3Borrowing powers
19.The Smith Agreement recommended that Scotland be given greater borrowing powers to reflect the additional economic risks, including volatility of tax revenues, which the Scottish Government will have to manage when further financial responsibilities are devolved. The Agreement states that those borrowing powers:
should be set within an overall Scottish fiscal framework and 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.19
The Smith Commission stopped short of stating what those fiscal rules should look like.
20.Borrowing powers fall into two categories: to support current expenditure, and to support capital expenditure and we discuss each in turn below.
Borrowing to support current expenditure
21.The Scottish Government is currently able to borrow up to £200m per year, up to a cumulative ceiling of £500m, to deal with circumstances where revenues are lower than forecast and there are insufficient funds in the cash reserve to maintain spending. It is not clear what criteria these specific limits are based on.20 What is evident is that these borrowing powers will be insufficient to cope with the volatility of those taxes due to be devolved to Scotland as a result of the Smith Agreement.
22.Without borrowing powers, if there were a shock to revenues then a government would be forced to cut spending (at a time when demand for public spending support might be increasing) or increase taxes. At a basic level, borrowing powers allow governments to continue to fund spending commitments through a downturn and to compensate for errors in revenue and spending forecasts. David Phillips, Senior Research Economist at the Institute for Fiscal Studies, confirmed to us that, following this latest round of devolution, Scotland “will need to be able to borrow to smooth the cycle, not just undo the mistakes it makes in its forecasts”.21 This is recognised in the Smith Agreement, which recommends:
Scotland’s fiscal framework should provide sufficient, additional borrowing powers to ensure budgetary stability and provide safeguards to smooth Scottish public spending in the event of economic shocks, consistent with a sustainable overall UK fiscal framework.22
23.What therefore needs to be calculated is how much volatility there is in the revenues that are to be devolved to the Scottish Parliament and the level of risk that both governments deem it appropriate for Scotland to be exposed to. This question of risk and reward goes to the heart of the latest round of devolution. The Smith Agreement stipulates that the UK Government “should continue to manage risks and economic shocks that affect the whole of the UK,”23 and that the Scottish Government should bear the risk and rewards from its own policy decisions but, as David Phillips explained, what the Smith Commission does not cover is who should bear the risk of exogenous shocks that hit only Scotland.24 There has been little public debate on this point. In the view of the UK Government:
if Scotland experiences an economic shock when the rest of the UK does not, the funding model would not provide the Scottish Government with additional funding to offset its lower tax receipts or higher spending pressures. The tools available to the Scottish Parliament […] should therefore enable it to respond to such an event.25
24.In order to address the question of what level of risk Scotland should bear one first needs to consider what tools Scotland will have to deal with situations such as an exogenous shock to revenues. When a recession occurs the number of people in need of benefit support tends to rise while tax revenues tend to fall. Under the Smith Commission proposals the majority of the welfare system, including housing benefit and unemployment benefit, will remain reserved. The Scottish budget is therefore relatively protected from a recession on the spending side. This is not the case on the revenue side. A Scottish recession would hit revenues, particularly those derived from Income Tax on earnings and the level of VAT receipts assigned to Scotland might also be affected as consumer spending would be expected to fall in a downturn.
25.In our view, it would only be acceptable for Scotland to bear the risks of an exogenous shock if it had the tools to address them but David Heald, Professor of Public Sector Accounting at the University of Glasgow, explained to us that “key taxes like VAT and corporation tax are in the control of the UK Government, and monetary policy is and immigration policy is”.26 Professor Heald continued:
to say that the Scottish Government should carry all the risks and rewards in terms of income tax revenues, I find that rather implausible, because I do not think the levers are there.27
John Swinney MSP, Deputy First Minister and Cabinet Secretary for Finance and Sustainable Growth, told us that, while the Scottish Government would assume responsibility for an exogenous shock, “there is a necessity for [Scotland] to have sufficient financial flexibility” to deal with its implications.28 We welcome the devolution of further powers to Scotland but there is a danger that, while those tax powers being devolved may look substantial, they are not particularly suited to addressing the problems caused by an economic shock. The fiscal framework should ensure that Scotland’s exposure to exogenous shocks is commensurate with the Scottish Government’s ability to take effective action to mitigate them. In the event of a substantial exogenous shock we would expect the Joint Exchequer Committee to be convened to discuss how such costs should be shared.
26.This leaves the question of what level of risk Scotland should carry. To some extent this will depend on the method chosen to devolve tax and spending powers. As will we discuss in the next chapter, the Smith Agreement states that there should be no detriment from the initial transfer of powers and that the amount deducted from the block grant to account for the devolution of a tax should be indexed over time (so that its value is not eroded by inflation or economic growth). The method of indexation is relevant to the question of borrowing powers. If the adjustment to the block grant is indexed to changes in the yield of the equivalent tax in the rest of the UK (rUK) then, if there were a UK-wide recession and rUK revenues fell, the amount deducted from the block grant would also fall. Under this mechanism Scotland therefore has some protection from shocks that affect the UK and the risks it faces are less than if other methods of indexing adjustments to the block grant were chosen.29
27.There are a number of different ways of indexing adjustments to changes in rUK revenues and each method has a different impact in terms of the size of the adjustment. Whichever method of block grant adjustment is chosen, we support the principle that adjustments to the block grant should be indexed to changes to rUK tax yields as this approach will limit Scotland’s exposure to UK-wide fiscal shocks.
28.If exposure to UK-wide economic shocks is reduced then the level of risk Scotland faces and therefore the level of borrowing powers required will also be lower. It has been suggested that the Scottish Government might want additional borrowing powers in order to enable it to follow a different path of fiscal consolidation to that of the UK Government. The UK Government has however been clear that:
the fiscal framework must require Scotland to contribute proportionally to fiscal consolidation at the pace set out by the UK Government across devolved and reserved areas.30
Witnesses to our inquiry doubted that the Scottish Government would be given sufficient borrowing powers to adopt a different fiscal stance. 31
29.Professor Heald told us that during debates on the Smith Commission and Scotland Bill there seemed to be an assumption that Scotland having more powers over welfare would lead to more welfare spend. It has been suggested that borrowing powers could be used to top up UK benefits. Professor Bell told the Devolution (Further Powers) Committee of the Scottish Parliament that “borrowing for welfare is normally thought not to be good overall macro policy.”32
30.The additional current borrowing powers that Scotland requires will more likely be determined by the perceived risk of volatility in its tax base and the level of trust in official forecasts. As David Eiser explained to us, “the borrowing is largely going to be about smoothing revenues, smoothing differences between forecasts and outturns and smoothing general year-to-year fluctuations. It is not about enabling very different levels of spending relative to GDP”.33
Balanced budget rule
31.The existing fiscal framework demands that the Scottish Government run an annually balanced budget. This not only constrains the Scottish Government’s ability to pursue a fiscal policy distinct from that of the UK but, as the Scottish Government’s dependence on Scottish revenues rises, then the inflexibility of this rule becomes increasingly detrimental to good economic practice as it forces Scotland to cut spending or raise taxes in a downturn.34 The Deputy First Minister told us that the Scottish Government would require a degree of flexibility to counter-balance the greater exposure to risk.35
32.With appropriate constraints in the fiscal framework the annually balanced budget rule could be relaxed to provide the Scottish Government with more flexibility without detriment to the UK’s overall fiscal position. But, as the Chief Secretary to the Treasury told us, such a rule would have to be consistent with the UK fiscal framework.36 The UK Government has a commitment to run a balanced budget over the economic cycle and we expect the negotiations over revising Scotland’s fiscal framework to provide a similar level of flexibility to the Scottish Government, subject to clear fiscal targets. An enhanced Scottish Fiscal Commission should monitor and report on the Scottish Government’s performance against those targets.
Capital borrowing
33.We asked the witnesses to our inquiry whether they thought the powers being transferred would increase the Scottish Government’s ability to influence economic growth. In terms of tax powers, we were told that on their own they would not add much to the Scottish Government’s existing policy levers (Professor Muscatelli), that their usefulness to stimulate economic growth was questionable (Professor Bell) and that any impact might be at the margins (Professor Heald).37 The general consensus was that the devolution of revenue raising powers was largely about improving accountability.
34.The view was more positive when it came to capital borrowing powers. Professor Muscatelli, Vice-Chancellor and Principal of the University of Glasgow, told us that if there were a sufficiently permissive cap on capital borrowing that enabled a different mix of spend between revenue and infrastructure spend then this might provide the tools with which the Scottish government could grow its tax base.38 Dr McCormick, Associate Director Scotland at the Joseph Rowntree Foundation, suggested to the Devolution (Further Powers) Committee that enhanced capital spending powers might be used to reduce future welfare spend:
We say that the debate should be much more about investing in the childcare infrastructure and affordable housing supply, which are the drivers of some social security demand. […] Capital spending should be the major draw on borrowing and bond issuing, but we could be more creative about how we define productive investment. Childcare and housing are two good examples of how we could do that. 39
35.On capital borrowing the Smith Agreement recommends:
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.40
In his introduction to the Smith Agreement, Lord Smith notes that “the Parliament will be given increased borrowing powers, to be agreed with the UK Government, to support capital investment and ensure budgetary stability”.41 The Scottish Government is currently able to borrow an additional 10% of its capital DEL budget (around £3bn) each year, up to a total cumulative cap of £2.2 bn.42
36.The Scottish Government expected to use this facility for the first time in 2015–16. In the Draft Budget 2015–16, the Scottish Government stated it will “borrow up to £304m in 2015–16, the maximum permitted.”43 When the existing capital borrowing powers were discussed during the passage of the 2012 Scotland Bill, the Scottish Government stated that it:
does not consider an arbitrary statutory limit on borrowing set by Westminster and lacking any objective justification to be acceptable as the basis for an agreement between Governments […] A regime along the lines of the prudential regime for borrowing which applies to local authorities, where decisions are made based on affordability, would be more appropriate.44
37.The Devolution (Further Powers) and Finance Committees of the Scottish Parliament both support the Scottish Government’s call for the introduction of a prudential capital borrowing regime and recommend it be put on a statutory basis.45 Scottish Local Authorities already operate prudential borrowing regimes and can collectively borrow sums far in excess of the current powers of the Scottish Government, but as David Phillips told us, central government can step in and overrule local authorities if they see imprudent borrowing. Mr Phillips sees such a step as being contentious at a sub-national level:
If there were disagreements about whether borrowing was prudential by the Scottish Government I think the politics would be much more difficult. If the UK Government were to grant these powers and then step in and say, “Oh no, we think you’re borrowing too much”, I think that would cause far more political ramifications.46
38.Any extension to the Scottish Government’s capital borrowing powers must sit within the UK’s overall fiscal framework and be subject to appropriate constraints to guard against imprudent behaviour. It is not for us to determine what the precise limits on capital or current borrowing should be or assess what level of risk Scotland should be exposed to but we make some general observations below.
Sources of Scottish Government borrowing
39.Scotland is currently able to borrow from the UK Government via the National Loans Fund, from commercial lenders and by issuing Scottish Government bonds. One of the advantages to the Scottish Government of borrowing via the National Loans Fund is that it is able to access the relatively favourable borrowing terms enjoyed by the UK Government. The extent to which borrowing from other sources would be more expensive depends on a number of factors including the perceived credit-worthiness of the Scottish Government, the transparency of its fiscal arrangements and its fiscal discipline. Arguments for borrowing directly from the markets are that doing so can impose market discipline and the transparency of a government’s fiscal activities is increased.47
40.The cost to a subnational government of borrowing directly from the market can be reduced if it is perceived that the debt would be underwritten by the national government, in other words whether, in extremis, the subnational government would be bailed out. Opinion on whether the UK Government should impose a ‘no bail out’ clause in the fiscal framework appears mixed. Arguments have been made that inserting a no bail out clause would be a means of imposing discipline on the Scottish Government and would protect the UK’s overall fiscal position.48
41.While we agree that the Scottish Government should not be able to operate on the basis that if it made mistakes with its borrowing then it would simply be bailed out, we think a no bail out rule is inappropriate for a number of reasons. First, as Professor Heald explained such rules exist elsewhere but:
One has to remember that the UK is a very integrated economy that is geographically very small, so things that you can do in the United States and Canada, for example, because of much greater physical space, are much more difficult to do in the UK.49
42.Given the inter-connectedness of the Scottish and rUK economies and the relatively small size of Scotland compared to the rest of the UK we do not think that the markets would believe that the UK would not bail out Scotland. Second, if the UK Government were to let Scotland go bankrupt it would inevitably harm the UK economy.50 Third, such a rule goes against one of the main arguments made by the UK Government during the referendum campaign—that remaining part of the union provides people of Scotland with a greater degree of economic security than the alternative. Finally, if it was thought that Scottish debt was being underwritten by the UK then the cost to Scotland of borrowing on the markets should be similar to those borne by the UK.51
43.One of the purposes of this latest round of devolution is to increase the accountability of the Scottish Government to the people of Scotland. Dr Angus Armstrong from the National Institute for Economic and Social Research argued that Scotland should be free to borrow but only under its own name from the capital markets because, “Only then will Scottish taxpayers be able to judge the benefit and true cost of Scottish government policies”.52 David Phillips told us that borrowing from the markets “would instil market discipline”.53 We are sympathetic to these arguments but it would not benefit either Scotland or the UK if Scotland were to borrow from the markets if the costs were higher than borrowing from the National Loans Fund. Any no bail out clause or similar provision would have a negative effect on the cost of Scottish Government borrowing.
44.It is our view that borrowing from the markets will instil a degree of market discipline and transparency to the Scottish Government’s borrowing. Such transparency should in itself act as a check on imprudence. If the cost of doing so is similar to that of borrowing via the UK, which it could well be if the UK Government were to be explicit that the debt would be fully underwritten, then this should be the default approach of Scottish Government borrowing.
Limits to Scottish Government borrowing
45.The Scotland Act 1998 provided the Scottish Government with the power to borrow up to £500m from the UK Government to manage situations when revenues are less than forecast. Despite the additional tax powers delivered by the Scotland Act 2012, the limit on current borrowing remained unchanged but the Act did include the provision for the Scottish Government to borrow up to £200m in any one year. Furthermore, in addition to being able to borrow from the UK Government via the National Loans Fund (NLF), the 2012 Act gave the Scottish Government the option to borrow from commercial lenders and issue Scottish Government bonds for capital purposes.
46.A number of commentators have argued that rather than a precise numerical limit on Scottish Government borrowing it should instead be linked to a measure of affordability such as a percentage of Scotland’s GDP.54 It has also been suggested that an upper limit for current borrowing is unnecessary as the Scottish Government will already be constrained by the need to balance its budget over at least the economic cycle. Professor Heald told us that limits were important:
I think the reason there should be limits—whether they are negotiated limits or statutory limits is a separate matter—is because Scotland is part of the United Kingdom and its numbers count in fiscal numbers for the UK, there has to be some method by which the UK Government know what the Scottish borrowing is going to be.55
The Chief Secretary to the Treasury observed that, while limits were a matter for negotiation, “what I can say is that with international best practice in this area, when you look at countries that have powerful devolved parliaments like Canada and Germany, they have limits.”56
47.We note that the limits for current borrowing did not change when a number of tax powers were devolved in 2012. Indeed it is not clear to us on what basis the existing limits were chosen in the first place. As part of the devolution of tax powers, the Scottish Government’s current borrowing powers must be increased significantly but in proportion to the additional risk Scotland will be taking on. We recommend that a specific limit on current borrowing be set and the criteria on which that limit is based be published. Transparency is vital if the fiscal framework is to be a lasting agreement. A specified limit for current borrowing will help people in Scotland understand the additional risk that Scotland is taking on as a result of the devolution of further powers and make them better able to judge the Scottish Government’s performance in managing that risk.
48.We also believe that there should be limits to capital borrowing for the reasons set out by Professor Heald. Lord Smith indicated that existing capital borrowing powers would be increased but the Agreement does not specify by how much or on what terms. We are aware of the arguments in favour of capital borrowing limits being determined by measures of affordability. Under this approach the amount borrowed by the Scottish Government would be directly related to its ability to support that borrowing by its own tax revenues. There is merit in both governments exploring whether limits to the Scottish Government’s capital borrowing powers should be based on a measure of affordability rather than a specific set value. Such an approach would better align Scottish Government borrowing powers with the performance of the Scottish economy. The methodology behind whatever debt rules are agreed must be clearly set out in the fiscal framework. This will provide clarity to those holding the Scottish Government to account and certainty to those pricing Scotland’s debt.
49.Peter Jones observes that forecasts of UK Government debt are made twice a year by the OBR—at the time of the Budget and Autumn Statement.57 We have already given our view that transparency will be key to discouraging imprudent borrowing. To that end, we recommend that an enhanced Scottish Fiscal Commission be required to give regular borrowing forecasts to the Scottish Parliament. The Commission should also be required to assess the state of Scotland’s public finances and their sustainability over the longer term.
Servicing the cost of borrowing
50.Currently the cost of Scottish Government borrowing is borne by the UK. If more revenues are devolved then Scotland will contribute less to the cost of servicing that borrowing (as the UK has less revenue to draw upon) and rUK taxpayers would effectively be asked to shoulder a larger proportion of borrowing costs. Furthermore, it could be argued that if the Scottish Government gets increased borrowing powers and chooses to borrow via the UK’s National Loans Fund there would also be costs that, for Scotland to bear, would need to be untangled from the UK’s overall borrowing costs. However, Professor Muscatelli explained that the costs of Scottish borrowing would have an “infinitesimal” impact on the overall cost of servicing the UK’s £1.6 trillion debt and as such it was something to maybe consider in the future.58
51.John Swinney told us that “when the Scottish Government takes on any borrowing it will be up to the Scottish Government to service that borrowing arrangement” and that raising borrowing at the cheapest price would be uppermost in his mind.59 We reiterate our view that the cost of borrowing is likely to be reduced if the criteria on which Scottish borrowing powers are based are seen to have been decided on objective and transparent criteria and that the issue of moral hazard is explicitly addressed in the fiscal framework.
19 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95.5
20 Written evidence submitted by Peter Jones to the House of Lords Economic Affairs Committee; the £500m ceiling was not increased when further responsibilities over taxation were devolved under the Scotland Act 2012
21 Q37
22 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95.5
23 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95.8
24 Q15
25 UK Government, Scotland in the United Kingdom: An enduring settlement, Cm 8990, January 2015, para 2.4.22
26 Q16
27 Q28
28 Q123
29 Scotland would not be completely protected because if UK revenues fell then it can be assumed that spending would also fall. The size of the block grant would be affected due to the effects of the Barnett Formula; if other methods of adjustment were chosen, such as indexing at a fixed rate, then the size of the adjustment would increase even if receipts were falling. This would go against the Smith Agreement principle that the UK Government should bear shocks that affect the whole of the UK.
30 UK Government, Scotland in the United Kingdom: An enduring settlement, Cm 8990, January 2015, para 2.2.7
31 Q87
32 Oral evidence taken by the Devolution (Further Powers) Committee of the Scottish Parliament on 21 January 2016
33 Q87
34 Oral and written evidence by Peter Jones, and Dr Angus Armstrong, to the House of Lords Economic Affairs Committee inquiry into the Devolution of Public Finances across the United Kingdom
35 Q124
36 Q194
37 Q73, Q72 and Q60
38 Q87
39 Oral evidence taken by the Devolution (Further Powers) Committee of the Scottish Parliament on 21 January 2016
40 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95
41 UK Government, Scotland in the United Kingdom: An enduring settlement, Cm 8990, January 2015, p4
42 UK Government, Scotland in the United Kingdom: An enduring settlement, Cm 8990, January 2015, para 2.3.9; Departmental Expenditure Limit (DEL) refers to the budgets allocated to and spent by Government Departments. The DEL budget is set at Spending Reviews.
43 Scottish Government, Scottish Draft Budget 2015–16
44 Letter from the Deputy First Minister to the Convener of the Scotland Bill Committee in the Scottish Parliament, 21 February 2011
45 See Devolution (Further Powers) Committee Report, New Powers for Scotland: An Interim Report on the Smith Commission and the UK Government’s Proposals, SP Paper 720, 14 May 2015, Para 225; and Finance Committee of the Scottish Parliament, 12th Report of 2015, Scotland’s Fiscal Framework, SP Paper 771, 29 June 2015
46 Q37
47 Q41; Q83
48 See Para 189 of House of Lords Economic Affairs Committee Report, A Fracturing Union? The Implications of Financial Devolution to Scotland, 20 November 2015, HL 55
49 Q60
50 Q83 [Professor Bell]
51 Q46
52 Written evidence submitted by Dr Angus Armstrong to the Scottish Parliament’s Finance Committee inquiry into the Fiscal Framework
53 Q47
54 This is discussed in the Devolution (Further Powers) Committee Report, New Powers for Scotland: An Interim Report on the Smith Commission and the UK Government’s Proposals, SP Paper 720, 14 May 2015, para 207
55 Q39
56 Q129
57 Written submission to House of Lords Economic Affairs Committee inquiry into the Devolution of public finances in the UK. Peter Jones is a freelance journalist. (The Economist, The Times, The Scotsman)
58 Q81
59 Q126
© Parliamentary copyright 2015
Prepared 9 February 2016