The Barnett Formula - Select Committee on the Barnett Formula Contents


Memorandum by cebr ltd

INTRODUCTION

  This short note is a response to the Select Committee's request for evidence. The response deals primarily with Questions 1a and 1b of the questions set out by the committee.

LEVELS OF PUBLIC EXPENDITURE AS A SHARE OF GVA

  It is conventional to consider public expenditure in a region or country of the UK in relation to public expenditure per head. This is certainly an important indicator and should not be discarded. But the requirements for public expenditure and the cost of public expenditure are also influenced by the levels of prices and earnings in the different regions/countries and their levels of GDP or GVA.

  The cost of providing equivalent levels of services will be affected by price and earnings differentials. This is an obvious point and does not need reinforcement. What is less obvious, but no less true, is that some of the requirements for services are affected by the levels of GDP/GVA. For example, transport projects are conventionally prioritised by the use of benefit/cost ratios. The relative benefit element of these ratios will largely be driven by relative GDP/GVA levels. Arguably some of the benefits of training, skills and education are also driven by the levels of regional prosperity.

  It is conventional also to think of high levels of regional GDP/GVA per capita as an inverse proxy for the extent of social problems and hence as in some way justifying relatively low levels of public expenditure per head. But the evidence from the UK does not support this. The most glaring anomaly is that London has a regional GVA per capita of around 50 per cent above the UK average. Despite this, its regional unemployment level is one of the highest in the UK, 7.2 per cent compared to 6.3 per cent for the national average for the UK.[4] Moreover, the local area with the highest rate of unemployment in the UK, Tower Hamlets, is in London. Looking in detail at the extent of social problems on a wide range of measures shows that London despite its higher level of GDP/GVA has much higher levels of social deprivation and hence needs than other regions.

  Since the evidence for the UK does not support the view that a high level of GDP/GVA per capital indicates a low requirement for public expenditure as a percentage of regional/country GVA it is worth examining the data for regional/country public expenditure as a percentage of regional/country GVA. The IMF points out that "International comparisons of public expenditure composition in relation to economic and social indicators can provide a useful basis for addressing imbalances in the use of public resources".[5]

  Cebr has for some years made this analysis, taking account of the regional data for public expenditure and the regional accounts and adjusting the data for consistency.

  The results for total identifiable expenditure on services for UK regions and countries as a share of regional/country GVA are shown in Table 1. This forms part of cebr work carried out this year for The Sunday Times.[6] A graph of public expenditure per capita and GVA per capita for UK regions and countries is shown in Figure 1.

Table 1


2003-04
2004-05
2005-06
2006-07

North East
50.7 %
51.2 %
52.3 %
50.8 %
North West
43.5 %
44.8 %
45.3 %
45.1 %
Yorkshire and Humberside
40.6 %
42.1 %
43.0 %
42.4 %
East Midlands
35.2 %
36.6 %
37.0 %
36.8 %
West Midlands
38.7 %
40.6 %
41.7 %
41.8 %
Eastern
28.5 %
29.5 %
30.2 %
30.2 %
London
28.8 %
28.8 %
29.2 %
28.5 %
South East
26.4 %
27.7 %
27.7 %
27.4 %
South West
34.9 %
36.1 %
36.3 %
35.9 %
Total England
33.8 %
34.8 %
35.3 %
34.9 %
Scotland
43.9 %
43.5 %
44.7 %
45.0 %
Wales
52.6 %
53.7 %
55.2 %
55.4 %
Northern Ireland
56.5 %
57.0 %
56.7 %
55.9 %
UK identifiable expenditure
35.8 %
36.7 %
37.3 %
36.9 %
Outside UK
44.0 %
45.4 %
38.8 %
39.0 %
Total identifiable expenditure
36.0 %
36.9 %
37.3 %
37.0 %


Figure 1


  Included in the Annex to this evidence is the cebr Forecasting Eye Special from 11 March 2008. This document shows that public expenditure as a share of GDP has risen to an estimated 43.0 per cent of GDP in 2007-08. The Forecasting Eye Special also outlines our methodology for calculating public expenditure from total identifiable and non-identifiable expenditure from HM Treasury statistics.

IMPLICATIONS OF THE VARIATIONS IN REGIONAL PUBLIC EXPENDITURE AS A PERCENTAGE OF GVA

  The unusually large variations in regional public expenditure as a percentage of GDP/GVA mean that in the higher income regions, many public services are disproportionately badly funded. This particularly affects unfairly those at the lower end of the income scale who are most dependent on public services.

  The implications of the variation of the levels of regional public expenditure as a share of GDP/GVA are exaggerated in the UK by the existence of a progressive tax system that does not take account of local variations in the cost of living. As a result of the shape of the UK tax system, where the progressivity is concentrated at the lower end, the effects of this also particularly hit those at the lower end of the income scale in the higher income regions. They pay a higher effective rate of tax than those with equivalent real incomes in lower income regions.

  Moreover, a further implication of the relatively high levels of public spending in relation to GVA in some regions/countries of the UK is that the private sector is crowded out. The large numbers of public sector jobs mean that employment patterns become distorted. Public sector pay in some regions is noticeably higher than in the private sector. It is no surprise that rates of business start ups in the regions/countries of the UK with levels of public spending as a share of GVA well above 50 per cent are very much lower than in the areas with much lower public spending. The tendency to look to the public sector to provide subsidised solutions to problems becomes built in.

Can the model of funding relatively high levels of public expenditure in relation to GVA in the North of England, Scotland, Wales and Northern Ireland be afforded in the future?

  Cebr has generated a provisional analysis of the prospects for public finances that has underpinned the speech given by one of the co-authors (Douglas McWilliams) to the Associate Parliamentary Group on Wholesale Financial Markets & Services in the House of Commons on 11 February 2009. This analysis was reflected in the following section of the speech

    "The calculations about fiscal transfers from the early 2000s indicated that London subsidised the rest of the UK by about £13 billion. My rough and ready estimate is that this rose to about £30 billion by 2007. This comes mainly from a mixture of corporation tax, national insurance contributions, income tax and VAT on spending raised on the relatively higher incomes and spending in London.

    I expect this to drop back to about £8 billion next year and to edge up to about £12 billion by 2013, and to continue to grow very slowly thereafter.

    What this means is that there is a shortfall of just under £20 billion (1.5 per cent) of GDP that will ultimately have to be made up. Now in a world where multi billion banking bailout packages seem to be announced almost monthly, this may seem like small beer. But unlike some of the other figures, which are often exaggerated and where the government has realistic hopes that it might eventually get most of its money back, this is a real shortfall.

    Can it be replaced? One option is higher tax rates, but very few studies are optimistic that this raises much more money. A second potential option is sustained high borrowing. But the bond markets would be most unlikely to accept it. The only alternative is for the regions with higher levels of public spending to cut their coats according to the cloth available. The high spending parts of the UK—Scotland, Wales, Northern Ireland, the North of England, the North West and Yorkshire and Humberside will need to cut their levels of public spending as a share of GDP by around 5 per cent of local GDP to offset the end of the subsidy from the rest of the country but mainly from London".

IMPLICATIONS FOR THE BARNETT FORMULA

  The Barnett Formula is designed to preserve in aspic the shares of public spending per capita for Scotland in particular.

  Yet our analysis infers that public spending per capita in the parts of the UK where public spending is high will have to be reduced disproportionately; partly because it builds in unfairness, partly because it damages the private sector and entrepreneurship and particularly because the money to finance high public spending is unlikely to be available in the medium term.

  There is therefore a need to change the Barnett formula to generate an outcome with a lower level of public spending in relation to the rest of the UK for the high public spending regions.

March 2009



4   Office for National Statistics, "Labour Market Statistics, First Release" (February 2009). Back

5   IMF Pamphlet 48 "Unproductive Public Expenditures: A Pragmatic Approach To Policy Analysis Appendix: Patterns of Government Expenditure by Country Groups"Back

6   See The Sunday Times, 25 January 2009. Back


 
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