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
| 
