint for devolved spending and revenues. This would also enable the Scottish Government to put forward innovative policies that were different to those set across the rest of the UK. Where administrative responsibilities for raising and collecting all government revenues were also devolved, this would create opportunities to put in place a simplified and more efficient collection regime. However, there may be the potential for overlap between devolved and reserved policies which act as constraints on the Scottish Government's ability to deliver real change. In addition, other elements of economic policy may remain reserved even under full fiscal autonomy.

5.37 We believe that only independence would provide the greatest degree of efficiency in policy setting in the light of specific preferences and needs for Scotland. Under independence, policy choices would have clear and identifiable implications for revenues (and/or borrowing requirements) and would encourage maximum rigour in the budget process. Policymakers would face maximum incentives to set policy efficiently. A more efficient system of tax administration and public service delivery which we believe would have the potential to more than compensate for any costs of transition. Furthermore, the transfer out of centralised administration in Whitehall to Scotland would also have direct economic effects with the potential creation of jobs and wider economic spill-over effects. This would include the establishment of a capital city of a full member of the European Union together with the increase in international exposure and recognition that this would bring.

Greater Accountability and Transparency

Greater Accountability and Transparency - Accountability and transparency are vital in ensuring public support and trust in the political system and incentivising best practice, better governance and policy actions. Changes to the fiscal framework should enhance accountability and transparency and create incentives for delivering best practice.

5.38 Accountability and transparency are vital in providing the appropriate incentives for decision makers to set policy to maximise economic growth. MacDonald and Hallwood (2006) 52 state, "with deficient incentives political decision-makers are unlikely to strive to increase efficiency in the provision of public provided goods, or to try to get the right balance between provision of goods and services by the public and private sectors, not to promote economic growth".

5.39 It has been argued that a system of 100% grant finance provides limited incentives to boost growth as the tax and revenue benefits of greater growth will flow to the central government and not to the local level leading to less efficient governance 53. Greater fiscal autonomy in terms of revenue and borrowing can create a stronger link between the benefits of growth and revenues, improving the incentives for efficient policy making.

5.40 A system that encourages accountability and transparency also ensures that citizens are fully engaged in the democracy and governance of their country. This can have important benefits not just for the economy and the delivery of good policy, but also in terms of social capital. Benefits of social capital include general improvements in the political process (such as monitoring), improved links between community groups and between community groups and the government (De Mello (2000)) 54.

Accountability

5.41 It is generally accepted that full accountability can only be achieved when decision makers face tough choices on both spending and revenue and are responsible for the performance of the economy and/or delivery of public services.

5.42 Under the current framework, the Scottish Government is responsible for providing a significant amount of the public goods and services for the benefit of Scotland. However, the UK Government also provides a significant amount of spending for Scotland on important services, e.g. international development, defence, social security and broadcasting. Some of the direct economic benefit arising from the provision of such services by the UK Government is likely to be lower than Scotland's population share. For example, a number of UK Government departments providing services across the UK are concentrated in Whitehall which brings with it considerable economic benefit, such as jobs and wider spill-over effects, to London and the South East of England. Furthermore, the UK Government retains a considerable degree of de-facto autonomy over the Scottish Budget through the Barnett Formula and the application of funding rules and guidelines. Overall, accountability for the wider performance of the economy and public sector in Scotland is therefore somewhat blurred by the two-tier nature of the current arrangements. This can lead to a lack of clarity over policy and/or policy outcomes. Short of independence, this issue would continue to arise.

5.43 Arguably of more importance is that within the current framework, accountability is limited to the allocation of public spending and not to the level of revenue raised in Scotland. By spending, but not directly raising its own revenue, the accountability of the Scottish Parliament has been challenged. Approximately 85% of the Scottish Government's Budget is financed by a block grant. In contrast, sub-central governments in the USA, Canada, Switzerland, Germany and the Scandinavian countries are responsible for raising between 50% and 60% of their own revenues 55.

5.44 Any attempt to increase the link between tax revenues raised in Scotland and the annual Scottish Budget should, in theory, increase the degree of accountability and sharpen the incentives for policy makers when setting policy.

5.45 In this regard, assigned revenues and enhanced devolution may arguably increase incentives for efficient policy delivery, particularly with regard to economic growth, as decisions made on devolved policies would have direct implications for the amount of revenue raised in Scotland. However, a number of key policy choices would remain reserved and would continue to have a direct impact on the size of the devolved budget. In this regard, the Scottish Government and to a lesser extent local authorities, may be held accountable for changes in policy which are the result not of direct policy decisions in Scotland, but changes at the UK level 56. This lack of clarity would continue to have implications for accountability.

5.46 For example, under assigned revenues the recent decision by the UK Government to temporarily reduce the VAT rate would have immediate implications for the level of revenue raised in Scotland. Without borrowing powers, and without the UK Government taking into consideration the wider implications of such policy announcements, this would translate into an unanticipated cut in the Scottish Budget with immediate implications for the delivery of public services. Assigned revenues may at first glance appear to lead to improvements in accountability but when considered more fully, such effects appear limited and may in certain instances lead to a system which damages accountability.

5.47 Incentives and accountability would clearly be high, but not optimal under devolution max. Constraints on the freedom to set policies and in the need to pay for UK-wide 'shared services' which may or may not be in the best interests of Scotland, may limit accountability.

5.48 Independence where policy makers would be fully responsible for all policy setting and outcomes in Scotland would create a framework of maximum accountability.

Transparency

5.49 Transparency is vital to ensuring that the fiscal framework operates efficiently and makes it easier for decision makers to be held accountable. A key motivation behind the process of greater decentralisation across the world in recent years has been the desire to bring government closer to the people and improve transparency 57.

5.50 The current framework is designed to be simple and transparent. However, as highlighted in Chapter 3, the limited public understanding of the Barnett Formula and instances of 'formula bypass', coupled with apparent spending differences across regions of the UK, appear to have tarnished the transparency of the system.

5.51 A fiscal framework short of independence may increase or decrease the degree of transparency relative to the current framework but it would depend upon the design. There is scope for simplicity, but also a risk that arrangements may seem opaque, particularly in any remaining funding arrangements with the UK. A complex system of enhanced devolution and/or assigned revenues, with a mix of devolved taxes, tax assignment, tax sharing, grant finance and reserved taxes could limit transparency.

5.52 Transparency would be more obvious under devolution max than the current framework or indeed enhanced devolution as there would be clarity over roles and responsibilities of both the Scottish and UK Parliaments. However, to the extent that certain areas of economic policy remained centralised at the UK level and continued to have implications for the conduct of fiscal policy in a fiscally autonomous Scotland, this may impinge on overall transparency. Furthermore, the need for a financial mechanism to allow payments to be made from Scotland to the UK Government for 'national public goods' such as defence and foreign policy may require a complex set of rules and regulations.

5.53 We believe that i ndependence would be the most transparent option as there would be clarity between revenues, spending outcomes and economic performance. Responsibility for taking forward Scotland would rest entirely with decision makers in Scotland and there would be maximum clarity over roles and responsibilities.

Sustainability

Sustainability- Changes to the fiscal framework should show the cost effectiveness of the funding mechanism and at the same time ensure sustainability of spending levels both in the short and long-term.

5.54 There are three critical elements to be considered in relation to sustainability:

  • macroeconomic stability;
  • budgetary stability; and
  • affordability.

Macroeconomic stability

5.55 The ability to respond flexibly to changing economic needs and circumstances is important in determining the ability of a country to stabilise its economy in the short-term as well as protecting long-term sustainability 58.

5.56 This is especially important during periods of economic uncertainty. The ability to respond swiftly and decisively to short-term economic pressures and challenges is vital to minimise negative shocks to growth, jobs and investment, and enable a stronger, faster recovery. As highlighted above, a distinct advantage of greater fiscal autonomy is that policies can be set to address the unique challenges of a particular locality. A 'one-size-fits-all' fiscal policy strategy by definition is unable to do this. Under greater decentralisation, action may be required to ensure that policies set at the sub-central level do not conflict either with each other or with central government efforts to stabilise the economy. This may point toward the creation of joint institutions which could coordinate certain aspects of policy and agreement on possible fiscal rules.

5.57 As recent events have demonstrated the economy is always exposed to a level of macroeconomic variability. The Scottish Government believes that what is important for Scotland to consider is who is best placed to meet such challenges - the Scottish Government with the full range of levers focussed entirely on what is best for the Scottish people and Scottish economy or the UK Government with a 'one size fits all' policy for the entire UK. All other independent countries are currently taking action to address the consequences of the downturn and putting in place policies and new economic frameworks that will ensure that they are best placed to take advantage of new opportunities that will arise when the world economy recovers.

5.58 Under the current framework, responsibility for macroeconomic stability rests almost entirely with the UK Government. Although in some instances pooling of risk can be an advantage, a centralised stabilisation policy limits the flexibility of public policy in Scotland to respond at a distinctive Scottish level to changes in the macroeconomic climate or to respond to particular expenditure pressures. The Scottish Government currently has no borrowing authority to provide a stimulus to investment, jobs and output in the light of declining demand; a position that the Scottish Government believes puts Scotland at a distinct disadvantage relative to other countries. More generally, macroeconomic policy solely focussed on what is best for the people of Scotland may quite conceivably take a different path to that taken at the aggregate UK level.

5.59 Assigned revenues would expose Scotland to the maximum degree of risk and in many ways this may be worse than the current framework. Annual budgets would be subject to volatility from changes in the economy, but without the additional devolution of levers over tax and spending choices or borrowing autonomy, the Scottish Government would be largely powerless to respond to changes in economic circumstance. In fact, in an economic downturn, and in light of falling tax revenues, a future Scottish Government may face the impossible situation of having to cut expenditure programmes to balance the annual budget at the exact time when a fiscal stimulus is required.

5.60 In theory, enhanced devolution and devolution max could offer a balance between flexibility, possibly through greater borrowing powers, and UK pooling of risk for example through retention of a UK-wide social security system. However, Scotland would remain wedded to other UK policy choices which may not support stability. The failure of the UK Government to invest for example a proportion of oil revenues for the long-term highlights the obvious limitations on the UK fulfilling this role. There would also be an opportunity to establish a revised framework for ensuring fiscal discipline such as an Internal Stability and Growth Pact. These however are also issues that in theory could be addressed through EU-wide initiatives, such as existing EU regional policy, or in specific partnership arrangements post independence.

5.61 With independence the Scottish Parliament would have the full authority and flexibility to put in place the optimal choice of macroeconomic policies to ensure stability, including borrowing. Responsibility for management of any net borrowing and national debt would lie with the Scottish Government. As highlighted above, a number of resource rich countries and regions within countries have established oil funds to assist in stabilising their economies, or to underpin long-term social provision. An oil fund for Scotland could be used in a similar manner. We believe that this would significantly enhance the economic protection currently available to the people of Scotland.

Budgetary Stability

5.62 At present, through the Barnett Formula and the setting of three-year spending plans, the current framework provides predictability for the devolved Scottish Budget. In practice however, this is not always the case - as the proposed reduction in future Scottish Government Budgets announced without prior consultation by the Chancellor at the UKPBR has demonstrated. End-year flexibility allows resources to be carried over from one year to the next (and into future spending review periods), but this is also subject to HM Treasury restrictions. Furthermore, in recent years there have been a number of instances where there has been 'formula bypass' where money that we believe should have been allocated to Scotland has been withheld - for example expenditure on prisons in England. Overall, this means that there is in fact a degree of risk and uncertainty in the Scottish Government budget position, despite the theoretical predictability implied by the Barnett Formula.

5.63 Assigned revenues would bring significant instability into the Scottish Budget with little or no opportunity to respond and this would carry maximum risk in both the short and long-term. It is inconceivable that some form of stabilisation mechanism, such as a stabilisation grant or borrowing powers would not have to be put in place to mitigate these risks. How such a mechanism was established and who controlled its operation could have significant implications not just for the delivery of public services, but also for the accountability and transparency of the overall framework.

5.64 As with the issue of macroeconomic stability, any form of 'real' increase in revenue decentralisation, such as devolution max or independence, would require greater responsibility for managing both the revenue and expenditure side of the public sector budget in Scotland.

5.65 The Scottish Government believes that these matters would be managed best in a way that is acceptable to the Scottish people rather than at a UK level. With either devolution max or independence, the Scottish Government would have responsibility for raising its own revenues and making choices on delivery of policy. As we believe that this responsibility rests best with the Scottish people and the Scottish Parliament, we believe that the clear lines of responsibility and budgetary control afforded by independence is therefore the best option.

Affordability

5.66 Any re-designed fiscal framework needs to be affordable.

5.67 The relative fiscal strength of a country raises important considerations as to the best design of policy making and fiscal framework. On the one hand, a centralised system can allow for transfers from more prosperous parts of a fiscal union to relatively poorer ones. However, this transfer of resources can lock less well-off areas into permanently lower levels of growth. Long-term economic development cannot be achieved on "a sustainable basis by transfers and redistribution" 59. A better outcome could be achieved if such a region was given the economic and fiscal tools to target policy to address the strengths and weaknesses in their locality and to become more competitive. Over the medium to long-term, this should serve to enhance affordability. For example, in the 1980s, Ireland was one of the poorest members of the EU, but the setting of a range of policies such as significant investment in infrastructure and education and skills, has led to GDP per capita levels which, even taking into consideration current economic challenges, are amongst the highest in the world. Similarly, better-off regions would also be able to take advantage of the opportunities that autonomy brings to build upon and develop their current strengths.

5.68 There has been considerable debate about Scotland's fiscal position under alternative fiscal structures. The most recent GERS report shows that, taking the current fiscal and constitutional framework as given, Scotland had a current budget surplus of £0.8 billion in 2006/07 when a geographical share of North Sea revenues is taken into consideration. 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 revenues is included. The equivalent UK position including 100% of all North Sea revenues, referred to as 'net borrowing', was a deficit of £30.1 billion (or 2.3% of GDP) 60. Other large OECD countries also operated deficits in 2007: France a deficit of 2.7%, Japan a deficit of 2.4% and the USA a deficit 2.9% of GDP61. As GERS takes the current constitutional and fiscal framework as given, care should be taken in using these figures when attempting to forecast Scotland's fiscal position under alternative fiscal frameworks. The value would depend largely on the policy choices of the government of the day, the economic climate and any settlement of UK assets and liabilities.

5.69 Scotland already pays for UK-wide services such as social security and defence. Independence would mean that these expenditures would be handled by the Scottish Parliament rather than by the UK Parliament. This would also allow for different policy choices, where, for example, the Scottish Parliament would have the opportunity to choose not to spend money on nuclear weapons but could instead divert this spending to support the Scottish economy and adopt different policies in other currently reserved areas such as pensions and support for families.

5.70 The greater the level of autonomy offered to the Scottish Parliament, the greater the need for allocation of UK assets and liabilities to Scotland and the rest of the UK. This would include a possible share of UK national debt, other liabilities such as public sector pensions, but also assets such as a geographical share of North Sea revenues and a fair and equitable share of public sector assets such as UK Government buildings.

5.71 Under the current framework, the amount of expenditure in Scotland is determined by the Barnett Formula and relevant UK Government expenditures in Scotland such as social security payments. Affordability of public services for Scotland to a large extent is therefore driven by affordability of the UK public finances. Scotland's level of public spending reflects elements such as additional costs of providing public services over more sparsely populated areas and differences in the structure of the public and private sectors in Scotland compared to the rest of the UK62.

5.72 Going forward, the UK fiscal position is forecast to deteriorate significantly. Net borrowing is not forecast to return to surplus until 2015/16 at the earliest, resulting in UK Government net debt reaching over £1 trillion in 2012/13 63. The IFS estimates that it may take over twenty years for net debt to return to pre-crisis levels 64. This is expected to put significant constraints on public expenditure over the medium term in Scotland and the UK.

5.73 With assigned revenues and enhanced devolution, short of the transfer of the vast majority of revenues to the Scottish Government, some form of grant mechanism would be required to ensure that the overall budget was sufficient to meet the requirements for financing devolved spending, given that the UK would retain a significant proportion of Scottish revenues.

5.74 The affordability of the funding arrangement over the long-term would arguably be of greatest importance for devolution max and independence. With independence, and to a lesser extent devolution max, responsibility for delivery of sound public finances and a robust economic framework over the short and long-term would be the responsibility of the Scottish Government.

5.75 Under devolution max, a payment would be required to be made to the UK Government for delivery of UK national public goods. How this mechanism actually worked in practice would be subject to negotiation at the time of any revised settlement.

5.76 The Scottish Government believes that independence would be the optimal environment for greater prosperity. The Scottish Government would commit to set out a clear and detailed budgetary and administration package to govern the transition to independence. Ultimately, the fiscal and economic success of Scotland under independence would depend upon the policy choices of the government and economic performance over the long-term.

Conclusion

5.77 This chapter has explored the options for reform and reviewed them against a number of key criteria to see how effective each option would be in achieving the aim of increasing sustainable economic growth and enable Scotland as a whole to realise its full potential.

5.78 The concluding chapter summarises our review of the options for reform and sets out a way ahead for Scotland through the National Conversation.