The Scotland Bill - Scottish Affairs Committee Contents


Written evidence submitted by Professor Andrew Hughes Hallett and Professor Drew Scott

EXECUTIVE SUMMARY

We have serious concerns about the economic consequences that will flow from the fiscal provisions contained in the Scotland Bill. The funding mechanism being proposed has an inherent deflationary bias, and might well force a future Scottish Government to implement unexpected and potentially damaging public spending cuts that have no equivalent elsewhere in the UK. Further the new provisions will be implemented at a time when the income tax base in Scotland has been seriously weakened following five years of public spending cuts. We believe this financing regime could trigger a damaging cycle of further spending cuts leading to higher joblessness which will further erode the income tax base. The Bill offers no new economic policy levers to Scotland's Government to counter this eventuality. We recommend a broadening of the tax base on which "own resource" income to the devolved administration is raised. We also consider the borrowing provisions for non-capital spending are both dynamically unstable and inadequate. Ideally borrowing for capital spending should be extended, but this should be accompanied by a broadening of the tax base available to the devolved administration.

1.  INTRODUCTION

1.1  We are pleased to offer the following comments in response to the call for evidence by the Scottish Affairs Committee of the Westminster Parliament.

1.2  The stated aim of the financial proposals within the Scotland Bill is to enhance the financial accountability of the Parliament for the revenues that it spends annually via the devolved Scottish budget. To a minor extent this will happen. But any benefits arising from this source are likely to be swamped by the wider economic costs that the new funding regime will impose on Scotland. This is because the new arrangements will result in both a deflationary bias being introduced to the Scottish budget and to a pro-cyclical dynamic instability of increasing size to the public spending undertaken by the Scottish Government. Accordingly, in terms of the consequences for the Scottish economy, the prospective funding arrangements are far from neutral - a matter that, in our view, has not been addressed by advocates of the new funding regime or by the UK Government.

1.3  Under the provisions of this Bill, a Scottish Government will be required to operate with a funding mechanism that has an in-built deflationary bias and which will require, on average, the Government to introduce measures that weaken the growth prospects for the economy. Added to this, Scotland's employment base upon which income tax receipts depend is especially vulnerable to the on-going deflationary macroeconomic policies being pursued by the current UK Government. That is a problem in itself. But the key point here is that the Scottish employment base on which the new Scottish income tax ultimately will be levied (ie by 2016) is likely at best to grow only slowly in the coming years—and may well decline, with the result that Scotland's income tax revenues decline, causing further budget cuts, job losses and funding reductions. Either factor alone is sufficient to render the proposed funding mechanism an inappropriate means of financing a devolved government in Scotland. When combined - as they will be by the middle of the current decade - the impact is likely to result in public spending and job cuts in Scotland that are not matched elsewhere in the UK; and/or increases in income tax that are visited only on Scotland. This will impart further lasting damage to the Scottish economy, not to mention the extra pressures it would create to separate from the rest of the UK.

2.  THE ECONOMIC IMPLICATIONS OF THE PROPOSED FUNDING MECHANISM

2.1  The stated aim of the new funding arrangement is to increase the financial accountability of the Scottish Parliament. Our calculations imply that, at best, the tax devolution proposals will result in a meagre 15% increase in the financial accountability - an increase that is highly unlikely to affect Scotland's economic performance in any significant way.

2.2  However, this increase in financial accountability is likely to be achieved at potentially significant cost to the Scottish economy.

2.3  Once the new funding mechanism has been introduced, the revenue accruing to the devolved administration will depend on two distinct financial flows. The first, from which the lion's share of funding will derive, will be a reduced block grant from UK Government adjusted annually by the Barnett formula. The second financial flow is the annual yield from the application of the new Scottish income tax, the rate of which will initially be set at 10p (and applicable to all tax bands) but which can be adjusted upwards or downwards as the Scottish Parliament decrees.

2.4  The rate at which the funds available to the Scottish budget grow annually will henceforth be determined by (i) the rate of growth of the Barnett consequential - this being determined by UK Government, at a rate related to the growth in public spending for the UK as a whole - and (ii) the rate of growth of the yield from Scottish income tax, this being determined by the rate of growth of the Scottish income tax base multiplied by the rate at which Scottish income tax is levied.

2.5  If the new funding regime is to provide at least as much funding to the Scottish budget as the current regime without an increase or decrease in the level of Scottish taxes, the rate of growth of the new tax revenue component has to be at least equal to the rate of growth of the Barnett consequential "block" that it has replaced.

2.6  It is, of course, impossible to forecast either of these elements for when the new regime becomes fully operational in 2018. We have no idea what the growth of UK public spending (for the grant element) and the growth of incomes (for the tax element) will be that far ahead. However we can look at what would have happened to the Scottish budget had the prospective funding regime been in place from 1999-00 when devolution was introduced.

2.7  Recent data provided by the Scottish Government assesses the impact on the total Scottish DEL had the proposed funding regime been in place over the period 1999-00 to 2010-11. In that event, there would have been an accumulated shortfall of almost £8 billion compared to what occurred under the current "full Barnett" model. This is a measure of the deflationary bias of the proposed funding model, and reflects the fact that the rate of growth of UK public spending has exceeded the rate of growth of Scotland's income tax revenues - as would be expected insofar as income tax is only one element of the total basket of taxes that underpin UK public spending trends.[5] Based on the empirical record, we see no reason for not expecting this trend to continue.

3.  FORECASTING AND RECONCILING SCOTLAND'S REVENUES: REVENUE BORROWING

3.1  The Bill proposes that an amount equal to the forecast yield of Scottish income tax would be assigned to the devolved administration for each year in the spending review period. However because of the manner and timing in which forecast and actual income tax receipts are to be reconciled, the Scottish Government will enjoy only very limited protection against such a contingency. In most cases, revisions to spending plans will be needed.

3.2  The Bill provides for a rolling financial reconciliation between forecast and actual (outturn) receipts from the Scotland's income tax "…no later than 12 months after the end of the financial year…" in question. Where the outturn exceeds the forecast an amount will be transferred to the Scottish Government which may be spent or retained; where the outturn is less than forecast an amount will be deducted from the Scottish Government which may be financed from "reserves" or by borrowing. To finance such a repayment Scottish Ministers will be allowed to borrow up to £200 million in any one year subject to an overall ceiling of £500 million of outstanding debt (non-capital borrowing). The presumption is that any amounts in excess of these limits must be financed by an immediate reduction in public spending.

3.3  Based on the latest estimate available for Scottish income tax receipts the proposed annual borrowing facility of £200 million represents less than 5% of the prospective (income tax) revenue stream. This means that should the OBR over-estimate Scotland's income tax revenues by more than 5% in any one year, the borrowing facility alone will be inadequate to finance the reconciliation that will be required from the following year's budget. Moreover this borrowing facility will also be required to make good any temporary mismatch in tax and spending financed by land transaction and landfill taxes.

3.4  To put this in perspective, revenue borrowing is only possible against forecast errors. Over the decade before the current recession, 1997-2007, the UK governments track record for income tax receipts is one of forecast errors that range between +7% to -4%, with an average of +1.1%. Since borrowing will follow from overestimates, this means the Scottish Government will need to cut spending or borrow every year on average and should expect to exhaust its borrowing limit several times in a decade. Finally, no borrowing power is provided if the revenue loss is due to (anticipated) bad economic shocks rather than poor forecasts. The current recession, for example, would according to calculations on the Scotland Office website have cut the Scottish budget by £748 million and £559 million in 2008 and 2009 respectively, sums that are beyond the entire borrowing ceiling - let alone the annual limit of £200 million. But no borrowing would be allowed in such cases anyway. Or, to put the point another way, given that there is a cycle and that adverse shocks do occur, the more accurate the tax forecasts the more volatile will Scottish revenues become and the more the Scottish government will be obliged to cut spending and social support in a downturn. This is why we say the Bill's borrowing provisions offer only limited protection against forecast errors and none at all against unexpected economic shocks.

3.5  In such a scenario, public spending in Scotland has to move pro-cyclically and consequently will simply worsen the severity of the initial economic shock - thereby adding to unemployment and lost output and delaying any subsequent economic upturn.[6]

3.6  Our conclusion is that the provision for non-capital borrowing as proposed is both woefully inadequate and, in economic terms, fundamentally flawed.

4.  SPECIFIC ISSUES

4.1  Scotland's income tax base: The proposal that part of devolved funding will accrue from income tax means that future trends in employment levels in Scotland become an important factor. In common with many economists, we are concerned that the employment effects of the current public spending plans are set to weaken - possibly considerably - the employment base in Scotland. If that happens then inevitably the tax yield will fall, implying that if public spending is to be maintained in real terms the rate at which Scotland s income tax is levied will have to increase. Otherwise real terms spending cuts are inevitable. This would set in motion a further round of deflation and further unemployment.

4.2  To put this point in perspective, Price Waterhouse Cooper, on behalf of Unison, has estimated that 95000 jobs are likely to be lost in Scotland as a result of the UK government's budget cuts.[7] At the current average wage of £24546, this implies £2.3 billion taxable income will be lost because the tax base shrinks. This implies £230 million - £350 million a year, at current average tax rates, will have to be cut from the budget for as long as those job losses last. If the spending multiplier is three (marginal propensity to spend = 2/3, plus investment spending less imports), this means a fall in Scottish non-oil GDP of £860 million or 0.75% each year. A standard production function, with elasticity of demand for labour of 2/3, will give us a rough estimate of the impact of this second round effect (ie of the Scotland Bill spending cuts, not the original job losses due to the UK government cuts). It implies a 1.1% loss in employment (or 1% higher unemployment) or a loss of 27800 jobs on Labour Force Survey employment figures for Scotland in 2010. These are additional losses due to the Scotland Bill itself; they would not be observed elsewhere in the UK.

4.3  Forecasting tax yield: Forecasts of the future value of any economic variable are, of course, invariably wrong. Predicting the future trajectory of Scotland's income tax receipts is no exception. Annual ex post adjustments will therefore be required to reconcile forecast with actual tax receipts for the previous year. It might be presumed that forecast errors will, over a number of years, sum to zero. Assuming we know the number of years involved, and we can estimate the forecast errors, one could argue that the combination of "savings" made in years when the forecast underestimated actual tax receipts, plus the new annual £200 million borrowing facility (up to a maximum outstanding debt of £500 million), will insure the Scottish Government against having to make unanticipated public spending cuts. But there is no evidence to support this presumption, and testing forecasts against outturns will be undertaken during the transition phase before the new regime is introduced. However it is unclear from the Command Paper what revision (if any) to the proposed regime will be made should the evidence display a persistent over- or under-forecast in the estimation of tax revenues, or what any future UK Government would deem to be acceptable regardless of this evidence. We have already noted that evidence demonstrates a persistent trend for Treasury to over-estimate tax revenues. This means that the Scottish Government will, on average, always find itself repaying money to Treasury in the annual reconciliation round. As borrowing is capped at £500 million in total, this necessarily means that public spending in Scotland will inevitably be forced down to finance this repayment.

4.4  Dynamic Instability: As already noted although the revenue "forecasting and reconciliation" arrangement proposed in the Bill rectifies one of the defects in the original Calman proposals, it does so only by introducing a new dynamic instability to the funding arrangement. This instability will arise either when the forecast of tax receipts is significantly (ie above 5%) above outturn (so borrowing will be restricted); and/or when the (£500 million) ceiling on borrowing to finance current spending has been reached and repayments are required now. Should either (or both) situation arise then under the proposals the Scottish Government would be forced to implement spending cuts immediately. We emphasise that neither scenario can be regarded as an "exceptional" circumstance. In addition, increasing the rate of income tax in these circumstances would not be an option because any additional tax revenue generated would not be available until at least the end of the next financial year while the repayment of tax receipts is required at the beginning of that financial year.[8]

4.5  Regressive Tax: The proposal that the Scottish rate of income tax be levied at the same amount for each of the three tax bands is not, in our view, appropriate. What this essentially does is to introduce regressivity into the income tax system which will be apparent in Scotland alone. This is not only undesirable in itself, it is inconsistent with inter-regional equity and a continued UK social union. This feature could only be avoided if the Scottish Government was able to apply the Scottish income tax at different rates according to tax bands - a solution we would recommend.

4.6  Recent Downturn: Estimates of income tax collected in Scotland since the onset of the current recession and financial crisis have been provided by the Scottish Government. This shows a significant reduction in Scotland's income tax revenues over the period 2007-08 to 2010-11 - a cumulative real terms reduction of approximately 11% (£523 million in real terms). Over the same period the "full Barnett" DEL grew by 3.3% in real terms. On Scottish Government data, the cumulative real terms "cost" to the Scottish budget had the proposed funding mechanism been in place since 2007-08 would have been £3.9 billion. Under the proposed scheme, the Scottish Government would have been required to begin repaying (at the expense of current spending) over-estimated tax receipts 12 months following the onset of the recession. This would have propelled the Scottish economy into an earlier and deeper recession than that which occurred. That in turn would have triggered further rounds of self-propelling deflation.

4.7  Borrowing Powers: We consider that both the non-capital and capital borrowing powers provided for in the proposed legislation are inadequate. As argued above, the non-capital powers are inadequate to protect public spending from cuts (or income tax from increasing) that result from either poor economic forecasting or unanticipated economic shocks adversely affecting the Scottish economy. We note that the capital borrowing limit lacks any explanation or justification, and has to be questioned. In principle we see no reason why Scotland's government should be prevented from borrowing on its own account on international capital markets.

4.8  However any debate surrounding borrowing powers must be set in the context of the prospective funding mechanism. We are very concerned this has not been addressed. We consider that the tax base on which part of Scotland's budget will depend is too narrow as proposed to form a secure basis on which net additional borrowing (for either non-capital or capital purposes) should proceed. The overwhelming reliance on income tax revenues creates a significant risk for all public spending and borrowing that is dependent on variations in the yield from this single tax base. We therefore urge that serious consideration is given to broadening the tax base so that the new revenue stream is diversified across a wider range of taxes under the general heading of "shared taxes". It is in our view unwise that income tax revenues alone should be relied upon to finance (service and repay) net additional non-capital and capital borrowing - even to the extent provided for in the proposed legislation.

4.9  Capital borrowing: The creation of a new borrowing facility to finance capital investment is, in principle, welcome. A ceiling of £2.2 billion is proposed (no explanation for this specific limit is provided) and the Scottish Government will be permitted to borrow "…up to 10% of the Scottish capital budget (approx. £230 million in 2014/15) in any year…". Such loans will be sourced from the National Loan Fund, the body responsible for lending to local authorities. Significantly the Scottish Government will not be permitted to issue its own bonds - an aspect of the prospective arrangements that distinguishes Scotland's fiscal authority from that of all other federalised "states" around the world. Therefore, while welcoming the new capital borrowing powers, we note that the scale of the borrowing to be allowed under the new regime is extremely modest and is subject at all times to "external" approval.

5.  OVERALL ASSESSMENT OF FINANCIAL PROVISIONS

5.1   We have very deep concerns about the economic consequences that will flow from the fiscal provisions contained in the Scotland Bill. The funding mechanism being proposed has an inherent deflationary bias, and are likely to force a future Scottish Government to implement unexpected and potentially damaging public spending cuts that have no equivalent elsewhere in the UK. The Bill provides no new economic policy levers to Scotland's Government at a time when, in our view, the Scottish economy is facing unprecedented challenges.

5.2  Second, the financial proposals have simply not been subject to any serious economic analysis by the UK Government. Indeed as far as we know no authority with a recognised economic expertise has endorsed these proposals, or seriously addressed the criticisms that we, and many others, have made.

January 2011


5   This follows from Treasury publications showing UK revenue sources. Back

6   Should the economic shock be beneficial to Scotland's economy then revenues (and spending) will rise which is also pro-cyclical and undesirable as it may exaggerate the economic upturn underway.  Back

7   Calculations by Ernst and Young for the Item Club are very similar. Back

8   The tax revenue available for the following year would be pre-determined by a previous forecast. Back


 
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