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The Scottish Parliament and Scottish Parliament Infor mation C entre l ogos .
Financial Scrutiny Unit Briefing
Scotland’s Fiscal Framework 15 December 2015
15/83
Anouk Berthier and Simon Wakefield
This briefing has been produced for the Devolution (Further Powers) Committee. It looks at some of the key issues relating to the fiscal framework that will accompany the Scotland Bill 2015-16 and is currently being negotiated by the UK and Scottish Governments. It discusses the various elements that are set to be included in the framework such as borrowing powers, block grant adjustment mechanisms and the “no detriment” principle. It also highlights some of the issues that have been raised in relation to the framework, including the lack of information that has been made available on the on-going intergovernmental negotiations. It has been argued by the House of Lords Economic Affairs Committee that this creates a significant information gap in parliamentary scrutiny.
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CONTENTS
EXECUTIVE SUMMARY .............................................................................................................................................. 3
INTRODUCTION .......................................................................................................................................................... 4
WHAT IS A FISCAL FRAMEWORK?.......................................................................................................................... 6
BACKGROUND ........................................................................................................................................................ 6 ELEMENTS OF A FISCAL FRAMEWORK .............................................................................................................. 6
Fiscal rules ........................................................................................................................................................... 6 Fiscal institutions .................................................................................................................................................. 7 Medium term budgetary framework ..................................................................................................................... 7 Sound fiscal reporting .......................................................................................................................................... 7
FISCAL ARRANGEMENTS AT THE NATIONAL AND SUBNATIONAL LEVELS .................................................... 8
UK FISCAL FRAMEWORK ....................................................................................................................................... 11
SCOTTISH FISCAL FRAMEWORK .......................................................................................................................... 12
SCOTLAND ACT 1998 AND SCOTLAND ACT 2012 ............................................................................................ 12 SCOTLAND BILL 2015-16 ..................................................................................................................................... 12 FISCAL INSTITUTIONS ......................................................................................................................................... 14
The Scottish Fiscal Commission (SFC) ............................................................................................................. 14 The Office for Budget Responsibility (OBR) ...................................................................................................... 14
JOINT EXCHEQUER COMMITTEE ........................................................................................................................... 14
BORROWING ............................................................................................................................................................. 15
BORROWING BY THE SCOTTISH GOVERNMENT ............................................................................................ 15 Current borrowing .............................................................................................................................................. 15 Capital borrowing ............................................................................................................................................... 16 Borrowing powers post-Smith ............................................................................................................................ 16 Bailouts............................................................................................................................................................... 18 Prudential borrowing regime for central government ......................................................................................... 19
THE PRUDENTIAL REGIME FOR SCOTTISH LOCAL AUTHORITIES ............................................................... 19 SUBNATIONAL DEBT: INTERNATIONAL OVERVIEW ........................................................................................ 21
BOND ISSUANCE ...................................................................................................................................................... 22
“NO DETRIMENT” PRINCIPLE ................................................................................................................................. 23
BLOCK GRANT AND BLOCK GRANT ADJUSTMENTS (BGA) ............................................................................. 24
BACKGROUND ...................................................................................................................................................... 24 SCOTLAND ACT 2012 AND BLOCK GRANT ADJUSTMENTS ........................................................................... 25 DIFFERENT BLOCK GRANT ADJUSTMENT METHODS .................................................................................... 27
Fixed deduction .................................................................................................................................................. 27 Proportionate reduction ...................................................................................................................................... 28 Own Base Deduction (OBD) .............................................................................................................................. 28 Indexation to the equivalent tax in the rest of the UK (rUK)............................................................................... 28
POST-SCOTLAND BILL 2015-16 BLOCK GRANT ADJUSTMENT ...................................................................... 32 Tax and welfare .................................................................................................................................................. 32 Adjusting the Block grant in relation to the devolution of welfare powers .......................................................... 34
TAX DEVOLUTION AND ASSIGNMENT UNDER THE SCOTLAND BILL 2015-16 ............................................... 35
TAX REVENUE FORECASTS ............................................................................................................................... 35 INCOME TAX ......................................................................................................................................................... 36 VAT ASSIGNMENT ................................................................................................................................................ 36
SOURCES .................................................................................................................................................................. 38
RELATED BRIEFINGS .............................................................................................................................................. 42
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EXECUTIVE SUMMARY
In 2014 the Smith Commission made recommendations on the powers to be devolved to the Scottish Parliament and on the principles which should underpin an updated fiscal framework for Scotland. This was followed by the Scotland Bill 2015-16 (“the Bill”) which completed its report stage and third reading in the House of Commons on 9 November 2015. The updated fiscal framework, it has been said, “will be central to future devolution arrangements” (UK Parliament 2015a).
The Bill makes provisions for new tax and welfare powers for Scotland. In order for Scotland to effectively manage its public finances within the wider UK fiscal framework, a new fiscal framework for Scotland is currently being negotiated between the Scottish and UK Governments. The Joint Exchequer Committee serves as the official forum for these discussions which have occurred “behind closed doors.” Although the framework is a central element to future devolution arrangements for Scotland, little information has been provided on these talks other than a broad indication from the Deputy First Minister (Scottish Government 2015f) of the topics being covered:
Baseline adjustments
Indexation
No detriment
VAT assignment
Administration costs
Crown Estate
Employability
Capital Borrowing
Resource Borrowing and other flexibilities
Fiscal scrutiny – institutions
Governance arrangements
The House of Lords Select Committee on Economic Affairs (the “Committee on Economic Affairs”) raised concerns about the absence of any detailed information on the fiscal framework without which it says the Bill cannot be understood. It recommended the Bill should not proceed to Committee stage until the fiscal framework is published (UK Parliament 2015a). However, following its third reading in the House of Commons, the bill was sent to the House of Lords where it began the committee stage on 8th December 2015.
This briefing discusses some key aspects of the fiscal framework namely borrowing powers, the “no detriment” principle and indexation options to adjust the block grant in relation to the new powers.
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INTRODUCTION
Following the Scottish independence referendum on 18 September 2014, the UK Government set up the Smith Commission to make recommendations for further devolution to the Scottish Parliament and on the principles which should underpin an updated fiscal framework for Scotland. The Smith Commission Agreement (“the Smith Agreement”) (UK Government 2014a) was published in November 2014 and was followed by the publication of Command Paper Cm 8990 “Scotland in the United Kingdom: An enduring settlement” (UK Government 2015a) in January 2015 and by the Scotland Bill 2015-16 (“the Bill”) in May 2015. Figure 1 summarises the timeline of events from the referendum onwards.
Figure 1 Timeline of major events in relation to the Scotland Bill 2015-16 since the independence referendum
Announcement of the
Smith Commission
Publication of the Smith
Commission Agreement
Publication of a draft Bill in Cm
8990 Scotland in the United
Kingdom: An enduring settlement
First reading of the Scotland
Bill 2015-16 in the House of
Commons
Second reading in the
House of Commons
House of Commons
Committee Stage
The UK Government publishes
new clauses & amendments
Report stage and third reading
in the House of Commons
First reading of the Scotland
Bill 2015-16 in the House of
Lords
Second reading in the
House of Lords
House of Lords
Committee Stage
18 September 2014:
Scottish independence referendum
19 September
2014
27 November
2014
22 January
2015
28 May
2015
15 June
to
06 July
2015
08 June
2015
02 November
2015
09 November
2015
10 November
2015
24 November
2015
08 December
2015
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The Bill includes provisions for new tax and welfare powers for Scotland. If it is passed, the Scottish Government will have greater responsibility but will also be exposed to greater risks. In order for Scotland to effectively manage its public finances within the UK’s own fiscal framework, Scotland’s current fiscal framework that accompanied the Scotland Act 1998 and the Scotland Act 2012 is being revised. The fiscal framework “will be central to future devolution arrangements” and the “implications of the Scotland Bill 2015 cannot be understood without reference to the fiscal framework and vice versa” (UK Parliament 2015a).
The new framework is currently being negotiated between the Scottish and UK Governments. The Joint Exchequer Committee (JEC) serves as the official forum for these discussions which have occurred “behind closed doors” (David Hume Institute 2015). Little information has been provided on these talks as they progress. Since the publication of the Smith Agreement, the JEC has met five times: on 7 July, 4 September, 23 September, 9 October and 7 December 2015. On 26 November 2015, the Deputy First Minister wrote a letter to the Scottish Parliament Devolution (Further Powers) Committee (“the Devolution (Further Powers) Committee”) on the framework, indicating that negotiations are likely to conclude following the publication of the Scottish Government’s Draft Budget 2016-17. The Deputy First Minister also set out a list of the topics under discussion (Scottish Government 2015f):
Baseline adjustments
Indexation
No detriment
VAT assignment
Administration costs
Crown Estate
Employability
Capital Borrowing
Resource Borrowing and other flexibilities
Fiscal scrutiny – institutions
Governance arrangements The Bill completed its Commons stages on 9 November 2015 with substantive amendments made at the report stage. It was introduced in the House of Lords on 10 November 2015 and received its second reading on 24 November 2015 with first day of Committee stage held on 8 December 2015. The House of Lords Select Committee on Economic Affairs (the “Committee on Economic Affairs”) raised concerns about the absence of any detailed information on the fiscal framework without which it says the Bill cannot be understood. The Committee on Economic Affairs criticised the way in which additional powers are being devolved to Scotland, noting that:
“The process by which powers are devolved should be clear and transparent, to experts and the public alike. Any solution should be logical, intended for the long-term and based on principle. The Scotland Bill and accompanying negotiations on the fiscal framework reflect none of these ideals.” (UK Parliament 2015a)
The Committee on Economic Affairs pointed out that the Bill had passed through the House of Commons without MPs having details of the fiscal framework. It pointed out that:
“The lack of an agreed fiscal framework leaves a significant gap in the information before Parliament. It is to be regretted that the Bill passed through the House of Commons without MPs having the opportunity to scrutinise the fiscal framework.” (UK Parliament 2015a)
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The Committee on Economic Affairs asked that the Government:
Provide up-to-date information to Parliament on the progress of the fiscal framework negotiations; and
Give a date by which the fiscal framework will be agreed. It also recommended that the Bill should not proceed to Committee stage until the fiscal framework is published (UK Parliament 2015a). Despite the lack of information available, the Scottish Parliament has started scrutinising the fiscal framework. In spring 2015, the Scottish Parliament Finance Committee (“the Finance Committee”) undertook an inquiry examining the proposals for a fiscal framework. It invited witnesses in a number of sessions and issued a call for evidence with a deadline of 17 April 2015. It published its report “Scotland’s Fiscal Framework” in June 2015 (Scottish Parliament 2015a).
WHAT IS A FISCAL FRAMEWORK?
BACKGROUND
In a written submission to the Finance Committee, the IMF explained that in order for the Government to manage public finances effectively, fiscal policy should be conducted within a transparent rules-based framework (Scottish Parliament 2015b). This is referred to as a fiscal framework. Fiscal policy is the use of government revenue collection (mostly taxes) and expenditure (spending) to influence the economy. If annual government revenues exceed expenditure, this creates a surplus. If expenditure exceeds revenues, this creates a deficit. Deficits require that governments borrow, and this contributes to government debt. Cm 8990 defined a fiscal framework as “the set of rules and institutions that are used to set and coordinate sustainable fiscal policy” (UK Government 2015a). This definition contains only two of a number of different elements that are generally included in the definition of a fiscal framework. In a written submission to the Finance Committee, Audit Scotland listed five key elements of a fiscal framework:
Fiscal rules;
Fiscal institutions;
Medium term budgetary framework;
Budgetary procedures including effective scrutiny; and
Sound fiscal reporting (Scottish Parliament 2015b).
ELEMENTS OF A FISCAL FRAMEWORK
Fiscal rules
Fiscal rules impose long-lasting constraints on fiscal policy through numerical limits on “budgetary aggregates” such as the deficit, debt and/or expenditure (Schaechter et al. 2012). These rules include:
Short-term and medium-term targets for debt and borrowing;
Rules restricting borrowing or encouraging saving; and
Other specific rules, such as a cap on welfare spending.
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Fiscal institutions
Fiscal institutions supplement fiscal rules. Referred to as Independent Fiscal Institutions (IFIs) and also known as independent parliamentary budget offices or fiscal councils, these institutions are “publicly funded, independent bodies under the statutory authority of the executive or the legislature which provide non-partisan oversight and analysis of, and in some cases advice on, fiscal policy and performance” (OECD 2014). The role of IFIs can include:
Preparing macroeconomic forecasts for the budget;
Monitoring fiscal performance, the implementation of budget plans and the respect of budgetary objectives;
Raising awareness about short and long-term costs and benefits of budgetary measures both among policy-makers and the public;
Assessing whether fiscal measures are appropriate in terms of respect of rules, sustainability of public finances, and stability-oriented fiscal policies; and/or
Advising the government on fiscal policy matters (European Commission 2015)
Courts of Auditors are included in the definition of an IFI if their activities go beyond accounting control and cover any of the above tasks (European Commission 2015). IFIs are relatively few and novel worldwide but their number is on the rise in OECD countries. Just over half of OECD members had an IFI in 2014 and slightly more than half of these had been established in the five years prior to 2014 (OECD 2014). According to the IMF, IFIs can promote stronger fiscal discipline as long as they are well-designed (IMF 2013). Key features of effective IFIs include:
Strict operational independence from politics;
Provision or public assessment of budgetary forecasts;
Strong presence in the public debate (notably through an effective communication; strategy); and
Explicit role in monitoring fiscal policy rules. The UK has an IFI, the Office for Budget Responsibility (OBR), which was created in 2010 (OBR 2015a). It provides analysis on the public finances at a UK-wide level and has also been tasked with forecasting the taxes of the devolved administrations.
Medium term budgetary framework
Audit Scotland justified the importance of having a “medium term budgetary framework” within a fiscal framework on the basis that this “is important in order to show the medium term effect of policy and budgetary decisions and to demonstrate the sustainability of public finances” (Scottish Parliament 2015b). It added that future budgetary procedures would need to consider both the income and expenditure side of the budget in order to ensure effective scrutiny.
Sound fiscal reporting
Fiscal frameworks should include sound fiscal reporting with comprehensive, reliable, timely and transparent information on past performance (Scottish Parliament 2015b). The Chartered Institute of Taxation and the Low Incomes Tax Reform Group, based on the European Commission’s Europe 2020 Strategy, also stated in a written submission to the Finance Committee, that a fiscal framework should include “sound fiscal statistics” (Scottish Parliament 2015b).
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FISCAL ARRANGEMENTS AT THE NATIONAL AND SUBNATIONAL LEVELS
Fiscal constraints are widely used by central governments to place limits on the fiscal policy of sub-central governments, but also by supranational institutions in economic unions to constrain the fiscal policy of member states. There are four types of constraints that can be placed on fiscal policy as shown in Table 1. Table 1 Types of constraints on fiscal policy
Description
Direct controls
by central
government
They impose binding constraints;
They are relatively rarely used in practice;
Examples include limits on sub-national borrowing.
Fiscal rules They impose less binding than direct controls as the central government cannot micro-manage sub-national fiscal policy; also subnational governments have some flexibility in how they meet fiscal targets;
They are the most common form of constraint;
Examples include balanced budget rules and limits on debt accumulation.
Cooperative
approaches
They allow sub-national governments to negotiate their fiscal targets on a regular basis;
Examples are primarily in European countries (e.g. in Austria and Belgium, annual fiscal targets are negotiated by federal, regional and local governments).
Market
discipline
They do not impose any formal constraint.
Source: SPICe summary of Cottarelli & Guerguil (2014)
According to the IMF (Scottish Parliament 2015b), fiscal rules are the most common type of constraint on subnational fiscal policy in the EU and the OECD. Of the 81 countries surveyed by Schaechter et al. (2012), 76 countries had at least one national and/or supranational fiscal rule in place by end-March 2012. Most countries have more than one fiscal rule in place today.
The most frequently used fiscal rules are debt rules and balanced budget rules, often used in combination (Schaechter et al. 2012). These two types of rule are explained in Table 2 along with other, less common fiscal rules.
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Table 2 Subnational fiscal rules
Description
Balanced
budget rules
(deficit rules)
Constrain the variables that primarily influence a country’s public debt levels and which are largely under the control of policy makers
Can be expressed: o In terms of the current balance thereby allowing the subnational
government some ability to borrow for investment purposes o As a requirement to run an average balance over a number of
years – this provides some flexibility to absorb cyclical variations in local government revenue
Debts rules
and targets
(limits on
debt
accumulation)
Set an explicit limit or target for public debt
Can be expressed in terms of the ratio of total debt/total revenue or total debt service/revenue
Imply that a primary deficit control rule has been agreed
Difficult to use because debt ratios can be volatile and provide a hard limit on year-to-year fiscal policy
Expenditure
rules
Set limits on total, primary or current expenditure
Usually defined in terms of limits on current public spending in aggregate, or limits to its growth, or a limit as a percentage of GDP, or in relation to the growth of productivity
Less common given the interdependence between subnational expenditure levels and levels of own resources and grants
Does not guarantee fiscal sustainability: these rules may need to be combined with rules placing a floor under revenues and a ceiling on debt
Revenue
rules
Set ceilings or floors on revenue
Aim to boost revenue collection and/or prevent an excessive tax burden
Difficult to use as revenues are dependent on the state of the economy
Structural
balance rules
Relatively uncommon because of the difficulties in calculating both subnational output and potential growth
Source: SPICe summary of Schaechter et al. 2012 and Scottish Parliament 2015b
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Table 3 summarises the benefits and disadvantages of the fiscal rules described in Table 2. Table 3 Advantages and disadvantages of fiscal rules
Advantages Disadvantages
Balanced
budget rules
Clear operational guidance
Close link to debt sustainability
Easy to communicate and monitor
No economic stabilization feature (can be pro-cyclical)
1
Headline balance could be affected by developments outside the control of the government (e.g. a major economic downturn)
Debt rules Direct link to debt sustainability
Easy to communicate and monitor
No clear operational guidance in the short run as policy impact on debt ratio is not immediate and limited
No economic stabilization feature (can be pro-cyclical)
Rule could be met via temporary measures
Debt could be affected by developments outside the control of the government
Expenditure
rules
Clear operational guidance
Allows for economic stabilization
Steers the size of government
Relatively easy to communicate and monitor
Not directly linked to debt sustainability since no constraint on revenue side
Could lead to unwanted changes in the distribution of spending if, to meet the ceiling, shift to spending categories occurs that are not covered by the rule
Revenue
rules
Steers the size of government
Can improve revenue policy and administration
Can prevent pro-cyclical spending (rules constraining use of windfall revenue)
Not directly linked to debt sustainability since no constraint on expenditure side (except rules constraining use of windfall revenue)
No economic stabilization feature (can be pro-cyclical)
Structural
balance rules
Relatively clear operational guidance
Close link to debt sustainability
Economic stabilization function (i.e., accounts for economic shocks)
Allows to account for other one-off and temporary factors
Correction for cycle is complicated, especially for countries undergoing structural changes
Need to pre-define one-off and temporary factors to avoid their discretionary use
Complexity makes it more difficult to communicate and monitor
Source: SPICe summary of Schaechter et al. 2012
Many governments’ fiscal frameworks include what is known as the “golden rule” of deficit financing. This means that current revenues must match current spending and borrowing is only permitted to fund public investment, as explained by Professor Hughes Hallett in a written submission to the Finance Committee (Scottish Parliament 2015b). Schaechter et al. found that there has been a widespread trend towards strengthening existing fiscal rules and implementing new fiscal rules since the 2008 Global Financial Crisis. These
1 This refers to a situation where an economy is hit by a shock (which generally causes government revenues to
decrease and spending to increase) and there is a binding fiscal rule in place such as a debt target – this may
serve as an incentive for the government to make fiscal policy “pro-cyclical” i.e. cut spending and increase taxes.
Pro-cyclical policies do not lead to economic stabilization as they follow economic trends caused by the crisis.
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“next-generation” fiscal rules are increasingly complex as they combine the objectives of sustainability with the need for flexibility in response to shocks, thereby creating new challenges for implementation, communication, and monitoring (Schaechter et al. 2012). The political and legislative basis for fiscal rules differs by type of rule and country and includes:
Political commitments;
Coalition agreements;
Statutory rules;
International treaties (supranational rules); and
Constitutional arrangements. There has been an increase in recent years in the number of existing or new fiscal rules that have been placed on a statutory basis. For example, the number of countries that have at least one fiscal rule on a statutory basis has almost doubled since 2010 (Schaechter et al. 2012).
Case study: Austria
In a written submission to the Finance Committee, the Austrian Parliamentary Budget office explained that all levels of the Austrian government (federal, regional and local) are involved in the consolidation of public finances laid out in the Austrian Stability Pact (ASP) (Scottish Parliament 2015b). The ASP prescribes deficit and surplus targets at these three levels of government in the form of legally enshrined budgetary commitments. Non-compliance triggers a sanction mechanism in the form of an interest-bearing deposit that is transferred to the governments in compliance if the target is missed for two years in a row and reimbursed otherwise. To date, these sanctions have never been used. The current ASP includes:
A debt break which sets upper limits for the structural deficits at each level of government (federal, Laender and municipalities);
An expenditure rule limiting annual expenditure growth of all governments at or below a reference medium-term rate of potential GDP growth. Excess must be matched by extra tax revenue; and
A requirement to reduce government debt which involves contributions from both the federal and subnational governments.
The ASP is managed by the Austrian Coordination Committee which includes representatives of the Finance Ministry, regional governments and municipalities. In addition, Austria introduced a medium-term expenditure framework in 2009 which established medium-term budgetary planning at the federal level by setting legally binding expenditure ceilings for 4 years in advance on a rolling basis. These ceilings include a fixed part and a counter-cyclical variable part to account for fiscal variations caused by the business cycle.
UK FISCAL FRAMEWORK
The UK’s fiscal framework is set out in the Budget Responsibility and National Audit Act 2011. This Act requires the UK Government to publish a Charter for Budget Responsibility which provides details on the formulation and implementation of fiscal policy and policy for the management of the national debt. HM Treasury’s objectives for fiscal policy are to:
Ensure sustainable public finances that support confidence in the economy;
Promote intergenerational fairness;
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Ensure the effectiveness of wider government policy; and
Support and improve the effectiveness of monetary policy in stabilising economic fluctuations (Scottish Parliament 2015a).
The Treasury’s mandate for fiscal policy is:
A forward-looking aim to achieve a cyclically-adjusted current balance by the end of the third year of the rolling, 5-year forecast period;
An aim for public sector net debt as a percentage of GDP to be falling in 2016-17;
The cap on welfare spending, at a level set out by the Treasury in the most recently published Budget report, over the rolling 5-year forecast period, to ensure that expenditure on welfare is contained within a predetermined ceiling (Scottish Parliament 2015a).
The UK’s fiscal framework also sets out how Scotland, Wales and Northern Ireland receive funding from the UK Government and the institutional arrangements that govern the process (UK Parliament 2015a).
SCOTTISH FISCAL FRAMEWORK
SCOTLAND ACT 1998 AND SCOTLAND ACT 2012
Scotland has a fiscal framework that sits within the wider UK fiscal framework. It is defined under the Scotland Act 1998, as amended by the Scotland Act 2012, and includes the following elements:
Fiscal rules: the Scottish Government is required to run an annual balanced budget, whereby its spending must be fully funded each year;
Funding: this includes mainly the block grant and revenues from the devolved taxes;
Tools to manage volatility: borrowing and the possibility to operate a cash reserve; and
Fiscal institutions: the Scottish Fiscal Commission (SFC) was set up in 2014 to scrutinise the Scottish Government’s forecasts for devolved taxes.
The Budget Exchange Mechanism is also part of the fiscal framework as it also allows the Scottish Government to carry over 0.6% of Resource Departmental Expenditure Limits (DEL) and 1.5% of Capital DEL from one financial year to the next (Scottish Parliament 2015a). The Scottish Government also introduced its own fiscal rule in relation to annual repayments resulting from revenue financed projects. It has committed to spending no more than 5% of its total DEL budget on repayments from revenue financing and from any future borrowing (Scottish Government 2011a).
SCOTLAND BILL 2015-16
The Smith Agreement noted that Scotland’s fiscal framework had to be consistent with the overall UK fiscal framework (UK Government 2014a). The Smith Agreement set out a number of aspects the fiscal framework should include:
Barnett formula: this will continue to be used to calculate the Block Grant;
Economic responsibility: the Scottish budget should bear the costs or alternatively the benefits from revenue/expenditure decisions made by the Scottish Government;
No detriment to Scotland or the rest of the UK (rUK) from devolution or from policy decisions made by the other Government (e.g. Scottish decisions should not impact on the rest of the UK and vice versa);
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Borrowing powers to reflect the additional economic risks associated with further devolution;
“Implementable and sustainable”: the framework should not require frequent on-going negotiation;
Independent fiscal scrutiny: the scrutiny of public finances in Scotland should be expanded and strengthened;
UK wide economic shocks: these should be managed by the UK government; and
Joint implementation by the two governments, with both parliaments being regularly updated (UK Government 2014a).
In terms of “economic responsibility”, the Smith Agreement emphasised that:
“The revised funding framework should result in the devolved Scottish budget benefiting in full from policy decisions by the Scottish Government that increase revenues or reduce expenditure, and the devolved Scottish budget bearing the full costs of policy decisions that reduce revenues or increase expenditure” (UK Government 2014a).
The basis of the revised fiscal framework for Scotland will include both the rules agreed between the UK and Scottish Governments and the rules set by the Scottish Parliament (Scottish Parliament 2015b). Audit Scotland emphasised the need for the fiscal framework to be transparent (Scottish Parliament 2015b). Professor Campbell Leith, in a written submission to the Finance Committee, argued that fiscal targets or rules should be set in terms of deficits instead of debt and should:
Apply over a sufficiently long time horizon to allow gradual adjustment to the target. For example, “the government should achieve a deficit of x% within 5 years”; and
The time horizon over which the target is to be achieved should be rolling to avoid the policy maker being forced to make undesirably large fiscal adjustments towards the end of the horizon date in order to achieve the target. This obviously creates the possibility of policymakers continually delaying fiscal adjustments (Scottish Parliament 2015b).
The IMF stated:
“Symmetry between national and subnational fiscal rules is important to ensuring effective coordination of fiscal policy across levels of government. Given that the national fiscal rules in UK Government’s Charter of Budget Responsibility are expressed in terms of the current balance and net debt of the public sector (including those of Scotland), the use of similar aggregates would facilitate fiscal policy dialogue between the UK and Scotland governments” (Scottish Parliament 2015b).
Cm 8990 highlighted that:
“In the context of Scottish devolution, the fiscal framework must ensure that Scotland contributes proportionally to the overall fiscal consolidation pursued by the UK Government … A fiscal framework needs to be established so that actions across the authorities in the union will deliver the fiscal mandate set by the UK Government, while enabling the Scottish Government to exercise its devolved powers effectively” (UK Parliament 2015b).
Professor Michael Keating suggested this appears to go beyond the requirement that any extra expenditure in Scotland be financed by Scottish revenues (which is already covered by the balanced budget requirements) (Keating 2015).
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Asked by the Scottish Affairs Committee whether the Scottish Government would be bound into continuing the UK Government’s austerity agenda and be limited in its policy decisions, the Secretary of State for Scotland said:
“What limits the Scottish Government is the amount of money available, and that is true across the whole of the United Kingdom. We have an overall fiscal framework in the United Kingdom, and that is what the people of Scotland voted to be part of on 18 September [2014]. Inevitably, given the size of the cake, there will be constraints. If you did not have them, you would have independence by the back door, which is not what the people of Scotland wanted” (UK Parliament 2015c).
FISCAL INSTITUTIONS
The Scottish Fiscal Commission (SFC)
The SFC is an IFI that has been established on a non-statutory basis since mid-2014. The Scottish Fiscal Commission Bill, which was introduced in the Scottish Parliament on 28 September 2015, proposes to put the SFC on a statutory footing from April 2017, with a remit to scrutinise, assess the reasonableness of and report on the Scottish Government’s devolved tax revenue forecasts and on the economic determinants underpinning the Scottish Government’s non domestic rate income forecasts (Burnside 2015). Its remit does not currently include the analysis and scrutiny of expenditure. For more information of the SFC and the Scottish Fiscal Commission Bill see SPICe Briefing Scottish Fiscal Commission Bill. Research for the Finance Committee by Ian Lienert (Lienert 2015) made a number of practical suggestions for the new SFC under the following headings:
Mandate, including the SFC’s role in assessing forecasts and the fiscal framework;
Operational independence, including access to information;
Governance arrangements; and
Accountability to Parliament and legal basis.
The Office for Budget Responsibility (OBR)
The Committee on Economic Affairs recommended that, in cooperation with the SFC, the OBR scrutinise the on-going operation of the fiscal framework and the funding of the devolved governments (UK Parliament 2015a).
The OBR already publishes a forecast for the devolved taxes – in November 2015 this included Scottish forecasts SRIT, Land and Buildings Transaction Tax (LBTT), Landfill Tax and aggregates levy (OBR 2015b).
JOINT EXCHEQUER COMMITTEE
UK and Scottish fiscal policies will have to be coordinated under the new fiscal framework. This will require regular interactions between the Scottish and UK Governments. The IMF believe the remit of the JEC should be reviewed to include the following objectives (Scottish Parliament 2015b):
Setting fiscal objectives or rules which apply to the UK and Scottish budgets;
Sharing information about national and local economic developments and prospects;
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Coordinating the preparation of medium-term plans and annual budgets between the two governments;
Managing new burdens being placed on local authorities and ensuring they are fully funded through adjustments to grants or funding formulae;
Discussing major investment projects before they are committed and agreeing national and subnational contributions to their cost;
Monitoring the execution of national and subnational budgets and compliance with local fiscal rules;
Discussing and agreeing corrective actions in case of slippage against national or subnational fiscal targets; and
Sanctioning those authorities that fail to take agreed corrective actions or adhere to other provisions of the central-local fiscal coordination framework.
BORROWING
BORROWING BY THE SCOTTISH GOVERNMENT
Government borrowing falls into two categories:
Current borrowing to fund current (revenue) expenditure, i.e. the day-to-day spending on public services; and
Capital borrowing for investment purposes. Governments can borrow from other governments and commercial lenders (e.g. banks) through loans or by issuing bonds. Other ways to fund government expenditure include:
Building up a cash reserve in years when tax revenues are high; and/or
Decreasing public spending and/or increasing taxes when there is an economic downturn – these are procyclical measures commonly referred to as “austerity” measures.
The Scottish budget is funded by the block grant and as of April 2015 also by devolved tax revenues. Tax devolution or tax revenue assignment incurs an adjustment to the block grant to reflect the loss of revenue by HM Treasury. As noted by David Phillips in a written submission to the Finance Committee, “the way in which the block grant mechanism is indexed will have major implications for the scale of current borrowing powers required” (Scottish Parliament 2015c).
Current borrowing
David Phillips notes that current borrowing is only available to the Scottish Government at present to cover forecast errors of tax revenues (devolved or assigned) (Scottish Parliament 2015c). Under the Scotland Act 1998, as amended by the Scotland Act 2012, when tax revenues are above forecast the Scottish Government is now able to retain this surplus in a cash reserve which can be used to offset any years in which the outturn is below the forecast. If there is no cash reserve and the deviation between forecast and actual revenues is more than 0.5% of the
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Scottish resource budget2 the Scottish Government may borrow up to £200m each year within a cap of £500m to be paid within 4 years to deal with cash management and the deviation between the forecast and the actual outturn (Scottish Parliament 2013). In 2011, the Scottish Parliament Scotland Bill Committee (“the Scotland Bill Committee”) raised concerns that the £500m cap would not be sufficient on the basis that, while the OBR had only a limited track record in forecasting at the time, HM Treasury forecasts for income tax had tended to be over-optimistic with the largest errors occurring during the recession (Scottish Parliament 2011a). The Scotland Bill Committee recommended that the £500m limit be at least doubled (Scottish Parliament 2011b). The Finance Committee also noted its concern that “the Scottish Government may have to borrow money as a consequence of forecasting errors rather than as a consequence of poor economic performance” (Scottish Parliament 2013). Borrowing for current expenditure purposes can only be from the UK Government’s National Loans Fund (Scottish Parliament 2013). Professor MacDonald, in evidence given to the Finance Committee, argued that “borrowing should be done on the open market as this is ―the only clean and effective way to bring market discipline”, a view shared by Professor Iain McLean in evidence given to the Finance Committee, who stated that “market discipline is the control that really works” although he pointed out that “it was not the view taken ultimately by the IEG [Independent Expert Group] or by Calman [the Calman Commission]” (Scottish Parliament 2015d).
Capital borrowing
The Scotland Act 2012 gives the Scottish Government the power to borrow (from April 2015) up to 10% of the Capital DEL per year within a statutory aggregate cap of £2.2bn (Scottish Parliament 2013). There is provision to raise (but never lower) the £2.2bn cap. Borrowing can be from the UK Government (the National Loans Fund) with a choice of the type of loan, from commercial lenders (banks or other lenders) (Scottish Parliament 2013), or by issuing bonds (UK Government 2015). In the Draft Budget 2015-16, the Scottish Government stated it will “borrow up to £304m in 2015-16, the maximum permitted” (Scottish Government 2014) – this will only be drawn if necessary.
Borrowing powers post-Smith
Borrowing powers will be an important part of Scotland’s fiscal framework (UK Parliament 2015a). In order to balance the increased financial responsibility following the expansion of its powers, the Smith Agreement committed to giving the Scottish Parliament increased current and capital borrowing powers, to be agreed with the UK Government (UK Government 2014). There is widespread agreement that Scotland will need additional borrowing powers under the Scotland Bill 2015-16. For example, The Committee on Economic Affairs stated Scotland’s borrowing powers, including the ability to issue bonds, “will need to be revised and, crucially, extended as increased dependence on taxation will expose the Scottish Government to greater volatility of income” (UK Parliament 2015a). The Smith Agreement argued that Scotland’s borrowing powers should be:
Kept under review in conjunction with the block grant adjustment mechanism(s); and
2 This 0.5% represents around £125m according to the Devolution (Further Powers) Committee (Scottish
Parliament 2015c).
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Subject to fiscal rules agreed by the Scottish and UK Governments based on “clear economic principles, supporting evidence and thorough assessment of the relevant economic situation” (UK Government 2014).
Cm 8990 noted that Scotland’s borrowing would have to be consistent with UK’s fiscal framework:
“Where the UK Government has put in place a number of fiscal targets and limits (to ensure the public finances reach and remain at a sustainable position) fiscal decisions in Scotland would lead to trade-offs in the public finances for the rest of the UK. A relatively higher level of borrowing in Scotland would mean that borrowing in the rest of the UK would need to be lower in order to meet a particular borrowing target and maintain market confidence (and sustain a given level of interest rates). This would force a fiscal choice on the rest of the UK, either to lower spending or increase taxes.” (UK Government 2015b)
The IMF agreed that borrowing should be subject to fiscal rules and that these need to be “transparent and binding” (Scottish Parliament 2015c). The Committee on Economic Affairs noted the Scottish and UK Governments should agree to simple and clear rules that include a ceiling on Scottish Government debt ( UK Parliament 2015a). Professor Anton Muscatelli, in evidence given to the Finance Committee, also stated that borrowing for the devolved administrations should be limited by a deficit ceiling, or “some sort of deficit rule” that would need to be maintained in a way that was consistent with the UK’s macroeconomic framework (Scottish Parliament 2015d). In a letter to the Convener of the Devolution (Further Powers) Committee dated 29 November 2015, the Deputy Finance Minister and Cabinet Secretary for Finance, Constitution and Economy provided a list of topics to be included within the fiscal framework. Concerning capital borrowing, he stated that:
“Any extension to the Scottish Government’s capital borrowing powers will be set out in the fiscal framework, including overall quantum and any annual limits. It will also set out how Scottish Government borrowing would sit within the context of the overall UK fiscal framework” (Scottish Government 2015e).
On resource borrowing and other flexibilities, he explained that:
“The extended resource borrowing limits for the Scottish Government will be set out in the fiscal framework. Resource borrowing will ensure budget stability and enable the Scottish Government to have flexibility to manage forecast error and smooth public spending in the event of economic shocks. Any non-borrowing flexibilities will also be outlined” (Scottish Government 2015e).
The Committee on Economic Affairs emphasised that new borrowing powers should be subject to clear limits (UK Parliament 2015a). Concerns have been raised over the absence of clauses in the Scotland Bill 2015-16 in relation to borrowing powers (SPICe 2015) and the lack of public scrutiny or engagement in the negotiation of new borrowing arrangements for Scotland.
David Phillips pointed out that:
“The scale of borrowing powers for current spending available to the Scottish Government should be commensurate with the additional spending and revenue risks faced by the Scottish Government following further devolution” (Scottish Parliament 2015c).
In relation to current borrowing, the Smith Agreement highlighted that additional borrowing powers should be sufficient to ensure budgetary stability and provide safeguards to smooth
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Scottish public spending in the event of economic shocks, consistent with a sustainable overall UK fiscal framework (UK Government 2014). The Scottish Government, in its response to the Devolution (Further Powers) Committee‘s Interim Report on the Smith Commission, explained that borrowing will help manage forecasting, cyclical and demand risks while protecting spending on Scotland‘s public services. It added that the powers for current borrowing within the Scotland Act 2012 need to be reviewed and expanded to enable Scotland to manage these risks (Scottish Government 2015c).
Regarding capital borrowing, the Smith Agreement stated that:
“The Scottish Government should also have sufficient borrowing powers to support capital investment, consistent with a sustainable overall UK fiscal framework. The Scottish and UK Governments should consider the merits of undertaking such capital borrowing via a prudential borrowing regime consistent with a sustainable overall UK framework” (UK Government 2014).
Professor Hughes Hallett stated, in a written submission to the Finance Committee, that the golden rule of deficit financing is a good place to start to determine what borrowing capacity Scotland might need because it separates borrowing for current spending from that for capital spending:
“Current spending should balance current revenues on average. That implies setting a borrowing limit from the distribution of unexpected uncovered spending (deviations from zero net revenues) such that 95%, say, of those unexpected deviations are covered by borrowing. The deviations will be from the distribution of forecast errors in devolved taxes since the block grant components are set and known in advance.” (Scottish Parliament 2015c)
The Institute of Chartered Accountants Scotland, in a written submission to the Finance Committee explained that the Scottish Government should have additional revenue borrowing powers to fund preventative spending on the basis that there should be a move away from crisis spending and towards preventative spending in order to achieve savings (Scottish Parliament 2015c).
Bailouts
Central to the discussion on borrowing powers for Scotland is the question of whether the UK Government would bail out Scotland if the latter were unable to repay its debts. This may be a moot point however. For instance, the Committee on Economic Affairs noted: “We consider than any ‘no bailout’ rule would not be believed by the markets. The assumption that the rest of the UK would bail out Scotland would prevail.” (UK Parliament 2015a).
This is consistent with research carried out by Jenkner and Lu who explained on the one hand that:
“Studies have shown markets may under-price sub-national governments’ risk on the implicit assumption that these entities would be bailed out by their central government in case of financial difficulties” (Jenkner and Lu 2014).
On the other hand, Jenkner and Lu (2014) demonstrated through an empirical case study of Spanish autonomous regions that when the central government bailed the latter out this led to a 70 basis point (0.7%) increase in federal borrowing costs. In other words it seems that central governments are at risk of paying a premium on their own borrowing as a result of announcing the bailout of a subnational entity.
Dr Angus Armstrong, in a written submission to the Finance Committee, while acknowledging that the probability of a bailout can never be reduced to zero, stated it can be minimised by
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taking measures which remove the incentive for the central government to bail out the sub-central government (Scottish Parliament 2015c). These measures include inscribing a no bailout commitment into law to at least raise the cost of back-tracking, as well as the requirement that Scotland’s share of public debt (which Dr Armstrong estimated at approximately £126bn) would need to be repaid before debt issuance powers were granted (Scottish Parliament 2015c).
Prudential borrowing regime for central government
The Smith Agreement recommended that the Scottish and UK Governments consider the merits of undertaking capital borrowing via a prudential borrowing regime. A prudential regime already applies to local government capital borrowing in England, Scotland and Wales (UK Government 2014). The UK Government accepted this recommendation in Cm 8990 (UK Government 2015b). The Scottish Government supports the existence of a prudential regime for capital borrowing:
“The Scottish Government believes that we should have flexibility to arrange our annual borrowing within a prudential borrowing regime, subject to the scrutiny of the Scottish Parliament, rather than be subject to an arbitrary annual limit set by the UK Government. This would give Scottish Ministers greater discretion over borrowing to allow us to take responsible investment decisions in Scotland’s economic interests” (Scottish Government 2014).
David Phillips believes “it is worthwhile investigating this option, as it is a regime that seems to have worked well for local government” (Scottish Parliament 2015c). He highlighted however that differences in the political relations between local and central government, and the Scottish and UK governments should be taken into account:
“It seems that there is more political space for central government to either (a) overrule autonomy of a local authority if it felt that the level of borrowing was not in fact ‘prudent’, or (b) bail out a local authority that got in to such trouble, than might be the case for the UK government acting in such a manner with respect to the Scottish government”(Scottish Parliament 2015c).
THE PRUDENTIAL REGIME FOR SCOTTISH LOCAL AUTHORITIES
Local Authorities have the statutory power to borrow under the Local Government (Scotland) Act 1975 for the following purposes:
Acquiring land;
Construction of buildings;
Undertaking permanent work or provision of plant and machinery;
Lending to relevant authorities or Community Councils; and
Any other purpose for which the authority is authorised under any enactment to borrow. Thus Scottish local government already operates under a fiscal framework. A key part of this is known as the prudential regime, and was brought in when the Local Government in Scotland Act (2003) introduced a new system of capital controls. Local Government is expected to manage its fiscal powers responsibly and local authorities must produce balanced budgets year on year and control borrowing through the prudential framework. The Scottish Government funds the debt servicing costs of some of this borrowing known as “supported borrowing”. “Unsupported borrowing” is arranged under the prudential regime and financed through Local Authorities’ own general resources. Local authorities are then free to make their
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own decisions about capital investments as long as their capital spending plans are prudent, affordable and sustainable. Scottish local authorities may borrow to fund capital spending under the code developed by the Chartered Institute for Public Finance and Accountancy (the CIPFA Prudential code for Capital Finance in Local Authorities). Currently borrowing by Scottish local authorities is done through the Public Works Loans Board (PWLB) (Scottish Parliament 2015c). The Scottish Public Finance Manual sets out the background (Scottish Government 2011b):
Capital investment by local authorities is largely funded through borrowing. The Scottish Government supports local authority capital investment in a number of ways: a) by funding the debt servicing costs (i.e. loan charges and redemption fees) of some of this borrowing, known as "supported borrowing", via general revenue grant, b) by the payment of specific ring-fenced capital grants and c) by payment of a general capital grant. Any unsupported borrowing is financed through local authorities' own general resources;
The Local Government in Scotland Act 2003 abolished the previous limits on local authority capital expenditure known as section 94 consents. Instead the 2003 Act places a duty on local authorities to determine and keep under review the maximum amount they can afford to allocate to capital expenditure. This allows local authorities the freedom to make their own decisions about capital investment. In doing so regulations require authorities to have regard to a Code of Practice developed under the auspices of CIPFA, called the Prudential Code for Capital Finance in Local Authorities. This requires local authorities to ensure that their plans are prudent, affordable and sustainable. Together the different elements of this framework are known as the Prudential Regime. Local authorities also have a duty to adhere to statutory guidance on Best Value, which stresses the importance of good financial management and project management control and of linking expenditure plans to effective asset management; and
Although no national or local limits have been set for borrowing, HM Treasury reserves the right to do so. In the meantime, the Scottish Government monitors capital plans, outturn expenditure and borrowing levels, and passes information to HM Treasury for monitoring on a UK-wide basis.
CIPFA (2012) states that the core objectives of the code are to ensure that:
Capital expenditure plans are affordable
All external borrowing and other long-term liabilities are within prudent and sustainable levels
Treasury management decisions are taken in accordance with professional good practice
A revision of the code in 2009 (CIPFA 2012) also emphasised the importance for councils’ plans for borrowing that should have the following aspects:
Service objectives, i.e. strategic planning for the local authority;
Stewardship of assets, e.g. asset management planning;
Value for money, e.g. option appraisal;
Prudence and sustainability, e.g. implications for external borrowing and whole life costing;
Affordability, e.g. implications for council tax, rents etc.; and
Practicality, e.g. achievability of the plan.
Audit Scotland reported that:
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“Borrowing is a key source of finance for councils to invest in vital public services. Overall borrowing has remained at around £12 billion for the last three years, with total assets of £39 billion. Councils have developed borrowing strategies to suit their own local priorities and needs, in response to the flexibility introduced by the Prudential Code in 2004. Seventeen councils have increased their borrowing levels, in real terms, over the last ten years.” (Audit Scotland 2015)
Cm 8990 also discussed the prudential code and pointed out:
“[it] was introduced to replace a system of credit approvals being sought by local authorities from central government, which in turn replaced an allocation of funds from central government for capital expenditure. It was not aimed at increasing the amount of capital expenditure rather the Code improved the efficiency and clarity of decision making by local authorities about investment decisions” (UK Government 2015b).
SUBNATIONAL DEBT: INTERNATIONAL OVERVIEW
At the end of 2012, on average in the OECD area, subnational government debt accounted for 22% of GDP with wide variations between states as shown in Figure 2.
The relatively small share of local government debt is driven by legal restrictions to local borrowing. In a majority of countries, local governments can borrow only for the long term to finance investment (the “golden rule”). Local borrowing is generally governed by strict prudential rules defined by central or state governments (OECD 2013).
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Figure 2 General government gross debt (as a % of GDP) and breakdown by levels of government, 2012
Source: OECD 2013
BOND ISSUANCE
The Scotland Act 2012 provided for the means of borrowing to be varied through secondary legislation such as enabling the Scottish Government to issue bonds. In December 2014, the UK Government announced that it was beginning the formal process to give the Scottish Government the power to issue bonds from 1 April 2015 (UK Government 2014b). A newspaper article in the Financial Times on 15 May 2015 (Financial Times 2015) noted that global agencies have not yet issued Scotland a credit rating and that Scottish bonds will not be underwritten by the UK Government “meaning that the interest rate Scotland attains will be a public indication of the way the country is regarded by investors around the world.”
To date the Scottish Government has not issued bonds.
0% 30% 60% 90% 120% 150% 180% 210% 240%
Estonia
Luxembourg
Norway
Korea
Switzerland
Sweden
Australia
Czech Republic
Slovak Republic
Denmark
Slovenia
Poland
Finland
Netherlands
Israel
Austria
OCDE30 country avg
Iceland
Hungary
Germany
Spain
Belgium
United Kingdom
Canada
France
United States
OCDE30 average
Ireland
Portugal
Italy
Greece
Japan
Local States Rest of public sectorStates + local
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“NO DETRIMENT” PRINCIPLE
The Smith Agreement outlined two “no detriment” principles that should underpin the devolution of further powers to Scotland:
“No detriment 1”: There should be no detriment as a result of the decision to devolve further power: the Scottish and UK Governments’ budgets should be no larger or smaller simply as a result of the initial transfer of tax and/or spending powers, before considering how these are used; and
“No detriment 2”: There should be no detriment as a result of UK Government or Scottish Government policy decisions post-devolution (UK Government 2014a).
These principles are of particular importance when considering how to adjust the block grant to reflect the devolution of tax-raising powers (the “block grant adjustment”). It has been argued that no detriment 1 is “straightforward” (SPICe Research 2015) and, according to David Phillips, “sensible at first glance” (Scottish Parliament 2015b), a point also made by the Chartered Institute of Taxation and the Low Incomes Tax Reform Group (Scottish Parliament 2015b).
Professor Keating noted that while no detriment, taken as a whole is “fair in principle, it is a minefield” (Keating 2015).
In a written submission to the Finance Committee, David Phillips noted that difficulties arise when considering how to implement both of these principles together (Scottish Parliament 2015b). He pointed out that in principle at least, the first year block grant adjustments are relatively straightforward to implement (even though the two Governments may disagree on their forecast of Scottish tax revenues) but in subsequent years it is more difficult because:
“One cannot simply continue to deduct or add an amount equal to the revenues or spending devolved. Doing this would remove any incentive for the Scottish Government to boost tax revenues or limit expenditure growth” (Scottish Parliament 2015b).
Continuing to adjust by the amount raised by the tax also means that none of the risks of tax devolution are transferred to the Scottish Government.
Many concerns have been raised, notably about the operability of the second no detriment principle. The Committee on Economic Affairs, for instance stated that the second no detriment principle “is unworkable in practice and a recipe for continuing conflict” (UK Parliament 2015a).
Of particular concern is what constitutes “no detriment” which requires defining what counts as a “detriment”. A detriment is broadly defined as the consequence of a policy decision by the UK or Scottish Government in a policy area that is devolved to Scotland. Detriments may be direct (e.g. a change in income tax rates has a direct impact on tax revenues) or indirect (e.g. a change in benefits may incentivise people to return to work, which may decrease expenditure on a range of benefits but may also lead to an increase in revenue through income tax, VAT, etc.). The Chartered Institute of Taxation and the Low Incomes Tax Reform Group noted that, “there is a lack of consensus regarding what might be detrimental and need to be taken into account” (Scottish Parliament 2015b). Professor Keating believes that “determining what should count as detriment will remain politically contentious and technically complex.” (Keating 2015).
The Chartered Institute of Taxation and the Low Incomes Tax Reform Group identified an additional problem beyond identifying what counts as a detriment, pointing out that, “it will be difficult to calculate the amounts involved – there are likely to be numerous possible methods. It may therefore not be practical to provide compensating transfers in many cases, particularly if the effects of the policy in question are conflicting” (Scottish Parliament 2015b).
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Professor Andrew Hughes Hallett highlighted that quantifying no detriment will require the modelling of counterfactual behaviour where the tax policies did or did not change i.e. what would have happened if a policy that did change hadn’t, and if a policy that didn’t change actually had (Scottish Parliament 2015b). Professor Hughes Hallett noted that the first round effects would have to be distinguished from the second round effects of devolved powers and gains/losses from second round effects would have to be taken into account even if there are none from the first round effects (Scottish Parliament 2015b). First round effects are the direct effects e.g. changes in tax revenues following a change in tax rates, or changes in government benefit expenditure following changes to eligibility criteria for certain benefits. Second round effects are the indirect effects of a policy change e.g. a change in income tax rates may affect taxpayers’ purchasing power which may lead to a change in indirect tax revenues such as VAT.
Audit Scotland recommended that the Governments “agree an initial list of direct effects that can be measured and only consider the indirect or behavioural effects at a later date if there is evidence of these being significant” (Scottish Parliament 2015b).
BLOCK GRANT AND BLOCK GRANT ADJUSTMENTS (BGA)
BACKGROUND
The Smith Agreement and Cm 8990 committed to keeping the Barnett formula to calculate the block grant. To reflect the revenue and spending changes arising from the newly devolved taxes and benefits under the Scotland Bill 2015-16, the block grant will have to be adjusted in a number of ways:
It will be decreased to reflect the revenue foregone by HM Treasury following the disapplication of air passenger duty (APD) and aggregates levy in Scotland. If a Scottish APD and/or aggregates levy is introduced, revenue from these taxes will be collected by Revenue Scotland instead of HMRC;
It will be decreased to reflect the revenue foregone by HM Treasury following the devolution of income tax on non savings non dividend income for Scottish taxpayers: this will continue to be administered and collected by HMRC but Scottish income tax will flow to the Scottish Government;
It will be increased following the devolution of a number of welfare benefits outside of universal credit that will be transferred from the Department for Work and Pensions to the Scottish Government; and
It may be increased or decreased following the devolution of the power to vary the housing cost elements of universal credit depending on whether or not the Scottish Government makes changes to these elements.
These block grant adjustments (BGA) are independent of one another and it is possible that different mechanisms to adjust the block grant will be used for each of them. As noted by the Chartered Institute of Taxation and the Low Incomes Tax Reform Group: “It is unlikely that the same method of adjusting the block grant will be appropriate for each area of tax or spending” (Scottish Parliament 2015b). Each adjustment mechanism exposes the UK and Scottish Governments to different risks whilst protecting them from others, for example differential population growth between Scotland and rUK or economic recessions. The following taxes are currently devolved in Scotland: Council Tax, non domestic rates, Stamp Duty Land Tax (SDLT) and Landfill Tax. A one-year BGA was agreed for the first year of their operation in 2015-16, which was the mid-point of the SFC and OBR forecasts. The Scottish Rate of Income Tax (SRIT) is set to be introduced in April 2016.
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There is no adjustment to the block grant in relation to Council Tax as this is collected, administered and spent by local authorities across the UK.
The devolution of non domestic rates affects the calculation of the block grant through the Barnett Formula. In the 2010 Statement of Funding Policy the Department of Local Government had a comparability factor of 17.3% for Scotland because 82.7% of local government funding in 2010-11 in England was (at least nominally) funded by English business rates (UK Government 2010a). The 2015 Statement of Funding Policy changed the way in which this was accounted for in the Barnett formula – local government now has a comparability factor of 100% for all the devolved administrations but business rates income (i.e. the redistribution of business rates income to local authorities in England) is now a separate line and has a comparability factor of 100% for all the devolved administrations (UK Government 2015e).
For more information on business rates and the Barnett formula see SPICe Briefing Spending Review and Autumn Statement 2015.
SCOTLAND ACT 2012 AND BLOCK GRANT ADJUSTMENTS
The Commission on Scottish Devolution, also known as the Calman Commission, was set up in 2008 to review the Scotland Act 1998. In its final report “Serving Scotland better: Scotland and the United Kingdom in the 21st century” (BBC 2015), the Commission made recommendations for the future of Scotland which included, on the tax side, the introduction of SRIT and the devolution of Stamp Duty Land Tax, aggregates levy, Landfill Tax and air passenger duty to the Scottish Parliament. It noted that in each case there should be a corresponding reduction in the block grant.
The UK Government published a response to the Calman Commission in Cm 7738 “Scotland’s Future in the United Kingdom: Building on ten years of Scottish devolution” (UK Government 2009) in which it laid out its own recommendations for Scotland. It further developed its proposals in Cm 7973 “Strengthening Scotland’s Future” (UK Government 2010b). The Scotland Act 2012 subsequently devolved Stamp Duty Land Tax, Landfill Tax and included provisions for the introduction of SRIT. However, as with the Scotland Bill 2015-16, it included no provision for the reduction in the block grant in relation to those new tax powers.
Cm 7973 noted that: “The [Calman] Commission made no recommendation for how the reduction in the block grant exchanged for the devolved tax powers should be calculated. We infer from the examples provided in the Commission’s final report that the reduction would be a percentage based on the average worth of the devolved tax receipts over a number of years, not a single year.” (UK Government 2010b)
Cm 7973 went on to propose that there be a one-off deduction to the block grant following a transition period as shown in Table 4.
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Table 4 Summary of the UK Government’s three-phased block grant adjustment proposal
Phase 1: to allow for the devolution of the smaller taxes When SDLT and landfill tax are devolved in April 2015, there will be a reduction which will then be deducted from the block grant for all future years. As these taxes are completely devolved to the Scottish Parliament, there will be no need for subsequent adjustments to the block grant to compensate for change to these after their devolution.
Phase 2: to allow for the devolution of income tax in a period of transition For income tax, the deduction from April 2016 in each year of transition will be calculated annually and be based on an OBR annual forecast of Scottish income tax receipts. These will not be reconciled during transition and the UK Government will bear the risk of any deviation of outturn from forecast. During the transition period, based on the principle of “no detriment” a change made by the UK Government to the structure of income tax would not have an impact on the Scottish Government as the value of the deduction will be recalculated annually
Phase 3: income tax: post transition Following the transition period, there will be a one-off deduction to the block grant and this will be the block grant that Barnett consequentials are added to in future years. The transition period will have provided real outturn data for Scottish tax receipts.
Source: UK Government 2010b
The method outlined in Table 4 was not in line with the Independent Commission on Funding and Finance for Wales’ (also known as the “Holtham Commission”) understanding of the Calman Commission. The Holtham Commission stated in its final report “Fairness and accountability: a new funding settlement for Wales” (Wales Assembly 2010), in contrast to Cm 7973 that:
“The Calman Commission has recommended that a common approach, namely the PD [proportionate deduction] model, should be applied to all devolved taxes; the initial offset to the block grant should be equivalent to the devolved tax take in the first year of devolution, and in subsequent years the offset should be a fixed proportion of the grant.”
The Holtham Commission was set up by the Welsh Assembly Government to carry out a review of the Barnett formula and identify possible alternative funding mechanisms for Wales. Its conclusions are also valid for the other devolved administrations. While acknowledging that the Holtham Commission had “considered in some detail an alternative to a one-off deduction” Cm 7973 concluded in 2010 that “practical constraints mean [the Holtham Commission’s] recommended method could not at present be applied” (UK Government 2010b). The “Holtham method” was subsequently adopted to adjust the block grant in relation to SRIT.
The one-off deduction method initially proposed by the UK Government for SDLT, Landfill Tax and SRIT “caused concern to the Scottish Government because of the effect that the approach would have had on the Scottish budget since 1999 had it been applied during these years” (Scottish Government 2013).
In 2012, following a meeting of the Joint Exchequer Committee, the Scottish and UK Governments agreed to keep the first two phases laid out in Table 4 for SRIT for a two or three year transitional period. After that the “Holtham method” would be applied whereby the deduction to the block grant would be indexed to the growth in the non savings non dividend income tax base in rUK (Scottish Parliament 2012, Scottish Government 2013). In a letter to
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both the Scottish Government and the Scottish Parliament, the then Secretary of State for Scotland stated that:
“The UK and Scottish Government agree that this approach is most closely aligned to our requirements for partially devolved taxes” (Scottish Parliament 2012).
The UK Government also rejected the one-off method laid out Table 4 for SDLT and Landfill Tax. According to the UK Government, the Holtham method would not have been appropriate for calculating the block grant adjustment method for SDLT and Landfill Tax (Scottish Parliament 2012). As highlighted by the Scottish Government:
“The UK Government moved away from this [one-off deduction method] by proposing a position which would change the Barnett Formula. This was a proposal that the Scottish Government could not accept, in addition to the fact that changing the Barnett Formula is something which the unionist parties have now vowed not to do. In order to make progress the Scottish Government reluctantly moved away from the Command Paper position and has proposed a mechanism which would see an initial adjustment indexed to the growth in nominal GDP. Progress has since been made in analysing and understanding the potential outcomes of different adjustment options. Options have to be assessed for robustness, transparency and fairness over time as well as in the first year” (Scottish Government 2014).
In November 2014, the UK Government proposed that there be an initial adjustment to the block grant for LBTT and Landfill Tax just for 2015-16 rather than a permanent solution (Scottish Parliament 2014). Reasons for this included the transitional nature of 2015-16, the possibility of considering a permanent solution in future alongside the rest of the package agreed by the Smith Commission, and HM Treasury’s decision to set budgets up to 2015-16. As the Scottish and UK Governments had different forecasts for LBTT and Landfill Tax, they agreed that the block grant deduction for 2015-16 would be the average of the UK and Scottish forecast receipts for 2015-16 (Scottish Government 2015d).3 The JEC met on 7 December 2015 and the Scottish and UK Governments agreed an adjustment to the block grant in 2016-17 in relation to LBTT and Landfill Tax (UK Government 2015d).
DIFFERENT BLOCK GRANT ADJUSTMENT METHODS
The Holtham Commission focused on four different deduction methods that can be used to adjust the block grant in relation to tax devolution in a devolved administration:
Fixed deduction;
Proportionate deduction;
Own base deduction; and
Deduction indexed to the rest of the UK (rUK) (Wales Assembly 2010).
Fixed deduction
This is the simplest method and it can easily be implemented using the Barnett formula. The deduction can be a one-off deduction (as was initially proposed with LBTT and Landfill Tax), a
3 The Cabinet Secretary for Finance, Constitution and Economy provided a breakdown of the forecasts to the
Finance Committee of 19 January 2015 (Scottish Government 2015f).
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fixed deduction in cash terms each year or a fixed deduction in real terms each year. An annual fixed cash-terms deduction would mean the value of the deduction is eroded in real terms over time. In particular, tax revenue and the block grant are likely to grow over time so the deduction would represent a smaller and smaller percentage of both revenue and the block grant. Alternatively, the deduction could be indexed to inflation (CPI or RPI for instance)4 or, more likely, nominal GDP growth. The block grant would be the same as before devolution so long as revenue increased at the same rate as the factor the deduction was indexed to. Using this method, Scotland would be exposed to UK-wide shocks that it is ill-equipped to bear with its current borrowing borrowers according to David Phillips (Scottish Parliament 2015b).
Proportionate reduction
The deduction would be a fixed percentage of the block grant and would thus rise in line with the block grant. In order for the Scottish budget to be no better or worse off as a result of devolution, Scottish revenues would have to grow at least as fast as the block grant. As with the fixed deduction method, the proportionate reduction method leaves the Scottish budget exposed to the risk that its revenues may fall, even if this fall affects the whole of the UK if UK Government spending is maintained. This is because the block grant, and hence the value of the deduction, would be the same.
As noted by David Bell (2012) “the correlation between the spending plans of the UK Government and the ability of the Scottish Government to raise additional revenue is key” to how this method would impact on the Scottish budget.
Own Base Deduction (OBD)
This is an indexation method that involves linking changes to the BGA to changes to the Scottish tax base. Contrary to the proportionate deduction method, this method shields the Scottish budget from the risk that Scottish revenues may fall: the lower the tax base, the lower the deduction. However, this method limits the Scottish Government’s incentive to increase the tax base, as any growth in the tax base would be cancelled out by an offsetting change in the deduction to the block grant. This seems to go against the very concept of devolution.
Indexation to the equivalent tax in the rest of the UK (rUK)
This indexation involves linking changes to the BGA to changes in a tax in rUK that is equivalent to the one that is devolved to Scotland. This can be done by looking at:
The change in the tax base or in tax revenue over time; and
The percentage change overall, the percentage change in “pounds per person” or the change in “pounds per person.”
Indexation to the tax base may be better suited to partially devolved taxes (e.g. SRIT). For instance, assume that SRIT is in place. If the UK Government increases income tax rates, these new rates also apply to the part of income tax in Scotland that is not devolved. As the tax base would not change the BGA would not change. This would be logical as SRIT revenues would not increase. Scotland would still “gain” from the extra tax levied on Scottish (and rUK) taxpayers in the form of increased spending on devolved services (as this would lead to Barnett
4 However, in normal times, if the economy is growing, income tax revenues should grow at a faster rate than
inflation. Thus this method, in normal times, may lead to an increase in the Scottish budget simply as a result of
the method. This would be against no detriment 1.
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consequentials) and on reserved matters (as this is assumed to benefit the UK as a whole). On the other hand, if the deduction is linked to tax revenue and the UK Government increases income tax rates, an increase in tax revenue would be matched by an increase in the deduction to the block grant. However, SRIT revenues would remain the same thus the Scottish budget would decrease simply because of a UK Government policy change. This would be against no detriment 2. In the case of a fully devolved tax e.g. income tax on earnings under the Scotland Bill 2015-16, it may be more appropriate to index the block grant deduction to the change in rUK tax revenues rather than the tax base. For instance, assume income tax is devolved. If the deduction to the block was indexed to the tax base (not revenues) and the UK Government increased income tax, the BGA would remain the same which would be logical as Scottish tax revenues would not increase - but rUK tax revenues would increase and Scotland would benefit from increased UK Government spending (on reserved and devolved services) funded by this extra revenue. This would also be against no detriment 2.
However, indexing the BGA to tax revenues may also pose a problem if the UK Government changed income tax rates: an increase in rUK tax revenues would lead to an increase in the BGA, and the Scottish Government would have to either increase income tax or decrease expenditure to match the decrease in its budget. If the UK Government used the extra rUK revenue to fund devolved services in England, Scotland would, as mentioned above, benefit through Barnett consequentials and the two effects may cancel each other out. However the extent to which this happens depends on the indexation method used for the BGA (see discussion below). In addition, avoiding a detriment to the UK Government or the Scottish Government in the event of a policy change by the UK Government would involve identifying whether a particular spend by the UK Government was funded by a reserved tax or one that is devolved to Scotland. In the absence of ring-fencing for most taxes, this discussion may not be possible.
Concerning reserved services, Cm 8990 noted that if rUK revenue is used to fund expenditure on reserved services, there should be an adjustment to the block grant to account for the fact that Scotland “benefits” from the increased expenditure without increasing its own revenue (UK Government 2015b). However, if two taxes, one reserved and one devolved were increased in the same year by the UK Government, it is difficult to see how either Government could say which tax, and in what proportion, paid for the increased spending which would make it difficult to determine whether or not there should be a further adjustment to the block grant in order to comply with the no detriment principle.
Percentage change in tax revenue
The most straightforward indexation method under this heading is to look at the percentage change in revenues over time. For instance, if rUK income tax revenues on earnings grow by 5% over a period of time, the block grant adjustment would also grow by 5%. Scotland would be no better or worse off if its tax revenues grow at the same percentage rate as rUK. Under these conditions, this method is broadly consistent with no detriment 1. This method insulates Scotland from UK-wide shocks but still gives the Scottish Government an incentive to grow its economy. For example, Scotland would capture the reward of relatively faster population growth. It would also “gain from attracting and retaining more income tax payers” (IFS 2015). While this indexation method may give the Scottish Government the “incentive” to increase its population or high income taxpayers in order to increase tax revenue, this may not be an appropriate incentive given that, for instance, migration and labour policy remain reserved matters. For those taxes where revenue is less per person in Scotland than in rUK, such as income tax which accounted in 2013-14 for 7.3% of tax revenue in the UK as a whole whereas the Scottish
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population accounted for 8.3% of the UK population (Scottish Government 2015b),5 Scotland would have to grow its revenues proportionally more per person simply to keep up with rUK using this indexation mechanism. Furthermore, if the population of Scotland declined relative to the UK as a whole over time, Scotland would have to grow its tax revenue per person increasingly faster than rUK for the Scottish budget to be no better or worse off as a result of devolution. This seems to be against no detriment 1. This method also implies that the “Barnett squeeze,” whereby expenditure per person on devolved services in Scotland should over time become closer to England, would happen faster than it otherwise would as Scotland would have to grow at a faster percentage rate than rUK simply for its budget to remain the same as before devolution. Another point that must be considered when using this method is the way the BGA would interact with the Barnett formula. For example, if income tax had been devolved in 2013-14, assume the initial deduction to the block grant for 2013-14 had been £11.4bn. Assuming the UK Government raised income tax rates in 2014-15 so as to raise an additional £10bn (equal to roughly 7% of rUK income tax revenue) and used this entire amount on the education budget, Scotland would on the one hand receive a Barnett consequential of £830m. On the other hand, the deduction to the block grant would increase by 7% of £11.4bn, equal to roughly £800m. In total Scotland’s block grant would increase by £830m - £800m = £30m. The opposite effect would happen for a tax that has a higher yield per person in Scotland than in England. Table 5 summarises the implications of this effect depending on whether the tax yield is higher or lower per person in Scotland. Table 5 Effect on the Scottish budget of a rUK tax and spending change
rUK tax & spending rise rUK tax & spending decrease
Tax yield lower per person in
Scotland than rUK (e.g. income tax)
Increase Decrease
Tax yield higher per person in
Scotland than rUK (e.g. aggregates
levy)
Decrease Increase
In other words Scotland would benefit (marginally) from an income tax rise in rUK and lose out (marginally) if there was a tax cut in rUK, if these changes in revenue were matched by changes in devolved matters. This (minor) effect exists because:
The Barnett formula leads to an addition to the Scottish budget of a Scottish population share of additional spending in devolved matters in rUK; and
The indexed deduction method takes away from the Scottish budget a Scottish percentage share of additional revenue in rUK.
Change in revenue per person
The effect described in Table 5 would not occur if the BGA indexation method was linked to changes in rUK revenues per head. One way to interpret this method is referred to as the “pound per person” method and implies that a £1 per person (in rUK) growth in rUK revenue leads to a £1 per person (in Scotland) increase in the BGA. Under this scenario, if Scottish revenues from the devolved tax were less per person than the equivalent tax in rUK, this
5 This effect is due to Scotland having a lower proportion of people in the higher tax bands (additional and higher
rate) than rUK.
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indexation method would cause the Scottish Government’s budget to increase less quickly than the above percentage change-in-rUK-revenue mechanism. In these circumstances, even if tax revenue in Scotland and rUK increased at the same percentage rate, the deduction to the block grant would grow faster than Scottish tax revenue leading to a decrease in the Scottish budget over time.
If the “pound per person” method was used in conjunction with the Barnett Formula, Scotland would to some extent be shielded from demographic changes (broadly speaking, if the population increased in Scotland, Barnett consequentials would be bigger than they would otherwise be, and the deductions to the block grant would also be bigger than they would otherwise be). For instance, if income tax had been devolved in 2013-14, assume the initial deduction to the block grant for 2013-14 had been £11.4bn. If Scottish revenue and rUK revenue both grow by 5% per year, by 2023-24 income tax revenue in Scotland would be £18.6bn. Based on projections of population estimates, applying the pound-per-person indexation leads to a deduction in 2023-24 of £19.5bn as shown in Table 6. Table 6 Ten-year effect of indexing the deduction to £ per person revenue growth in rUK
Income tax revenue in Scotland (£bn)
Deduction to the block grant (£bn)
Difference between the tax revenue and the block grant (£bn)
2013-14 11.4 11.4 0.0
2014-15 12.0 12.1 -0.1
2015-16 12.6 12.7 -0.2
2016-17 13.2 13.5 -0.3
2017-18 13.9 14.2 -0.4
2018-19 14.5 15.0 -0.4
2019-20 15.3 15.8 -0.5
2020-21 16.0 16.7 -0.6
2021-22 16.8 17.6 -0.7
2022-23 17.7 18.5 -0.8
2023-24 18.6 19.5 -1.0
The shortfall would be of £1bn in 2023-24 and would increase over time. Scottish revenues would have to grow quicker than rUK revenues for this not to be the case. The indexation is such that, all other things being equal:
The larger the population in Scotland, the bigger the deduction;
The bigger the rise in rUK revenue in a given year, the bigger the deduction.
This indexation method insulates Scotland from UK-wide shocks while still “incentivising” it to grow its economy and tax revenues. It also protects Scotland in the event its population grows at a lower rate than rUK, and may be justified on the basis that Scotland does not have control over immigration policy. However, the downsides of this method for Scotland are:
For the Scottish budget to be the same as before devolution, the growth in revenue in pounds per person in Scotland has to be the same as in rUK. However, incomes are on average lower in Scotland than in rUK so that implies a higher relative increase in people’s income in Scotland than rUK;
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The Scottish budget would not benefit from revenue increases that resulted from population growth; and
This method may be inconsistent with the Barnett Formula as the formula does not take account of differential population growth, because it does not update the base-level spending to account for the change in population.
POST-SCOTLAND BILL 2015-16 BLOCK GRANT ADJUSTMENT
Tax and welfare
Although it stated that changes to the block grant should be appropriately indexed, the Smith Agreement, as noted in Cm 8990 “stopped short of suggesting what the index should be” for the block grant adjustment following the devolution of new tax and welfare powers (UK Government 2015b). It is important to note that whichever method is used, the year in which the indexation starts may have an impact on the BGA in future years. Of the methods identified by the Holtham Commission, the Committee on Economic Affairs discussed three adjustment methods in relation to the Scotland Bill 2015-16 (UK Parliament 2015a):
Fixed percentage change;
Indexed to changes in rUK revenues; and
Indexed to changes in rUK revenues per head. The Committee on Economic Affairs stated there was no obvious choice between these three methods and pointed out that there were also many other methods to choose from. The IFS (2015) in their paper “Adjusting Scotland's Block Grant for new Tax and Welfare Powers: Assessing the Options” considered “three options where the BGAs are linked in some way to what happens to equivalent tax revenues (or welfare spending) in rUK.” These are:
Indexed Deduction (ID): this is the method that indexes the change in the BGA to the percentage change in total comparable tax revenues (or spend) in rUK;
Two ways of interpreting the “indexation to changes in rUK revenues per head” method: o Per Capita Indexed Deduction (PCID), which indexes the block grant adjustment per
capita to the percentage change in comparable rUK revenues per person. Scotland would be protected from slower population growth, but would not benefit from faster population growth than rUK and the “Scottish Government would therefore lack incentives to boost growth through attracting more people to Scotland” (IFS 2015); and
o Levels Deduction (LD), which works in a similar way to the Barnett formula in that it “calculates the change in the BGA as a population share of the change in comparable revenues in rUK. For example, if income tax revenues increased by £10 billion in rUK, then if Scotland’s population was 9% of rUK, Scotland’s BGA would increase by £900m. The rationale for the LD approach is that, by being based on a population share of a cash terms change in revenue, it is symmetric with the spending side of the Barnett Formula (which calculates the change to Scotland’s block grant as a population share of the cash terms change in English spending)” (IFS 2015).
Concerning the LD approach, the IFS pointed out that:
“This symmetry property is useful when it comes to changes in rUK tax rates. Changes in UK tax rates for taxes that are devolved are likely to lead to a change in spending by the UK Government. To the extent that this spending is likely to benefit Scottish taxpayers in some way (either because it leads to an
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increase in the Scottish block grant via the Barnett formula, or because it leads to an increase in ‘reserved’ spending in Scotland), the block grant to Scotland would need to be adjusted to ensure that increases in taxes in rUK tax do not fund higher spending in Scotland, without a corresponding increase in Scotland’s tax effort. This is the ‘taxpayer fairness’ element of the Smith Commission’s ‘no detriment’ principles” (IFS 2015).
In contrast, the IFS highlighted that the other two methods discussed in their paper do not “fully satisfy the ‘taxpayer fairness’ principle. They found that if the three methods had been in place between 1999-00 and 2013-14:
“Relative to the LD method, the ID method could have resulted in the Scottish Government’s budget being around £1 billion higher a year after 14 years, with the PCID approach delivering an even bigger budget. These are quite sizeable numbers in the context of a block grant to Scotland equal to around £30 billion a year in 2013–14. Our analysis also shows that eventually though, if relative population decline continues, Scotland would start to do less well under the ID method than the LD method (…) the ID method would not represent a sustainable long-term compromise between the PCID and LD methods that, in the short term, would be most beneficial to the Scottish Government and UK Treasury, respectively” (IFS 2015).
The IFS concluded that:
“It is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett Formula remains in place” (IFS 2015)
Dr Jim Cuthbert, in a paper published by the Jimmy Reid Foundation (JRF) titled “IFS report provides inadequate basis for Scottish fiscal settlement negotiations” (JRF 2015) criticised the 2015 IFS report on the basis that they only focused on indexing changes to the BGA to devolved tax revenues and that this has “profound implications for the types of risk to which the Scottish government’s revenues would be exposed, and for the way in which Smith’s second no-detriment principle will impact on the freedom of action of the Scottish government.” Because of this, according to Dr Cuthbert, the IFS’ paper provided a “distorted assessment of the options for the post-Smith fiscal settlement” (JRF 2015). He argued that the IFS had failed to address the following points:
“What effect does the Scottish government’s lack of economic powers have in affecting the balance between risk and potential reward in the eventual fiscal settlement.
What are the limitations, and risks, of trying to run a monetary union on the basis of a largely formulaic approach to distributing resources” (JRF 2015).
In a letter to the Convener of the Devolution (Further Powers) Committee dated 29 November 2015, the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy noted:
“The fiscal framework will cover the annual adjustments to the Block Grant to account for the new spending powers and new revenue raising powers. Three categories of indexation mechanisms have been considered:
Linked to the block grant
Linked to the corresponding UKG [UK Government] tax receipts or tax base or UKG expenditure; and,
Linked to the economy
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The indexation mechanism adopted for each power being devolved will be outlined along with the appropriate methodology for calculating the adjustment” (Scottish Government 2015e).
At the meeting of the Parliament on 9 December 2015, Malcolm Chisholm MSP stated: “I think that we all agree that the fiscal framework is central and that indexation of the block grant adjustment for income tax is pretty central to that.” He pointed out that the majority of academics seemed the be saying that the best method and most risk-free option for Scotland was indexing for changes in the tax base per head. He asked the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy if he agreed that this was the case and the latter responded: “I am very happy to confirm to Parliament that I do” (Scottish Parliament 2015e).
Adjusting the Block grant in relation to the devolution of welfare powers
The Finance Committee stated that “the initial adjustment for devolved welfare expenditure will need to be indexed to the prime drivers of welfare spend somehow” (Scottish Parliament 2015a). One way to estimate over time what the UK Government would have spent in Scotland had the benefits not been devolved is to look at changes to UK Government spending on these benefit in rUK. The IFS highlighted that:
“One option that has many attractive features is to index the block grant reduction (or addition) to what happens to revenues from the equivalent tax (or spending on the equivalent benefit) in the rest of the UK. This insulates the Scottish Government from revenue or spending shocks that hit the whole of the UK, but still gives the Scottish Government the incentive to grow revenues and limit expenditure, and the responsibility to bear the effects of its policies on Scottish revenues and expenditures.” (IFS 2014).
In many ways adjusting the block grant in relation to welfare devolution is the mirror image of adjusting it in relation to tax devolution and the IFS (2015) noted that the same sorts of options as for the tax side could be used: ID, PCID and LD.
Some consideration must be given however to the particularities of welfare spending and welfare devolution under the Scotland Bill 2015-16. For instance:
Across the benefits being devolved, “per capita expenditure is significantly higher in Scotland than in rUK” (IFS 2015); and
A high share of the claimants of the benefits being devolved to Scotland are likely to be aged 60+ and Scotland’s share of the UK population aged 60+ is projected to increase over time (ONS 2013).
The IFS (2015) pointed out that one way to account for differential demographic or socio-economic change between Scotland and rUK is the index the change in BGA to the change in spending per “person at risk” (IFS 2015).
Changing welfare policy has a number of effects:
Direct effect through changes to benefits (eligibility criteria, rates, thresholds, exemptions, etc.); and
Indirect effect through changes in the economy and in people’s behaviour as a result of changes to benefits including spending on other benefits that may be devolved or reserved.
No detriment 2 implies that each government is responsible for the effects of the welfare policy changes that it makes. This raises a number of issues if adjustments to the block grant reflecting welfare devolution are indexed to spending on the equivalent benefit in the rest of the UK. For instance, if a change in devolved benefits by the Scottish Government is accompanied
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by an increase in the employment rate in Scotland and a decrease in the number of people claiming reserved benefits, this could be seen to be a result of Scottish welfare policy changes in which case the UK Government should in principle transfer any savings made through a decrease in reserved benefit expenditure to the Scottish Government. However, there may be a range of other factors that lead to people finding work e.g. economic growth and an increase in the labour demand, in which case there may be no reason for the UK Government to transfer money to the Scottish Government depending on where the “cause” of this economic upturn lies. In addition, an increase in the employment rate may lead to an increase in tax revenues. An increase in devolved tax revenues in Scotland would be a “fair” gain if this is a result of Scottish welfare policy changes. However an increase in reserved taxes (excise duties or VAT for instance), if “caused” by Scottish Government policy changes, should lead to a payment from the UK Government to the Scottish Government.
Other points to consider in relation to welfare devolution and the BGA include:
Universal credit: The housing elements of universal credit can interact with other elements of universal credit so any adjustment to the block grant following a Scottish change to the housing element will have to take into account the change in overall universal credit spending.
Means-tested benefits: Some benefits are paid net of income tax. If the Scottish Government changes income tax in Scotland, this will directly impact the cost of benefits that the UK Government pays. For example the Scottish Government could raise income tax and this would lead to a decrease in people’s net income. More people may become eligible for some means-tested benefits and people who already claim benefits may see their benefits rise, causing an increase in Scottish expenditure by the UK Government. Under the no detriment principle, the Scottish Government would receive any savings from lower UK Government benefit spending or meet any costs of higher UK Government benefit spending.
Passporting: Some benefits act as a passport to other benefits. If either the Scottish or the UK Government change the eligibility criteria for a benefit that is used as a passported benefit by the other government, this will have an effect on the other Government. In this case the increased spend by the latter Government would be met by the government making the change. Equally, any savings arising from this change would lead to a transfer to the Government making the change.
Employment Programmes: Employment Programmes may also come into play: these influence how quickly unemployed people get back to work and have an impact on the UK benefit bill. This is reflected in the Work Programme which is funded by savings made in benefits spending. The White Paper Cm 8990 notes that: “While future negotiations with Scotland need to be conducted, we must ensure that this aligns with the no detriment principle. Any funding arrangement must ensure that Scotland receives funding on an equivalent basis to the rest of the UK” (UK Government 2015b).
TAX DEVOLUTION AND ASSIGNMENT UNDER THE SCOTLAND BILL 2015-16
TAX REVENUE FORECASTS
Table 7 shows the OBR’s November 2015 forecasts for SRIT, LBTT, Landfill Tax and aggregates levy from 2015-16 to 2020-21. Of these taxes, only LBTT and Landfill Tax revenues are forecast by both the OBR and the Scottish Government. The OBR’s forecast for LBTT has been revised down significantly from previous forecasts and is now closer to the Scottish Government’s forecast. Changes in OBR forecasts over time raise the question of
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whether there would be a change to the BGA if it was based on these forecasts and they changed over time.
Table 7 Scottish tax forecasts, 2015-16 to 2020-21
£ million 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21
SRIT 4,649 4,900 5,226 5,521 5,802 6,148
LBTT 397 496 557 628 700 769
Landfill tax 140 131 120 120 127 140
Aggregates levy 46 43 39 39 42 46
Total 5,232 5,569 5,942 6,309 6,671 7,104
Source: OBR 2015
INCOME TAX
The Scotland Act 2012 introduces the power for the Scottish Parliament to set a Scottish Rate of Income Tax (SRIT) from April 2016. The UK Government will deduct 10 pence in the pound at the basic, higher and additional rates of income tax on earnings for Scottish taxpayers, i.e. income from employment, self-employment, pensions and rental income. The Scottish Parliament will then set SRIT which will apply equally to these three rates. Scottish taxpayers will thus pay a “UK income tax” (at 10p in the pound less than taxpayers in the rest of the UK) plus SRIT. Thus if SRIT is set at 10p, income tax will remain the same for Scottish taxpayers as in the rest of the UK (Berthier 2015).
The Scotland Bill 2015-16 includes provisions for the Scottish Parliament to set the rates of income tax and the band thresholds on earnings of Scottish taxpayers. The Parliament will not have the power to change the personal allowance threshold but will be able to introduce a zero pence rate which could effectively increase the personal allowance threshold. It will not be able to introduce different rates for different types of income (for example it cannot create a separate income tax rate for pension income). The devolution of income tax will supersede SRIT. Income tax on savings and dividends will remain reserved. Income tax on savings and dividends represented 4.4% of total income tax in Scotland in 2013-14 (Berthier 2015). HMRC will continue to collect all of income tax (Berthier 2015).
While agreeing that income tax devolution is a suitable candidate for devolution, the Committee on Economic Affairs highlighted that no central government comparable to the UK Government has relinquished full receipt, and almost full control of the income tax on earnings of a subnational unit (UK Parliament 2015a). It raised concerns “that this will weaken the connection between the Scottish electorate and the UK Government” (UK Parliament 2015a).
VAT ASSIGNMENT
The Smith Commission proposed that the Scottish Government should be assigned a share of Scottish VAT receipts equivalent to the first 10 percentage points of the revenue raised from this tax in Scotland. The UK Government's draft legislation also proposes assigning the first 2.5 percentage points of revenue raised in Scotland from the 5% reduced rate which applies on certain goods, such as domestic energy, energy efficiency measures or some health related products (UK Government 2015b). As a result, the Scottish Government would receive 50% of VAT receipts from Scotland. The Scottish Parliament will not have any control over the setting of VAT rates.
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GERS 2013-14 (Scottish Government 2015b) indicates there a number of methodological difficulties in apportioning VAT revenues.
In evidence to the Finance Committee (Scottish Parliament 2015a) Dr Jim Cuthbert also expressed concerns:
“Scotland‘s historic share of VAT revenues has been fairly volatile, so a lot of attention needs to be paid to putting those estimates on a much sounder footing so that we can cope with the potential volatility of VAT.”
Dr Cuthbert suggested that the issue: “is suddenly going to become very important. However, I suspect that the data is not up to the weight that it is being asked to carry” (Scottish Parliament 2015b). In its evidence to the Finance Committee, ICAS (Scottish Parliament 2015b) identified a number of issues:
Considerable analytical and statistical work will be required if there is to be an amount that can be identified which truly reflects the VAT attributable to Scotland and will in future reflect any changes in the Scottish economy;
How accountability to the Scottish Parliament is arrived at through assignment has yet to be decided; and
Should the calculation be based on the point of production or consumption? o Calculating VAT at point of production – within the UK it may be difficult to pinpoint
exactly where value is added in the production process to identify the “Scottish VAT”;
o Calculating VAT at point of consumption – the VAT paid when goods are sold to the final consumer may not reflect the productivity or economic success of the Scottish economy.
PWC in written evidence to the Committee on Economic Affairs were concerned that the Scottish Government would “bear the risk of any fluctuations or falls in [VAT] revenue, whilst having no direct influence on the setting or collection of the tax” (UK Parliament 2015a).
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Scottish Government (2015a) Letter from the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy to the Finance Committee to the Convener of the Finance Committee. 22 January 2015, available at - http://www.scottish.parliament.uk/S4_FinanceCommittee/General%20Documents/Cabinet_Secretary_for_Finance_Constitution_and_Economy_to_the_Convener_dated_22_January_2015.pdf
Scottish Government (2015b) Government Expenditure & Revenue Scotland 2013-14, Annex A – Revenue Methodology, available at - http://www.gov.scot/Publications/2015/03/1422/9
Scottish Government (2015c) Letter from the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy to the Finance Committee. 7 June 2015, available at - http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/General%20Documents/SG_Response.pdf
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Scottish Government (2015d) Letter from the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy to the Convener of the Finance Committee. 14 January 2014, available at - http://www.scottish.parliament.uk/S4_FinanceCommittee/General%20Documents/Letter_to_Finance_Committee_14_Jan.pdf
Scottish Government (2015e) Letter from the Deputy First Minister and Cabinet Secretary for Finance, Constitution and Economy to the Convener of the Devolution (Further Powers) Committee. 29 November 2015
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Scottish Parliament (2011a) Report on the Scotland Bill Volume 2 - Main Report, 1st Report, 2011 (Session 4), Scotland Bill Committee, available at - http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/Reports/sbr-11-01-vol2w.pdf
Scottish Parliament (2011b) Report on the Scotland Bill Volume 1 - Conclusions and Recommendations, 1st Report, 2011 (Session 4), Scotland Bill Committee, available at - http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/Reports/sbr-11-01-vol1w.pdf
Scottish Parliament (2012), Letter from the Secretary of State for Scotland to the Cabinet Secretary for Parliamentary Business and Government Strategy and the Cabinet Secretary for Finance and Sustainable Growth, available at - http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/General%20Documents/M_Moore_letter_to_Bruce_Crawford.pdf
Scottish Parliament (2013) Report on implementation of the financial powers in the Scotland Act 2012, 8th Report, 2013 (Session 4), Finance Committee, available at - http://www.scottish.parliament.uk/S4_FinanceCommittee/Reports/fiR-13-08w.pdf
Scottish Parliament (2015a) Scotland’s Fiscal Framework,12th Report, 2015 (Session 4), Finance Committee, available at - http://www.scottish.parliament.uk/S4_FinanceCommittee/Reports/fir15-12w.pdf
Scottish Parliament (2015b), Scotland's Fiscal Framework – written submissions in response to the call for evidence, Finance Committee, available at - http://www.scottish.parliament.uk/parliamentarybusiness/CurrentCommittees/88670.aspx
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UK Government (2009) Scotland’s Future in the United Kingdom: Building on ten years of Scottish devolution, Command Paper 7738, available at - https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/228529/7738.pdf
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UK Government (2015b) VAT rates on different goods and services, available at - https://www.gov.uk/guidance/rates-of-vat-on-different-goods-and-services
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RELATED BRIEFINGS
SB 15-77 Spending Review and Autumn Statement 2015
SB 15-72 Income Tax in Scotland
SB 15-67 Scottish Fiscal Commission Bill
SB 15-16 Further Devolution for Scotland: The Draft Clauses
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