House of Lords - Economic Implications for the United Kingdom of Scottish Independence

Economic Implications for the United Kingdom of Scottish Independence - Economic Affairs Committee Contents

Chapter 2: the economic realities of Scottish independence

The United Kingdom single market

17. The United Kingdom forms a single market of over 60 million people. There are no borders, customs checks, administrative or accounting procedures on the movement of labour, goods or services. Currency, regulation and most taxation are uniform. In short, economic activity within the United Kingdom carries minimal transaction costs. This promotes price transparency and competition and the efficient use of resources between Scotland, England, Wales and Northern Ireland.

Trade

18. Access to markets was a main driver of the Act of Union of 1707 which established the unitary Kingdom of Great Britain. Excluded from England's trade with the colonies, the Scots had tried in the late 1690s to set up their own entrepot on the Darien isthmus, investing perhaps a quarter of the country's liquid capital. After the disastrous failure of the Darien scheme, the Act of Union brought economic security to Scotland and secured England's defences. It led to economic integration of England and Scotland and to greater prosperity in the later eighteenth century as Glasgow tobacco barons, for example, grew rich on colonial trade. The industrial revolution of the nineteenth century and the service-based economy of more recent times have further consolidated the UK single market.

19. After 300 years of union, Scotland's economy and that of the rest of the UK remain closely integrated and the UK market is more truly single than that of the EU. At present, trade with the rest of the UK is worth over two-thirds of Scotland's output (see Appendix 5). Rt Hon Alistair Darling MP reminded us that 94% of Scottish insurance industry products were sold to the rest of the UK and only 6% in Scotland.[12] Mr John Cridland, Director-General of the CBI, told us:

20. The United Kingdom single market has helped the Scottish financial services sector to grow. Financial services make up a similar proportion of the Scottish economy as the UK's. But the Scottish economy is dwarfed by the balance sheets of Scottish banks. The total assets of Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS) are over 15 times Scottish GDP and were more than 20 times its GDP in 2008. Both figures are much higher than for the UK and countries which buckled under the weight of rescuing their banking sectors such as Iceland and Ireland.[14] The banking sector's size creates particular problems for an independent Scotland which will be examined later in this report. Mr Darling and Rt Hon Danny Alexander MP, Chief Secretary to the Treasury, separately reminded us that UK government support for RBS had amounted to a sum equivalent to 211% of Scotland's GDP.[15] [16]

21. The UK's single market brings economic benefits to Scotland and the rest of the UK. If it fragmented after Scottish independence, Scotland's smaller economy would be disproportionately affected.

22. The trade policy of an independent Scotland would crystallise after a "Yes" vote. If, after negotiation, it became a member of the European Union, as the Scottish Government intends, single market regulations would apply which would encourage trade. Even if it did not, it must be assumed that it would continue to adhere to the GATT, and the general consensus in favour of free trade, though an autarkic alternative would of course be available to a Scottish Government. A combination of the use of the pound and membership of the EU would clearly make it more likely that the present close trading relationship endures. Professor David Bell of Stirling University said: "For the rest of the United Kingdom, if Scotland stayed with the pound, there would be little disruption of trade flows."[17]

Inward Investment

23. One key objective of an independent Scotland would be to attract substantial investment from outside Scotland. This is an area where Scotland has been successful under devolution. Professor Gerald Holtham, Chairman of the Independent Commission on Funding and Finance for Wales, thought this was in part because "Scotland has a high degree of international recognition in a way that Wales does not".[18] In his view, Scotland would still be attractive to foreign investors after independence. Professor John Tomaney of Newcastle University agreed. He thought that Scottish Enterprise "gave certain kinds of economic development advantages that were not available in the north of England". He added: "Many of the things … in terms of Scotland's ability to attract a higher proportion of foreign direct investment are already there."[19]

24. Many of the same considerations affecting its trading prospects would also influence an independent Scotland's continuing scope to attract investment. Success is again likely to depend on the decisions the Scottish Government takes on some of the issues raised in this report. Preservation of an effective UK single market would be desirable; Professor Tomaney pointed out that Scottish Enterprise had successfully offered investors in Scotland access to the United Kingdom market. Important also would be an independent Scotland's relationship with the EU (see Chapter 5 below).

25. A single market is not simply a matter of free trade and investment. Its cohesion can also be weakened by divergences over currencies, regulation and taxation. The severity of the threat to the UK single market would depend to a large extent on the decisions of the Governments of an independent Scotland and of the rest of the UK.

Currency

26. The Scottish Government at present intends that sterling should be Scotland's currency—though it used to favour the use of the Euro, as Professor Gavin McCrone recalled.[20] Professor Robert Rowthorn of Cambridge University said: "Sterling is probably the simplest currency because Scotland trades on such a large scale with the UK."[21] Business strongly favours retention of sterling, as Mr Iain McMillan, Director of CBI Scotland, made clear.[22] An independent Scotland's use of sterling would raise many questions about monetary policy and financial regulation in the rest of the UK as well as in Scotland; these are discussed in Chapter 3. Despite the Scottish Government's target of March 2016, independence might not occur for some years after a "Yes" vote in 2014 because lengthy negotiations would follow between the Scottish and the rest of the UK Governments, as witnesses including Professor John Kay told us.[23] During this time, it is perfectly conceivable that the relative attractions to a Scottish Government of the pound and those of the Euro could shift in the latter's favour. Scotland might even decide to have a currency of its own, neither Euro nor pound. Use of a currency other than sterling would raise greater transitional risks. If the pound was not the currency, a barrier to trade would immediately arise, a risk foreseen by Mr Keith Cochrane, CEO of Weir Group.[24] The implications of an independent Scotland's use of a currency other than sterling are examined in Appendix 6.

Regulation & Taxation

27. Even with commitment to free trade and a shared currency, the British single market could be eroded if an independent Scotland's regulatory regime came to differ from that of the rest of the UK. There might be (for example) different regimes for health and safety, or different competition regulation, or different rules for advertising. There already are divergent plans for minimum alcohol prices. The prospect of more or different Scottish regulation is unwelcome to Scottish-based business. Sir Philip Hampton, Chairman of the Royal Bank of Scotland, said: "The overriding preference would be for simplicity, because we already have enormous complexity."[25] Mr David Nish, CEO of Standard Life, said: "What I benefit from today is from having a single regulator in a geographical area."[26] Mr Rupert Soames, CEO of Aggreko, pointed out in relation to pensions that "we have a defined benefits scheme. Which side of the border will that fall on? Who will be the pensions protection agency?"[27]

28. Professor Bell noted that the Scottish Government had not made use of its power under devolution to vary the basic rate of income tax up to 3p.[28] But Professor McCrone thought: "Over time personal taxation in [an independent] Scotland would be different from England, just as it is in Ireland."[29] Mr Darling doubted if cutting corporation tax in Scotland would be effective: "Suppose Scotland cut its corporation tax and it worked. How long do you think it would be before the rest of the UK thought, 'Well, it's working; [we] will cut our rate too?' … Then you get the ridiculous situation of beggar your neighbour, and the only people laughing are the multinationals who pay corporation tax … I have always been sceptical about whether cutting corporation tax would make a big difference. There is no way that the other side will not retaliate."[30] Mr Cochrane expressed concern about the possible effects on his business of different rates of corporation tax in Scotland and the rest of the UK.[31] Ms Katie Schmuecker of IPPR North thought that the fear that business would drain north in response to low Scottish corporation tax was overplayed.[32] But Mr John Swinney MSP, the Scottish Government's Cabinet Secretary for Finance, Employment and Sustainable Growth, said that the Scottish Government "still take the view that business taxation is an area where we can provide the opportunity to make Scotland an attractive place for investment".[33]

29. One of the arguments for independence is that an independent state can make decisions on e.g. currency, regulation and taxes which reflect the preferences of its people. These decisions need not mean that trade would be greatly diminished. The nature of a country's regulatory regime is one of the factors that affect its costs of production and therefore its comparative advantage in trade. Nevertheless regulatory differences can affect trade relations. A post-independence Scottish Government and its counterpart in the rest of the UK should try to preserve, as far as possible, the single UK market, which brings economic benefits to both.

30. As things stand, the economic structures of Scotland and England are very similar.[34] Scotland's output per head of £20,200[35] and its fiscal deficit of 11% of GDP[36] are close to the UK's (see also Appendix 5). But there are already differences, even under devolution. Public sector spending per head is 11% higher in Scotland than the UK overall.[37] Professor Kay said: "The proportion who are employed in public sector activities is about 2% higher in Scotland than in the UK."[38]

31. The "challenges to the medium-term fiscal sustainability of Scotland as a single unit"[39] foreseen by the Chief Secretary to the Treasury would be heightened by an independent Scottish Government's dependence on volatile net tax revenues from North Sea oil and gas.

32. An independent Scotland would need quickly to establish the legal and administrative framework to promote its interests in the single British and EU markets and more widely. This would require enhanced skills and capabilities in a range of areas now the responsibility of the UK Government, including revenue raising, payment of pensions and benefits, financial regulation, treaty negotiation, defence policy and overseas representation.

33. Any reduction in intra-British trade and investment following erosion of the single market would be felt in the rest of the UK as well as in Scotland. Given the disparity in size between the Scottish economy and the rest of the UK economy, the effect on the rest of the UK as a whole would be much smaller than that on Scotland.

Division of Assets and Liabilities

34. All sorts of bodies and departments would need to be divided between the two countries including spending departments, the armed forces and even the NHS. Assets to be divided include natural resources such as North Sea oil and gas reserves. Liabilities include the UK's public sector debt and other commitments including pensions.

35. What principles would apply to the division? Professor Rowthorn recalled that in the Anglo-Irish Treaty of 1921 the newly formed Irish Free State "agreed to assume responsibility for a proportionate part of the United Kingdom's debt, as it stood on the date of signature".[40] Dr Karen Henderson of Leicester University told us that in the 'velvet divorce' of Czechoslovakia into the Czech Republic and Slovakia in 1993 the general principle was that property should belong to the republic in which it was located, and that other assets and debt were divided 2:1 in line with the size of the two republics' populations.[41] The ICAEW argued for a simple approach.[42]

36. Our witnesses agreed that shared physical onshore assets should be apportioned by location, although military installations (see Chapter 6) might need negotiation. Most also agreed that financial assets and liabilities should be apportioned on a per capita basis. As a starting point, the division of UK physical assets should be on a geographical basis. Financial assets and liabilities should be divided by share of population.

North Sea oil & gas

37. One of the traditional arguments for Scottish independence is that an independent Scotland would benefit from the bulk of the North Sea oil tax revenues instead of having to share the benefits with the rest of the UK. Professor Rowthorn estimates they would be about 5-10% of Scottish non-oil GDP.[43] Professor McCrone said that, on the expected geographical division, about 90% of revenues would accrue to an independent Scotland.[44] This assumes that Orkney and Shetland remained part of an independent Scotland; if they did not, Scotland's reserves would be reduced by a third, with concomitant effects on tax revenues.[45]

38. These North Sea oil tax revenues are the economic bridge over which Scotland would pass to independence. Our witnesses expect them broadly to make up for loss of the Barnett formula's effect on the Treasury's block grant to Scotland—which allocates Scotland a share of UK public spending—on independence. But revenue from the North Sea is not assured. Output, and therefore tax revenue, is extremely dependent on the price of oil, which is set in world markets. Quite small reductions in price can make much of North Sea oil uneconomic to develop because of high costs. Therefore the benefit to Scotland of keeping North Sea oil will vary with the price.

39. What is the likely future oil price? Estimates of future commodity prices are notoriously subject to large margins of error. It follows that, whatever is the central prediction as to the price of oil, there exists a substantial downside risk, probably greater if forecasts that the US is to become a net energy exporter are accurate. This matters less to a Scotland that is part of the United Kingdom. If oil revenues fall short, they can be replaced by taxes that fall on a largish country (or by spending cuts), so the effect is diluted. In an independent Scotland however oil revenues might amount to some 5-10% of non-oil GDP[46] and some 19% of tax revenues.[47] If oil revenues turned out lower than expected, and they could be substantially lower, that would hit the economy of an independent Scotland hard.

40. Another issue is how long the oil will last. Forecasters generally expect a long term decline in North Sea oil output. Professor Rowthorn said: "If you look over the 25 or 30-year perspective, Scottish oil revenues will decline almost whatever happens to the price of oil."[48] So the Scottish economy will have to cope with a decline similarly in the benefits to the country and its exchequer that North Sea oil brings.

41. There is also the question of decommissioning costs. These are substantial—Professor Alex Kemp estimates them at some £30 billion over 30 years, of which more than 50% would fall on governments in the form of net tax reductions to the companies.[49] The SNP has argued that, since the tax revenues from past oil revenues accrued to the UK as a whole, decommissioning costs too should fall on the UK as a whole. North Sea oil decommissioning costs will be very substantial. The oil companies will want to offset them against future tax due, which would reduce an independent Scottish Government's revenues. How these matters are resolved will have an important bearing on the value to Scotland's economy of oil.

42. To make best use of North Sea oil at any level of price or output, an independent Scotland would need to take over oil industry regulation from the UK Government. Professor Kemp drew attention to the complexities, which would need to be carefully managed, especially during a transition, including licensing, taxation, capital allowances and decommissioning.[50] Asked to forecast net tax revenues from oil production in the Scottish sector of the North Sea, Professor Kemp told us: "I can make a guesstimate that for the Scottish sector it could range annually between £5 billion and £10 billion per year for the next decade."[51]

43. It remains the case that the Scottish economy would be likely to gain from North Sea Oil revenues. The scale of that gain is much more uncertain as is how long it will last. So is its value to the underlying health of the rest of the Scottish economy, especially given the very real possibility of volatility in output and revenues. Oil alone will not ensure that an independent Scotland is a prosperous Scotland.

44. As things stand, payments from the British exchequer fund much of the Scottish Government's spending. As with Wales and Northern Ireland, they are made through a block grant, itself funded by general UK taxation to which Scotland makes its contribution. Application of the Barnett formula is however generally recognised as raising the exchequer's block grant to Scotland. Block grant payments would cease on independence. All an independent Scotland's revenue would have to be levied within Scotland. Witnesses thought that oil revenues would broadly make up the loss of the benefit to Scotland of the Barnett formula's effect on the block grant. Professor Kay said:

After a "Yes" vote in the referendum, the Scottish Government would need to make timely arrangements to levy its own taxes on independence. Even if an independent Scotland's oil revenues broadly made up for the loss of the Barnett formula's effect on the block grant,[53] they would be a less predictable source of revenue than transfers from the British Treasury.

Other assets

45. Aside from oil, Barnett payments and defence (see Chapter 6) many UK functions and institutions would have to be divided on Scottish independence, ranging from tax collection to air traffic control to fisheries protection. Ms Johann Lamont MSP, leader of the Scottish Labour Party, recalled the UN International Law Commission's view that movable state property as well as state debt should pass to the successor states in an equitable proportion.[54] The Institute of Chartered Accountants in England and Wales (ICAEW) favoured a simple approach but recognised that in practice allocations could be highly complex with different rules applying to different assets and liabilities.[55] Negotiations on division of assets are likely to be intricate and lengthy, leading to uncertainty until successor systems and institutions prove themselves in Scotland and the rest of the UK.

Debt/liabilities

46. According to the Office of Budget Responsibility (OBR) the UK's Public Sector Net Debt (PSND) was £1,104bn in the financial year ending in March 2012.[56] Assuming that this debt is shared between an independent Scotland and the rest of the UK on the basis of size of population, Scotland would be allocated 8.4% or £93bn. If North Sea oil is allocated on a geographical basis (see paragraph 37), the ratio of Scottish debt to GDP would be around 62%. This measure does not include what would become Scotland's share of known future UK liabilities, such as payment of public sector pensions in Scotland. Added together, an independent Scotland's share of the UK's public sector debt and its share of the UK's known future liabilities, based on relative size of population, would be around 123% of GDP. These figures are set out more fully in paragraphs 86-89 below. A newly-independent Scotland would have no track record with international lenders. Sir Nicholas Macpherson, Permanent Secretary of the UK Treasury, said:

An independent Scotland would need to service its own sovereign debt and to manage its spending, borrowing and taxation in such a way as to win and retain the confidence of global lenders that its debt burden is manageable.

47. After agreement was reached on how much public sector debt would be assumed by an independent Scotland, there would be the important issue of how to transfer this debt to an independent Scotland. This is not a straight forward matter. It would take a newly established independent Scotland some time to establish a successful credit history (see Chapter 4). This is an important matter for Scotland and the rest of the UK. It is for the Scottish Government to explain to voters well ahead of the referendum how it intends to take over its share of the UK's public sector debt.

Fiscal

48. An independent Scottish Government would have to manage its own budget. Estimates show that in 2011-12 a separate Scotland with geographical share of North Sea oil revenues would have had a budget deficit of 5.0% of GDP, comparing well with a UK deficit of 7.9% of GDP.[58] The prospective budget deficit of an independent Scotland is harder to estimate since it is not clear whether Scotland would raise enough tax revenues to compensate for loss of the block grant. Moreover, the UK has (still) a strong credit rating based on a very long record of international borrowing. International markets might exact higher interest payments from an untried Scotland much more dependent for income on volatile oil revenues. This issue is explored further in Chapter 4.

Entrepreneurship, management and productivity

49. Ultimately the prosperity of an independent Scotland will depend on the productivity of its businesses and workers. That in turn will largely depend not just on how much firms invest, but on the skills of their managers and workers, and entrepreneurship. Such factors are hard to predict let alone quantify, but they will in the end determine if an independent Scotland is a success economically.

50. So far as management skills are concerned, Scottish managers have established some powerful reputations—not least in countries other than their home country. The Scottish financial services industry boom depended on the reputation for probity and canniness, though this has been somewhat eroded by the subsequent bust. Scotland has produced not only great managers but the great professionals—lawyers, accountants, actuaries—that great managers need to succeed.

51. So far as entrepreneurship is concerned, Scotland's position is less strong. There are of course some Scottish firms which have grown to be acknowledged successes. But Scotland needs to do better at incubating new businesses. As Mr Ian McKay of the Scottish Institute of Directors pointed out: "Scotland continues to have a very poor record of business start-ups."[59] Data from the Office of National Statistics show that the share of innovative businesses and the amount of expenditure on research and development relative to output in Scotland is lower than the UK average.[60]

52. Few of our witnesses believed that independence would set loose a new spirit of entrepreneurship north of the border, one enthused by the historic destiny of this small nation to strive and to succeed. Others, particularly the economists who gave evidence to us, are less convinced. Professor Kay was unsure:

Professor McCrone did not believe independence would generate a wave of entrepreneurship.[62]

53. There can be no definitive answer to the question of whether an independent Scotland would be more prosperous, less prosperous or as prosperous as Scotland is now. Our report identifies clear threats to Scotland's prosperity under independence; while the upside is uncertain.

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14 Scottish Parliament Information Centre, Banking inquiry: additional material supplied in response to Members Enquiries, (Edinburgh: SPICe, February 2009), p. 6 Back

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