4Adjusting the block grant
52.The block grant is the main source of funding for Scotland. When taxes are devolved to Scotland, receipts are paid directly into the Scottish budget and the block grant is reduced by the amount of revenue foregone by the UK Government. This presents two challenges. First, both governments must agree a method for calculating the initial deduction and second—and far more complex—they must agree a method of indexing that adjustment over time so that its value is not eroded by inflation and economic growth. The Smith Agreement offers some guiding principles as to how these challenges might be met (set out in the Appendix) but the Commission left it to the two governments to decide how the system would operate in practice.
The initial adjustment
53.The Smith Agreement states that the initial adjustment to the block grant must correspond to the amount of revenue foregone by the UK Government. The amount of revenue foregone is not necessarily as straightforward a calculation as it first appears and past experience shows that it will be subject to political negotiation. Professor Heald explained to us that “even on the initial deduction, one has to be careful because the state of the economy and where you are in the economic cycle and particular big events can make a difference.”60 Not only do tax receipts vary year-by-year but the Scottish Government and OBR might produce different forecasts of the amount of revenue that will be foregone. This is what happened when Stamp Duty Land Tax was devolved under the Scotland Act 2012. For this tax the UK and Scottish Governments eventually agreed a block grant deduction for 2015–16 of £494 million, reflecting the average of the OBR and Scottish Government forecasts for the tax revenues that would be foregone by the UK Government.61 The method of determining the initial adjustment from the block grant must be transparent and fair to both sides. If there is any perception of unfairness over the initial adjustment then the prospect of a stable settlement will be remote. To prevent the initial adjustment capturing the effects of an atypical year in the economic cycle we suggest the forecast be based on an average of outturns over several years.
Indexing the adjustment
54.There are a number of different ways in which the adjustment to the block grant might be indexed going forwards. In a letter to the Devolution (Further Powers) Committee, the Deputy First Minister lists three categories that have been considered: linking the adjustment to the block grant; to corresponding UK Government tax receipts, or tax base or UK Government expenditure; and linking to the economy.
55.The method of calculating the adjustment to the block grant needs to accommodate the principle that Scotland should benefit in full from policy decisions that increase revenues or reduce expenditure and bear the costs of policies that do the opposite.
In other words the adjustment to the block grant cannot simply be to deduct the amount equivalent to the revenues raised by the Scottish Parliament in that year. The Scottish Government would lack any incentive to boost tax revenues if any change were simply to be cancelled out by adjustments to the block grant.
56.The calculation must also have regard to the two no detriment principles put forward by the Smith Commission. The first of these states that there should be “no detriment from the decision to devolve further powers” and that future growth in the adjustment “should be indexed appropriately”.62 The second principle states that “changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK.”63 This has been coined the ‘taxpayer fairness’ principle. Rt Hon Greg Hands MP, Chief Secretary to the Treasury, explained the UK Government’s view of how these principles should be applied:
Consistent with paragraph 95.3 [of the Smith Agreement], we will ensure that funding for Scotland and the rest of the UK is unchanged at the point of devolution and thereafter, consistent with paragraph 94.4(b), Scottish taxpayers will benefit from growth in Scottish taxes so taxpayers in the rest of the UK should similarly benefit from growth in their corresponding taxes. […] Put simply, this means that neither Scotland nor the rest of the UK should be better or worse off as a result of the initial act of devolution.64
57.While the UK Government’s view looks straightforward in practice, behind it lies a complicated debate on the key question that the Smith Commission left unanswered—how to index the adjustment to the block grant so that both the principle of ‘no detriment from devolution’ and the principle of ‘taxpayer fairness’ are satisfied. As we set out below, the answer may rest on how both these terms are interpreted.
No detriment from devolution
58.Of the different possible ways in which to adjust the block grant listed by the Deputy First Minister, the one that has received the most attention from commentators—and the one we focus on in this Report—is for the adjustment to be linked to what happens to equivalent revenues in the rest of the United Kingdom. We focus on this option because we consider it best meets the Smith Agreement recommendation that the UK Government should continue to manage risks and economic shocks that affect the whole of the UK. Under this option, if rUK revenues were to fall then the size of the deduction to the block grant also falls. Scotland therefore receives a degree of protection from shocks to the UK economy. As many of the levers required to respond to economic shocks will remain reserved it is only right that the UK should continue to bear most of the risk from UK-wide fiscal shocks.
59.The question for those negotiating the fiscal framework is which of the several ways of measuring change in rUK revenues is most suitable for the adjustment to be indexed to. If the adjustment were simply to be indexed to the rate of growth in rUK revenues—as is the case with the Scottish Rate of Income Tax (SRIT) devolved under the 2012 Act—then if rUK revenues increased by 5% the size of the adjustment would increase by 5%. This method, known as ‘Indexed Deduction’, allows Scotland to benefit if its revenues grow at a faster rate than the equivalent revenues in rUK.
60.However, there is a strong link between population growth and tax revenues. As Scotland’s population is growing at a much slower rate than rUK’s and has a lower proportion of earners in the higher tax brackets, we heard that there is a risk that over time, the growth of Scotland’s revenues will not keep pace, let alone exceed, that of rUK.65 Over the next 25 years Scotland’s population is forecast to grow by 7.5%, while over the same period the population of the rest of the UK is forecast to increase by 15%. David Eiser told us, “the idea that the Scottish Government have the powers to fundamentally change the relative rates of population growth with respect to the rest of the UK is probably unreasonable.”66 The Chief Secretary to the Treasury however, disagreed. He told us:
I think the Scottish Government should have and does have levers to increase its population. [...] Population is also about being able to do things like grow your economy, use planning powers, which the Scottish Government has. It is about housing powers, which the Scottish has. It is about the high quality universities in Scotland and the high quality skills base. All of these other things are perfectly within the powers of the Scottish Government to be able to attract more people coming to Scotland. I am talking not just about more people from within the UK but in terms of people coming to the UK, the Scottish Government is well placed to be able to make Scotland an attractive destination for those immigrating to the UK or coming in for one reason or another.67
61.We note the Scottish Government’s arguments that a method of indexation that does not take account of Scotland’s relatively slower rate of population growth would see Scotland’s budget adversely affected. This might be considered unfair if it is considered that Scotland lacks the policy levers required to increase its population. Under such circumstances arguments have been made that such an approach would breach the Smith principle that Scotland should not be worse off as a result of the initial act of devolution.
62.The concerns described above could be avoided if comparative population change were removed from the equation. Basing indexation on relative revenue changes per capita would insulate Scotland from the effects of a comparatively slower rate of population growth. Under this approach Scotland would not be able to reap the benefits from a faster rate of population growth. Professor Heald told us:
It is very obvious the one that is more fiscally neutral is the per capita indexation. The other methods imply, over a long period, very substantial reductions in the Scottish budget. Ever since the Act of Union, Scotland’s population has gone down relative to the population of the UK.68
63.In addition to concerns over relative population growth, Professor Muscatelli told us that he also preferred the Per Capita method because it did not diminish the effect of the Barnett Formula which “was reiterated as the central principle of the Smith Commission agreement, anything else is likely to erode Barnett over time”.69 Under the Per Capita method of indexation Scotland would still bear the risks of falling revenues, if Scotland did not grow its tax income as fast as the rest of the UK (in relative per capita terms), it would lose in terms of the block grant adjustment.70 We see this as an appropriate level of risk for Scotland to bear.
Taxpayer fairness
64.We have considered the first principle, that there should be no detriment from the act of devolving a power, but policy-makers must also have regard to the second principle, the ‘taxpayer fairness’ question. The Vow and the Smith Agreement that followed were clear that the Barnett formula should be retained as the mechanism for determining Scotland’s block grant. The Barnett Formula allocates to the devolved nations a population-based share of the change in spending on those areas in England (or England and Wales) where the equivalent is devolved. Because Scotland’s tax revenues are lower per person than those in rUK, Scotland currently benefits by receiving a share of spending that is based on population. In Professor Muscatelli’s view, because Barnett is central to the latest round of devolution it should be expected that such redistribution would continue.
65.The questions facing those negotiating the fiscal framework are the extent to which the redistribution of funding should continue, in order for the principle of ‘no detriment as a result of devolution’ to be satisfied, and at what point will the level of redistribution be considered to breach the second principle of taxpayer fairness. The two Governments appear to have opposing views on the answer to these crucial questions.
66.The principle of taxpayer fairness looks reasonable in theory but far from straight-forward when subject to scrutiny, not least because taxes are not hypothecated. For example, how will it be determined that an increase in a particular rUK tax has contributed to an increase in a particular area of spend? One suggestion is to index the adjustment to the block grant to an amount equivalent to a population share of the change in rUK revenues. This is known as the Levels Deduction method. It has the advantage of operating on a similar basis to the Barnett formula by using population share as the prime determinant. Under this approach, increases in rUK spending that would otherwise benefit Scotland, would be cancelled out by a commensurate adjustment to the block grant. The Levels Deduction method would therefore appear to satisfy the taxpayer fairness principle.
67.However, the adjustment to the block grant is intended to represent the amount of revenue that would have been generated in Scotland had devolution not occurred. If the trends of relatively lower tax revenues per person in Scotland and comparatively slower rate of population growth continue, this suggests that, in the absence of devolution, the growth in Scottish revenues would not equal an adjustment based on a population share of revenues raised in the rest of the UK. In effect, under the Levels Deduction approach, tax revenues in Scotland would need to increase at a faster rate than in rUK in order for the existing levels of public spending in Scotland to be maintained. Phillips, Eiser and Bell point out that this approach:
Does not seem to satisfy the spirit of the principle that there should be ‘no detriment from the decision to devolve’: there will be detriment to Scotland under this approach, unless revenues in Scotland grow at a faster rate both per person, and in aggregate than in rUK. This might be seen as an unfair challenge for Scotland to meet.71
68.The Per Capita method of indexation addresses this problem to some extent because it protects Scotland from relative lower population growth and the associated dampening effect on revenue growth. This approach locks in the current level of redistribution and therefore satisfies the first no detriment principle, i.e. under Per Capita Indexed Deduction (PCID) Scotland will not have to grow its taxes faster to maintain the same levels of public spending. However, left unchecked this approach would see the level of redistribution rising. This is because a population-based share of spending would be greater than a revenue-based adjustment to the block grant and that gap would be expected to grow if current population trends continued. This would breach the taxpayer fairness principle. David Eiser explained:
What the Barnett formula does is effectively rewards Scotland for having relatively slower population growth than the rest of the UK. You might say if the Barnett formula is rewarding Scotland for relatively slower population growth on the spending side, why should the indexation method for the block grant adjustment protect it from that relatively slower population growth on the revenue side?72
69.John Swinney told us that “this issue has to be addressed as part of the discussions. We are perfectly happy to address that.”73 The UK Government states that “the tax deduction element of the funding model therefore needs to work alongside the Barnett Formula to ensure that increases in ‘rest of UK’ tax do not fund higher spending in Scotland.”74 In their paper Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options, Phillips, Eiser and Bell conclude that:
It therefore turns out 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. 75
However, we heard that it might be possible to satisfy the two seemingly mutually exclusive principles. Professor Muscatelli told us that he believed that it would be possible to have an additional adjustment, which could be mechanistic and automatic:
Every time the UK Government tries to increase spend or, for that matter, decrease spend, because it can work both ways, let’s see whether we can correct the per capita index deduction to take account of those situations. I think you can make it reasonably automatic and reasonably self-administering.76
David Eiser suggested that the governments could consider opting for Per Capita Indexed Deduction combined with a ceiling on the Barnett consequential so that Scotland’s funding per capita does not increase beyond a certain point relative to rUK.77 Professor Bell told us that adjusting the PCID approach would be adding complication on top of complication but doing so to ensure that there is no redistribution from English taxpayers to Scotland when there are spending increases in rUK “is probably the least worst option”.78
70. The method of indexing the adjustment to the block grant to account for devolved revenues should not expose Scotland to risks that it lacks the powers to mitigate. We note the UK Government told us that the Scottish Government has the levers to increase Scotland’s population. Furthermore, we consider any method of indexation that requires Scotland to increase its tax revenues at a faster rate, per person or in aggregate, than in rUK in order to maintain existing levels of public spending as breaching the first principle of no detriment. The Per Capita Indexed Deduction method both removes the risk arising from slower population growth and satisfies the Smith principle of ‘no detriment at the point of devolution’. It also exposes the Scottish Government to revenue risks allowing it to bear the costs or reap the benefits of its own policy decisions.
71.However, implemented unchecked the Per Capita Indexed Deduction method would breach the second no detriment principle, that of taxpayer fairness. It would be unfair on the rest of the UK if the method of adjusting the block grant were to exacerbate the existing redistribution of funding from rUK to Scotland. We heard that an additional adjustment could be made to the Per Capita Indexed Deduction approach to ensure that Scotland’s funding per capita does not increase beyond a certain point relative to rUK. We recommend that both governments explore this option to determine whether it provides a suitable compromise between their respective positions.
72.We heard from the Deputy First Minister that the same method of adjustment should be used for all revenue streams. The Chief Secretary to the Treasury echoed this view. He told us, “the most important thing there is to have, if at all possible, is the same model across the different areas. I think that is consistent and explicable.”79 We support the views of the Deputy First Minister and Chief Secretary to the Treasury that the same approach to indexation should be used across the range of devolved and assigned taxes.
Reserved spending
73.The question of taxpayer fairness is not limited to those areas which affect the Scottish Government’s budget via Barnett. In the Command Paper which accompanied the publication of the draft Scotland Bill, the UK Government argued that the tax deduction mechanism should also account for increases in rUK revenues that are spent on reserved areas as such spending would also be for the benefit of Scotland. David Phillips told us that “given that there is a reserved powers model of devolution, Scotland needs to contribute to these reserved matters.”80 Mr Phillips explained:
I think that is important for fairness. If more money is being spent on things that benefit Scots, as well as people in the rest of the UK, Scots should make a contribution to that. They had a vote in the UK Government elections, these things have to pass double majorities with the English votes for English laws even, so they have a say in these matters.81
74.Dr James Cuthbert however viewed the idea that the UK Government can use increases in rUK income tax to pay for reserved services and then demand a contribution from Scotland through adjusting the block grant as “profoundly unsatisfactory” and “counter to the popular conception of the scope of the extra powers promised under Smith”.82 Dr Cuthbert’s concerns centred on the possibility that the contribution might be calculated in a way that was unfair to Scotland. The solution is not obvious, as Phillips et al observe, “no simple method of indexing the BGA will necessarily exactly offset other changes in spending for the benefit of Scotland.”83 We were surprised to learn from the Chief Secretary to the Treasury that “reserved areas will still be financed by reserved taxes […] that situation would be unchanged by the devolution of most of income tax”.84
Compensatory transfers
75.In circumstances where policy changes of one government impact on the budget of the other, the Smith Agreement recommends that “the decision-making government will either reimburse the other if there is an additional cost, or receive a transfer from the other if there is a saving.”85 The UK Government observes that there “will need to be a shared understanding of this principle in order to deliver a workable outcome.”86 Witnesses to our inquiry found this element of the Smith Agreement to be fraught with problems. David Phillips told us:
I think this is a bit of a can of worms in terms of implementing it as a day-to-day feature of the fiscal framework. Virtually all policies by one government or the other will have knock-on effects on the other. 87
76.Professor Bell agreed, he observed, “I do not think it is implementable. I think it is just too complicated […] to have people spending lots of time trying to research the implications of tax changes would be fruitless because no one would agree on them”.88
77.The UK Government offers a number of examples where this principle might take effect including employment programmes, benefits paid net of income tax and benefits used as eligibility criteria for other benefits.89 Professor Nicola McEwen, Professor of Territorial Politics at the University of Edinburgh, offers the following example:
The Work Programme is largely financed by savings in social security spending. If this programme (or its equivalent) designed and delivered by the Scottish Government, failed to meet DWP expectations and targets for getting the long-term unemployed back to work, the Scottish Government may be expected to compensate the UK Government for higher than expected benefit costs.90
While some mechanical interaction effects might be clear there are any number of behavioural effects which will be more difficult to capture.
78.The issue of whether detriment has occurred and compensation is due is not limited to the welfare side. If the Scottish Government were to increase the top rate of tax and this caused high earners to shift their income into dividends, UK revenues from tax on dividend income would increase; it could be argued that the UK should compensate the Scottish Government but how does this fit with the Smith Agreement recommendation that the Scottish Government should bear the cost of its policy decisions? In this example, the tax changes may also have behavioural consequences such as high earners relocating or working less. Phillips et al point out that “estimating models of how people respond to tax changes is notoriously difficult and even once an agreed method is chosen, subject to wide margins of error.”91 The Institute for Chartered Accountants in Scotland counsels that “isolating what constitutes ‘no detriment’ from such a range of policy aims will require considerable care”.92
79.In evidence to the Finance Committee of the Scottish Parliament Professor McEwen observed that it is not clear “which authority would be entrusted to determine when detriment had occurred, the precise cost incurred as a result of policy decisions, and the level of compensation which should be paid.”93 The Deputy First Minister suggested that, given the sensitivity involved, it would benefit from third-party scrutiny to ensure that there was an independent assessment of the many implications.94 Professor McEwen also questioned whether “one possible consequence of the ‘no detriment’ principle is that it may present a disincentive to develop divergent policies likely to have cross-border effects.” In evidence to the Finance Committee, Professor Holtham, Chair of the Holtham Commission on Funding and Finance for Wales, simply observed “it is absurd to worry about negative detriment”, “I do not think that there is any possibility of this principle being made operational”,95 an opinion shared by both the House of Lords Economic Affairs Committee and Scottish Parliament’s Finance Committee.96
80.Some of the witnesses we heard from did see an element of merit in this aspect of the Smith Agreement. David Phillips was slightly less pessimistic than others. He told us:
I think it might be worthwhile having some principle that where there are significant knock-on effects and they can be easily and demonstrably linked to a particular policy, there is scope sometimes for compensation payments to be made. But that would rely on it being something you can be fairly concrete about, otherwise I think it would just be disagreements and difficulties and it would become unworkable. Having it as a backstop measure in this somehow may not necessarily be a completely crazy idea, but trying to implement it on every case of a policy decision would quickly become unworkable.97
81.In any case, given the relative sizes of their economies any spillover from Scotland to the rest of the UK is likely to be relatively minor and worth consideration in only a few cases. The same might not true for effects in the other direction. Professor Muscatelli gave the example of a major change in pension law or the way National Insurance is structured as something that might have sufficient effect on the Scottish tax base to require a transfer between governments. This suggests to us that, in a small number cases where the effect might be substantial, there is merit in the principle of compensation. The Chief Secretary to the Treasury told us that any solution would have to be as mechanical as possible, as well-informed as possible and of a certain magnitude. The Chief Secretary was optimistic that the question of spill-over effects could be resolved and contained within the fiscal framework.98
82.There is some sense behind the principle of compensatory payments, but we think that it can only work in a small number of cases where the effects are substantial and mechanical rather than behavioural. In those cases, for the principle of compensatory transfers to work without dispute, they must be well-evidenced and either be set out in the fiscal framework in advance or agreed separately by both governments. Although we have heard the case for an independent arbiter, within the current constitutional settlement of the UK we believe such matters are best solved at a political level.
60 Q11
61 UK Government, Third Annual Report on the implementation and operation of part 3 (financial provisions) of the Scotland Act 2012, March 2015
62 Smith para 95.3
63 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95.4
64 Q157
65 See Office for National Statistics 2014-based Statistical Bulletin
66 Q71
67 Q168
68 Q21
69 Q67
70 Q79
71 David Phillips, David Eiser and Professor David Bell, Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options report published by the Institute for Fiscal Studies, November 2015
72 Q71
73 Q132
74 UK Government, Scotland in the United Kingdom: An enduring settlement, Cm 8990, January 2015, para 2.4.14
75 David Phillips, David Eiser and Professor David Bell, Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options report published by the Institute for Fiscal Studies, November 2015
76 Q91
77 Q104
78 Q94
79 Q167
80 Q31
81 Q30
82 Written evidence submitted by Dr James Cuthbert to the House of Lords Economic Affairs Committee inquiry into Devolution of public finances in the UK
83 David Phillips, David Eiser and Professor David Bell, Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options report published by the Institute for Fiscal Studies, November 2015
84 Q183
85 The Smith Commission, Report of the Smith Commission for further devolution of powers to the Scottish Parliament, 27 November 2014, Para 95.4
86 UK Government, Scotland in the United Kingdom: an enduring settlement, Cm 8990, January 2015, para 2.4.16
87 Q47
88 Q97
89 UK Government, Scotland in the United Kingdom: an enduring settlement, Cm 8990, January 2015, para 2.4.16
90 Written evidence submitted by Professor Nicola McEwen to the Finance Committee inquiry’s into the Fiscal Framework
91 David Phillips, David Eiser and Professor David Bell, Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options report published by the Institute for Fiscal Studies, November 2015
92 Written evidence submitted by ICAS to the Finance Committee’s inquiry into the Fiscal Framework
93 Written evidence submitted by Professor Nicola McEwen to the Finance Committee’s inquiry into the Fiscal Framework
94 Q143
95 Written evidence submitted by Professor Holtham to the Finance Committee’s inquiry into the Fiscal Framework
96 Finance Committee of the Scottish Parliament, 12th Report of 2015, Scotland’s Fiscal Framework, SP Paper 771, 29 June 2015; House of Lords Select Committee on Economic Affairs, 1st Report of Session 2015–16, A Fracturing Union? The implications of financial devolution to Scotland, HL 55, 20 November 2015
97 Q47
98 Q200
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Prepared 9 February 2016