Our evidence is based on the proposals made by the UK Government to change the manner in which the devolved administration is funded as set out in the Command Paper ‘Strengthening Scotland’s Future’. In our evidence we do not comment on the merits of the UK Government’s proposals for financing devolved spending in comparison to alternative proposals which have been made, including proposals that we ourselves have put forward.[1] Rather we focus our attention solely on the potential economic consequences of the proposal which the UK Government has brought forward.
The stated aim of the financial proposals within the Scotland Bill is to enhance the financial accountability of the Parliament for the revenues that it spends annually via the devolved Scottish budget. To a minor extent this will happen, but as we demonstrate below any benefits arising from this source will be swamped by the wider costs that the new funding regime is likely to impose on the Scottish economy. This is because the new funding arrangements will both result in a deflationary bias being introduced to the Scottish budget and lead to a pro-cyclical dynamic instability of increasing size to public spending undertaken by the Scottish Government. Accordingly, in terms of the consequences for the Scottish economy, the prospective funding arrangements are far from neutral – a matter that, in our view, has not been addressed by advocates of the new funding regime or indeed by the UK Government.
The adverse economic consequences of the proposed funding model become all the more problematic because the Bill fails to provide for the transfer of any additional economic levers to the Scottish Government which it otherwise could utilise to improve the overall rate of economic growth (e.g. competence to improve competitiveness, corporation tax, labour market policies, etc.). As we discuss below, this in our view is the single greatest defect in the Scotland Bill, particularly given the considerable economic challenges that face Scotland at present. Indeed rather than enhancing the capacity of the Government to address these problems, we suggest that it will be unwise to use the new power over income tax (along with the two minor taxes) to try and influence the growth performance of the economy. Not only is income tax, when used in isolation from other taxes, an outstandingly ineffective lever to affect the rate of economic growth. In addition – as we have previously argued and as recently demonstrated by Jim and Margaret Cuthbert – it is quite possible that a reduction in income tax could lead to a loss of income tax revenue to the Scottish budget.[2] Consequently it is entirely misleading to assert – as some have done – that the new funding mechanism will offer an incentive for a Scottish Government to better promote economic growth.[3]
If there is no economic incentive to use the new tax, because to lower rates is likely to reduce revenues and spending to support the economy, and to raise them is to increase costs and wage demands, one must question the judgement of those who propose it. At the very least, it is an extremely expensive way in terms of lost economic performance to create a marginal increase in accountability and no increase in responsibility
As we explain below, under the provisions of this Bill a Scottish Government will be required to operate with a funding mechanism that has an in-built deflationary bias and which will, as a consequence, require the Government to introduce measures that weaken the economic growth prospects for the economy. Added to this, we consider that Scotland’s employment base on which income tax receipts depends is especially vulnerable to the on-going deflationary macroeconomic policies being pursued by the current UK Government. Consequently the (Scottish) employment base on which the new Scottish income tax ultimately will be levied (i.e. by 2016) is likely at best to grow only slowly in the coming years – indeed it may well decline as will Scotland’s income tax revenues. Either factor alone is sufficient to render the proposed funding mechanism an inappropriate means of financing a devolved government in Scotland. When combined – as they will be by the middle of the current decade – the impact is likely to result in public spending cuts in Scotland that are not matched elsewhere in the UK. This will impart further lasting damage to the Scottish economy, not to mention the extra pressures it would create to separate from the rest of the UK.
The analysis we present in this paper is exclusively economic. It is surprising to us that the various UK Government documents published alongside the Scotland Bill made available fail to include any analysis of the possible economic consequences of the proposed funding regime. At best what is provided is a financial (in the narrow accounting sense) assessment of the proposals, but no analysis whatsoever of the economic consequences to which the new regime will give rise. This is all the more surprising insofar as these likely negative economic consequences have been identified, analysed and (as far as data permits) quantified repeatedly by us, and many others, since the Calman Commission first mooted such a funding regime back in 2009. It is almost inconceivable that advocates of the prospective funding regime fail to recognise that it will have consequences for the wider Scottish economy. And these consequences will result even if the income tax powers proposed in the Bill are never used.
In our view it is essential that the Scottish Parliament’s Committee recognises that the new financial arrangements will have significant economic ramifications which are likely to be negative – at least as far as Scotland’s economy is concerned. There is a danger that the economic risks associated with the proposed funding regime will be ignored on the basis of the assurances of “no detriment” in the Command Paper which makes no comment about the economic dimension to the proposals.[4]
1. The Economic Implications of the Proposed Funding Mechanism
The proposals for amending the current “full Barnett” arrangements for financing Scotland’s budget with a “partial Barnett” scheme in which a part of the block grant will be replaced with revenues raised from the application of Scotland’s new income tax have been well publicised. The aim of the new arrangement is to increase the financial accountability of the Scottish Parliament. Our calculations imply that, at best, the tax devolution proposals will result in a meagre 15% increase in the financial accountability – an increase that is very unlikely to significantly affect Scotland’s economic performance.
In our view this increase in financial accountability will be achieved at potentially significant cost to the Scottish economy. But it is not clear that advocates of the new regime have understood its full economic ramifications. Before addressing the specific questions on which the Committee has invited comment, we provide an economic analysis of the proposed funding arrangements.
Once the new funding mechanism has been introduced, the revenue accruing to the devolved administration will depend on two distinct financial flows. The first, from which the lion’s share of funding will derive, will be a reduced block grant from UK Government annually adjusted by the Barnett formula. The reduction in the block grant implies a loss of revenue to the Scottish Government to match the introduction of the new Scottish rate of income tax (levied at 10p), the revenues from which will accrue directly to the devolved administration. The second financial flow is the annual yield from the application of the new Scottish income tax, the rate of which will initially be set at 10p (and applicable to all tax bands) but which can be adjusted upwards or downwards as the Scottish Parliament decrees.
The rate at which the funds available to the Scottish budget grow annually will henceforth be determined by (i) the rate of growth of the Barnett consequential – this being determined by UK Government – and (ii) the rate of growth of the yield from Scottish income tax – this being determined by the rate of growth of the Scottish income tax base multiplied by the rate at which Scottish income tax is levied. From the date of the switch-over to the new arrangements, the trajectory of the total funding available to the devolved administration will therefore be different from that which otherwise would have occurred (under the “full Barnett” model).
A key question in the proposed funding model is whether it will result in Scotland receiving more or less funding than would have been the case under the “full Barnett” regime. If the new regime offers more funding, then Scotland’s public spending can increase faster than otherwise, or the Scottish Parliament can lower the rate of Scottish income tax without reducing public services. If funding is less, public spending will be lower than otherwise or the Scottish rate of income tax will need to be increased to maintain public services; or spending will have to be cut.
If the new regime is to provide at least as much funding to the Scottish budget as the current regime without any increase in the level of Scottish taxes, the rate of growth of the new tax revenue component has to be at least equal to the rate of growth of the Barnett consequential “block” that it has replaced.
It is, of course, impossible to forecast either of these elements as the new regime seems unlikely to be fully operational before 2018. We have no idea what the growth of UK public spending (for the grant element) and the growth of incomes (for the tax element) will be that far ahead. However we can look at what would have happened to the Scottish budget had the prospective funding regime been in place from 1999-00 when devolution was introduced.
Recent data provided by the Scottish Government assesses the impact on the total Scottish DEL had the proposed funding regime been in place over the period 1999-00 to 2010-11. In that event, there would have been an accumulated shortfall of almost £8 bn compared to what occurred under the current “full Barnett” model. This is a measure of the inherent deflationary bias of the proposed funding model, and reflects the fact that the rate of growth of UK public spending has exceeded the rate of growth of Scotland’s income tax revenues – as would be expected insofar as income tax is only one element of the total basket of taxes that underpin UK public spending trends.[5]
This critique is open to the obvious challenge that while we can say what would have happened had the proposed regime been in place during previous years, we cannot know how each element of the new funding regime will evolve in the future. As we have already noted, if the income tax component grows faster than the Barnett consequential component it replaces the overall Scottish budget will be higher than otherwise. But not forever. While the empirical record provides no support for this proposition, the sheer scale of the public spending cuts that are to be implemented over the course of the current spending review period could lead to such a situation arising during the current spending review period.[6] In fact any such outcome must necessarily be both temporary and to lead to further downward pressure on Scotland’s budget as employment levels decline.[7]
We note from previous evidence to the Committee that some debate has revolved around the impact that the initial adjustment to the budget would have on the scale of any deflationary bias of the new regime. As the Command Paper notes, the basis for calculating this initial adjustment has not been determined although it is clear that it will be based on an average of the Scottish income tax yield over a number of years. In itself this is desirable, although it has to be stressed that this will have no direct impact on the rate of change of the two revenue streams that finance the Scottish budget thereafter. In other words the deflationary bias we identify cannot be removed by the initial adjustment, although they will influence the size of the bias over the next few years.[8] This is simply because the higher is the share of income tax in the budget in the first year the greater will be the weight that the rate of growth of Scottish income tax revenues will play in determining the annual growth of the Scottish budget thereafter (and the less the weight attaching to the annual growth of the Barnett consequential). Conversely the lower the initial income tax share then the lesser the weight attached to this revenue stream going forward. Therefore if one believes Scotland’s income tax revenues will grow faster than the Barnett consequential, then all else being equal one will want the initial tax share to be as high as possible. The opposite is the case if one expects the rate of growth of the Barnett consequential to exceed that of Scotland’s income tax revenue (as it has done in the past).
2. Forecasting and Reconciling Scotland’s Income Tax Revenues: Non-Capital Borrowing
An obvious defect in the original Calman proposals was to propose that current spending by the Scottish Government should be based on current tax receipts. This has been corrected by the proposals in the Bill that an amount equal to the forecast yield of Scottish income tax would be assigned to the devolved administration for each year in the spending review period. This, it is stated, will ensure that “…the Scottish Government is protected from unexpected economic shocks which would require a revision to their Spending Review spending plans”.[9] However as we explain below, because of the manner in which forecast and actual income tax receipts are to be reconciled, the Scottish Government will enjoy only very limited protection against such a contingency. In most cases, revisions to spending plans will be needed.
The Bill provides for a rolling financial reconciliation between forecast and actual (outturn) receipts from the Scotland’s income tax “…no later than 12 months after the end of the financial year…”[10] in question. Where the outturn exceeds the forecast an amount will be transferred to the Scottish Government which may be spent or retained; where the outturn is less than forecast an amount will be deducted from the Scottish Government which may be financed from “reserves” or by borrowing.[11] To finance such a repayment Scottish Ministers will be allowed to borrow up to £200 million in any one year subject to an overall ceiling of £500 million of outstanding debt. The presumption (although this is not stated in the Command Paper) is that any amounts in excess of these limits must be financed by an immediate reduction in public spending.
Based on the latest estimate available for Scottish income tax receipts as shown in table 1, the proposed annual borrowing facility of £200 million represents less than 5% of the prospective (income tax) revenue stream. This means that should the OBR over-estimate Scotland’s income tax revenues by more than 5% in any one year, the borrowing facility alone will be inadequate to finance the reconciliation that will be required from the following year’s budget. Moreover this borrowing facility will also be required to make good any temporary mismatch in tax and spending financed by land transaction and landfill taxes. No information is provided on how either the annual borrowing limit of £200 million or the overall borrowing ceiling of £500 million were calculated, nor why these limits are deemed appropriate.
To put this in perspective, borrowing is only possible against forecast errors. Over the decade before the current recession, 1997-2007, the UK governments track record for income tax receipts is one of forecast errors that range between +7% to -4%, with an average of +1.1%. Since borrowing will follow overestimates, this means the Scottish Government will need to cut spending or borrow on average every year and should expect to exhaust its borrowing limit several times in a decade. Finally, no borrowing power is provided if the revenue loss is due to (fully anticipated) bad economic shocks rather than poor forecasts. The current recession, for example, would according to calculations on the Scotland Office website have cut the Scottish budget by £748m and £559m in 2008 and 2009 respectively, sums that are beyond the borrowing ceiling let alone the annual limit of £200m. But no borrowing would be allowed in such cases. Or, to put the point another way, given that there is a cycle and that adverse shocks do occur, the more accurate the tax forecasts the more volatile Scottish revenues will become and the more the Scottish government will be obliged to cut spending and social support in a downturn. This is why we say the Bill’s borrowing provisions offer only limited protection against forecast errors and none at all against unexpected economic shocks.
In such a scenario public spending in Scotland has to move pro-cyclically and consequently will simply worsen the severity of the initial economic shock, thereby adding to unemployment and lost output and delaying any subsequent economic upturn.[12]
How might this deficiency in the proposed funding arrangements be resolved? One solution may be to raise the borrowing ceilings that are to be permitted to finance current spending. And doubtless that is one possibility. In our view, however, three alternative solutions are more appropriate. The first is to increase the overall economic policy levers available to the Scottish Government through a comprehensive devolution of responsibility for fiscal policy. That would permit a Scottish Government to implement those fiscal measures necessary to address the economic circumstances it faces – including unexpected country specific shocks. A second solution is to increase the numbers of taxes over which the Scottish Government has authority. This would essentially diversify the risks attached to having a disproportionately large share of revenues being dependent on just one tax base – namely income. Devolving competence over additional taxes that are not as vulnerable to the economic cycle as is income tax will reduce the risk that Scotland’s Government would be forced to follow a pro-cyclical spending policy in the face of adverse shocks. Third the Scottish Government should be given the right to raise additional finance by issuing its own bonds – a solution that is applied across a wide range of federal fiscal systems elsewhere. (Denmark and South Korea are the only countries in the OECD area not to allow such borrowing). This solution overcomes both the adverse fiscal consequences of the borrowing ceilings as proposed, and the extremely short repayment period (of 4 years) in which borrowing has to be repaid – a requirement that does not apply to any other local authority borrowing in the UK.
Our conclusion is that the provision for non-capital borrowing as proposed is both woefully inadequate and, in economic terms, fundamentally flawed. We recommend that the Committee seeks to amend these provisions by (i) extending and diversifying the tax base from which revenue to the Scottish Government accrues, and (ii) thoroughly reforming the non-capital borrowing provisions in the Bill and including a right for the Scottish Government to raise additional funds through issuing Scottish bonds.
3. Responses to specific questions asked by the Committee
1) The aims of the Scotland Bill and the White Paper (Strengthening Scotland’s Future) are that it will ―enhance the financial accountability of the Parliament and Government in Scotland, improve working arrangements between Westminster and Holyrood Parliaments and Governments, and extend the powers and functions of the Scottish Parliament and the Scottish Government.― In your view, do the proposals in the Bill and the White Paper achieve these purposes?
As noted earlier, the proposed funding arrangements will produce a minor increase in financial accountability of the Parliament and Government in Scotland but at a significant cost in terms of the wider adverse economic effects (in terms of growth and employment) to which it will give rise. The Scotland Office asserts that the impact of the Bill will be to increase to 35% the share of Scottish Parliament spending accounted for by taxes devolved to Scotland.[13] We have been unable to reproduce this result on the basis of the Scotland Office estimates of Scotland’s tax receipts in any of the years for which such estimates have been provided (e.g. the £4.6bn tax for 2007-08 represented just over 15% of the Scottish DEL in that year).
Nonetheless the presumption is that increased financial accountability will result in improved efficiency in Scotland’s public spending. While not contesting the a priori validity of this proposition, it is worth noting there is no firm evidence demonstrating the strength of this effect unconditionally. Indeed it is hard to imagine how an improved economic performance can be created without allocating some policy levers to the Scottish Parliament. But none have been granted. Moreover, as discussed above any efficiency gains arising from this very modest increase in financial accountability have to be offset against the consequential adverse economic consequences we presented above.
We also suggest that the new regime is bound to lead to recurring conflict over finances between the Scottish and UK Governments. The reliance on forecast tax yield is an obvious possible source of dispute for two reasons.[14]
The first is possible disagreement over the actual forecasting model to be used, and the results it generates. Economic models incorporate key assumptions about the behaviour of economic variables, and frequently economists will disagree over these assumptions. That is why we have a plethora of competing economic models and forecasting organisations. An obvious example would be forecasting the impact on tax yield as a result of a change in Scotland’s rate of income tax. Whether one forecasts total tax yields to rise or fall depends on the assumption one builds into the model concerning the relative strengths of the income and substitution effects.
The second reason revolves around the financial reconciliation procedure being proposed. As noted earlier, the inadequacy of the borrowing provisions for current spending will require a Scottish Government to introduce unanticipated spending cuts which are likely to be politically unpopular and economically damaging. It is therefore likely that this will become a source of tension between the two governments. Therefore far from improving relations between the two administrations, we expect these to become more difficult and contested.
2) What is your view on the approach proposed in the Scotland Bill to substituting the revenue from taxes levied by the Scottish Parliament for some of the grant from the UK Government which presently supports the Scottish budget?
We are critical of the approach proposed in the Scotland Bill on two principal counts. First the evidence from the period since 1999 shows that the rate of growth of Scotland’s income tax revenue is less than the rate of growth of the Barnett consequential that determine the size of the block grant. IMF research has shown that has also been true for all 42 years since 1965. Therefore the proposed approach is likely to impose a deflationary bias on the Scottish economy. Second the approach provides no additional economic levers to the Scottish Government to enable them to offset this deflationary bias, or to spread the risk associated with reliance on one revenue stream (i.e. income tax) as a replacement income source to the Barnett consequential (which is a highly diversified income source).
3) What is your view of the proposal in the Scotland Bill for a Scottish rate of income tax levied on all income tax bands, and the reduction of UK income tax in Scotland by 10p in the pound accordingly? How would this work, are the proposals effective and are the proposed inter-Governmental mechanisms adequate?
We have already noted our concerns about the economic flaws inherent to the proposed funding (and non-capital borrowing) mechanism. We augment these general points here with a few remarks about specific aspects of the proposal.
a) Forecasts of the future value of any economic variable are, of course, invariably wrong. Predicting the future trajectory of Scotland’s income tax receipts is no exception. Therefore it will be inevitable that an annual ex post adjustment will be required to reconcile forecast with actual tax receipts for the previous year. It might be presumed that forecast errors will, over a number of years, sum to zero. Assuming we know the number of years involved, and we can estimate the variance of the forecast error, one could argue that the combination of “savings” made in years when the forecast underestimated actual tax receipts, plus the new annual £200 million borrowing facility (up to a maximum outstanding debt of £500 million), will insure the Scottish Government against having to implement unanticipated public spending cuts. Clearly there is no evidence to support this presumption at the present time, and testing forecasts against outturns will be undertaken during the transition phase ahead of the new regime being introduced. However it is unclear from the Command Paper what revision (if any) to the proposed regime will be made should the evidence display a persistent over- or under-forecast in the estimation of tax revenues, or indeed what any future UK Government will deem to be acceptable regardless of this evidence. We have already noted that evidence demonstrates a persistent trend for Treasury to over estimate tax revenues. This means that the Scottish Government will, on average, always find itself repaying money to Treasury in the annual reconciliation round. As borrowing is capped at £500m in total, this necessarily means that public spending in Scotland will have to fall eventually to finance this repayment.
b) As already noted although the tax revenue “forecasting and reconciliation” arrangement proposed in the Bill rectifies one of the defects in the original Calman proposals, it does so only by introducing a new dynamic instability to the funding arrangement. This instability will arise either where the forecast of tax receipts is significantly (i.e. above 5%) above outturn (so borrowing will be restricted) and/or where the (£500 million) ceiling on borrowing to finance current spending has been reached and repayments are required now.[15] Should either (or both) situation(s) arise then under the proposals the Scottish Government would be forced to implement spending cuts immediately. We would emphasise that neither scenario should be regarded as an “exceptional” circumstance. Increasing the rate of income tax in these circumstances would not be an option because any additional tax revenue generated would not be available until at least the end of the next financial year while the repayment of tax receipts is required at the beginning of that financial year.[16]
c) The proposal that the Scottish rate of income tax be levied at the same amount for each of the three tax bands is not, in our view, appropriate. What this essentially does is to introduce an element of regressivity into the income tax system as it affects Scotland alone. This is easily shown. Should the Scottish Government decide to raise the rate of income tax from 10p to 11p, all income tax payers in Scotland will be required to pay an additional 1p tax regardless of income. Clearly therefore a disproportionate burden of the increase in tax will fall on low income earners (a 1p tax rise constitutes a higher share of low incomes than high incomes), with the result being that at the margin the increase in income tax operates as a “flat tax” and is highly regressive. We regard this as a highly undesirable feature of the proposal. This feature could only be avoided if the Scottish Government was able to apply the Scottish income tax at different rates according to tax bands – a solution we would recommend. This defect in the tax proposal is significant. As we demonstrated above, the combination of an inherent deflationary bias and the application of a ceiling on borrowing to finance current spending under the proposed funding regime is likely to require, sooner rather than later, the Scottish Government to utilise its tax raising power in order to maintain public spending and avoid cutting vital public services. However if the Scottish rate of income tax is raised to maintain public service provision, the tax system as applied in Scotland unavoidably will become more regressive than elsewhere in the UK.
d) Also, as we demonstrated earlier, there is no incentive to use the Scottish tax to improve Scotland’s economic performance. Raising tax rates will damage competitiveness and increase wage demands. Lowering tax rates down will lower revenues and support payments, and any extra revenues generated from increased growth will simply go to the UK Treasury at least until the end of the forecasting period. After financial reconciliation the same applies because spending cuts (reducing activity one-for-one) have to be imposed up front, while the repayments of extra revenues (from increased activity at less than one-for-one because they depend on extra spending less saving from higher disposable incomes) happen two years later at the earliest.
4) How would the framework have performed over the recent downturn, particularly in the light of the significant shocks to tax revenues? Is the system robust to cope with such challenging periods and return Scotland to economic growth – if not, what frameworks are in place to address this?
The answer to this question is clearly no, on the Scotland Office’s own calculations quoted earlier.
In more detail: estimates of income tax collected in Scotland since the onset of the economic recession triggered by the financial crisis have been provided by the Scottish Government.[17] As one would expect this shows a significant reduction in Scotland’s income tax revenues over the period 2007-08 to 2010-11 – a cumulative real terms reduction of approximately 11% (£523 million in real terms). Over the same period the “full Barnett” DEL grew by 3.3% in real terms. Based on this data the cumulative real terms “cost” to the Scottish budget had the proposed funding mechanism been in place since 2007-08 would have been £3.9 billion. And although one might contest the data from which this estimate is derived, it is that certain that a net cost to the budget would have been incurred.
That the recent financial crisis and subsequent deep economic recession were not anticipated illustrates quite starkly the defects in the proposed funding regime. The proposed funding mechanism will see a share of Scotland’s income tax revenues assigned to the devolved administration based on forecasts produced by the OBR. That forecast will be made as part of the Comprehensive Spending Review (CSR), and will therefore ensure the Scottish Government knows its budget over the ensuing spending review period. However within that period an annual adjustment (lagged by 12 months) to the Scottish Consolidated Fund will be made to reconcile actual and forecast tax receipts.
As the sharp fall in income tax revenues that accompanied the onset of recession would not have been anticipated in the CSR of 2007, the forecast income tax receipts assigned to the Scottish Consolidated Fund for the forecast period would have significantly overestimated actual receipts for each of the following 3 years (07-08, 08-09, 09-10) and repayments from subsequent annual budgets would have been required as the true tax data became known. Consequently the Scottish Government would have had to cut spending, or borrow from the new facility, in order to balance its budget from 2008-09 onwards. Assuming it opted to borrow, and the same position was taken in the subsequent 2 years, and on the basis of estimated tax receipts during this period, simple arithmetic shows that the proposed £500 million revenue-smoothing borrowing ceiling would have been insufficient to accommodate total re-payments of over-paid tax revenues (of £523 million – the fall in tax receipts that actually occurred) required under the prospective arrangements. In practice the over-estimation of Scotland’s tax receipts by the OBR almost certainly would have been considerably in excess of £523 million quoted. This is because OBR forecasts ahead of the economic recession most probably would have assumed rising income tax receipts in Scotland, and the subsequent re-payments would therefore have included an additional amount.
We conclude that had the proposed funding regime been in place in 2007, ahead of the economic recession, the Scottish Government would have been required to introduce swingeing public spending cuts from 2009 onwards. Such a policy would have greatly exacerbated the already severe economic downswing that the Scottish economy has experienced since then and from which it has yet to recover. Indeed it is difficult to conceive any circumstances in which such an outcome could have been avoided, so restrictive are the financial provisions of the Bill.
5) What is your opinion of the proposals to create devolved taxes, Stamp Duty Land Tax and Landfill Tax, and the power to create new devolved taxes?
Both stamp duties and landfill tax represent minor sources of revenue. Moreover neither tax can be regarded as an independent economic policy instrument with significant macroeconomic leverage. Accordingly in economic terms the merit of including both taxes in the tax devolution package is that they diminish, but only very slightly, the overall risk to which the Scottish Government expenditure will be exposed under the new funding arrangement – overwhelmingly dependent as it will be on a relatively diminishing income tax base. Accordingly we believe it is essential that additional taxes are devolved in order further to diversify this revenue risk. There are a number of “minor” taxes that could be devolved which would not be expected to move synchronously with income tax receipts – such as fuel duty, excise duty, air passenger duty, vehicle duty etc.
The power to create new taxes is one that, in our view, should be used with considerable caution. Although a new tax offers the prospect of an additional revenue source, the introduction of any new tax may have significant, and possibly unintended, economic effects which need to be fully assessed. Of particular importance is to identify where the incidence of the tax falls – that is, it is often the case that those liable to pay a tax are able to “shift” the cost of the tax to other organisations and/or individuals.
It is also worth noting that very tight restrictions are to accompany the competence to introduce a new tax in Scotland, and that this will require the consent of the UK Parliament. Moreover any such proposal will need to be comprehensively justified, and a range of potential economic effects must be examined. Somewhat ironically perhaps the economic and financial tests that a proposed new tax must be subject to are considerably more sophisticated than those to which the new Bill’s tax proposals have been subjected.
6) Do you have a view on the proposed new borrowing powers set out in the Scotland Bill?
Current spending: We have already remarked in critical terms about the proposed borrowing facility to support current spending where the Scottish Government is required to make a payment to Treasury to reflect a difference between forecast and outturn income tax receipts. To recap, our view – based on the evidence since 1999 – is that the overall limit of £500 million and annual borrowing facility of £200 million will be insufficient to avoid the Scottish Government imposing unexpected spending cuts in the event of forecast errors in excess of 5% and/or an unanticipated economic shock reducing income tax revenues in Scotland. The possibility of such “emergency” spending cuts being introduced will add to the existing economic risk of deflation to which the new funding system will be vulnerable. Under the proposed tax devolution regime, these risks can only be avoided by raising these borrowing ceilings and/or empowering the Scottish Government to raise additional funds by issuing its own debt instruments, as is common practice in many federal systems.
Capital spending: The creation of a new borrowing facility to finance capital investment is, in principle, welcome. A ceiling of £2.2bn is proposed (no explanation for this specific limit is provided) and the Scottish Government will be permitted to borrow “…up to 10% of the Scottish capital budget (approx. £230m in 2014/15) in any year…”. Such loans will be sourced from the National Loan Fund, the body responsible for lending to local authorities. Significantly the Scottish Government will not be permitted to issue its own bonds – an aspect of the prospective arrangements that distinguishes Scotland’s fiscal authority from that of many other federalised “states” around the world. Therefore while welcoming the new capital borrowing powers we note that the scale of the borrowing to be allowed under the new regime is extremely modest and is subject at all times to “external” approval.
7) What is your assessment of the plans for the implementation of this new financial system and the risks and costs associated with that and have the UK Government adequately quantified these? How would the proposals to revise the system of funding work in practice? Is there sufficient information provided yet to enable a full assessment of the proposed funding arrangements? What key decisions remain to be taken?
It is clear from our preceding remarks that we have very deep concerns about the economic consequences that will flow from the fiscal provisions contained in the Scotland Bill. The funding mechanism being proposed has an inherent deflationary bias, and might well force a future Scottish Government to implement unexpected and potentially damaging public spending cuts that have no equivalent elsewhere in the UK. The Bill provides no new economic policy levers to Scotland’s Government at a time when, in our view, the Scottish economy is facing unprecedented challenges.
The financial proposals have simply not been subject to any serious economic analysis by the UK Government. Indeed as far as we know no authority with a recognised economic expertise has endorsed these proposals, or addressed seriously the criticisms that we, and many others, have put forward.
A significant number of decisions about the detailed operation of the funding regime have been postponed until some later date. This means that not only are the Scottish and UK Parliaments now engaged in scrutinising legislation whose financial and economic impact they have failed to subject to detailed investigation, but additionally today’s politicians seem prepared to impose this settlement on a Scottish Parliament that will not convene before 2015 at the earliest.
It is clear that the basis on which the initial adjustment to the block grant will be made has yet to be decided. This is important as it will determine the percentage of the Scottish budget that will be determined by Scotland’s income tax revenue thereafter. However the Committee should note that this decision will have no impact whatsoever on the rate of growth of income tax revenues subsequently. So while this element of the proposed model remains undecided, we stress that the criticisms we have made of the proposed financing arrangements remain valid regardless of the decision made about the share of the block grant that to be replaced by income tax revenues.
How do the proposals fit with systems from other jurisdictions – particularly in relation to more federal or quasi-federal countries?
There is a very wide variety of systems for financing sub-state parliaments across the world. For the purposes of the work of this Committee, we would submit that each is characterised to a greater or lesser degree by two key features.
The first is the range of taxes which might be described as “shared” between the central and sub-central levels of government. Almost all the countries that we have looked at “share” a wide range of taxes, and assign partial or total authority over these taxes to the sub-central government. Therefore it is commonplace to find responsibility is jointly exercised over a wide range of taxes in many federal or quasi-federal states including income tax, corporation tax, VAT (or sales taxes), natural resource taxes, excise taxes, and fuel duties. Indeed, as far as we know, there is no federal or quasi-federal country in the world which shares only one major tax as is being proposed in the Scotland Bill.
The key point is that where one tax alone is used to provide the overwhelming part of the “tax sharing” income accruing to the sub-central government, then there is almost no diversification in risk with respect to the income stream accruing to that government should the base on which the single tax is levied be subject to any sort of economic shock. By devolving competence (establishing tax sharing) over a wider range of taxes this risk is reduced. The lower the correlation between the yields of different taxes then the more diversified is the financing risk. For instance one would not expect any significant correlation between revenues from taxes levied on North Sea oil exploitation and revenues generated by income taxes levied on residents of Scotland. Yields in either case are determined by a wholly independent set of factors.
The second feature that almost all systems of devolved financial responsibility share is a capacity for the sub-central government to borrow funds by issuing its own bonds. This is expressly ruled out in the Scotland Bill.
It is worth noting that, on the basis of these two features alone, as far as we are able to discern from our research the funding regime that is being proposed in the Scotland Bill has no parallel with any other federal or quasi-federal country. In every case that we have studies – including Canada, Spain, Belgium, the USA, Germany, Italy, Australia, and Switzerland – sub-central governments enjoy significantly greater control over taxes levied in their own jurisdiction than is being proposed in the Bill and are able to raise funds by issuing their own bonds.
[1] Hughes Hallett, A. & Scott, A. (2010) ‘Scotland: A New Fiscal Settlement’.
[2] See Cuthbert, J. & Cuthbert, M. ‘The Scotland Bill is Broken, Scottish Left Review 2010. The underlying logic in this argument is based on the elasticity of response of income tax receipts (inclusive of the effect on work effort) following a lowering in the rate of income tax. If that elasticity is less than unity then total tax receipts will fall in response to a cut in Scotland’s rate of income tax.
[3] For example see Jim Gallagher “Why the Scotland Bill is good news for England”, The Telegraph, 30 November 2010. It is significant that this rare defence of the bill concerns itself with the advantages to England, not the benefits for the Scottish economy.
[4] Rather worryingly the (Scotland Bill) Impact Assessment published by the Scotland Office offers no economic analysis of the effects of the new regime on Scotland. Instead it remarks “…The UK Government considers the findings and supporting analysis [of the Calman Independent Expert Group] to be definitive on this subject…”. However that Expert Group did not – nor claimed to – evaluate the dynamic stability (or otherwise) of the tax devolution model that is now being proposed. In other words the simply is no “supporting [economic] analysis” underpinning the Scotland Bill fiscal proposals.
[5] This can readily be established from Treasury publications showing UK revenue sources.
[6] Also this effect will be more likely because the impact on Scottish income tax receipts associated with the adverse employment effects of UK public spending cuts will lag, by about 2 years on average, the implementation of the cuts. That would amplify the downward bias.
[7] There is legitimate concern that the impact of these cuts will be more serious in employment terms in Scotland than in some other parts of the UK due to proportionately higher numbers employed by the public sector in Scotland and in the view of the vulnerability of Scotland’s private sector to public spending cuts.
[8] In technical terms the slope of the income tax revenue curve will not be affected, although the initial positioning of the curve will be.
[9] Command Paper 7973 p27
[10] Ibid.
[11] The “reserve” will be amounts accumulated during years in which forecast tax receipts were less than outturn receipts, and a payment was made by Treasury to the Scottish Government.
[12] Should the economic shock be beneficial to Scotland’s economy then revenues (and spending) will rise which is also pro-cyclical and undesirable as it may exaggerate the economic upturn already underway.
[13] Command Paper 7973 p23
[14] By way of example it is simply worth reflecting on the disagreement over financial data which has accompanied the work of this Committee.
[15] Opinions will of course differ on the likelihood of such a set of circumstances arising. However should it arise then it will have significant implications for public spending.
[16] That is, the tax revenue available for the following year would be pre-determined by a previous forecast.
[17] No alternative data has been published.