The Scottish Budget under the Smith Proposals

David Bell and David Eiser

The Smith Commission proposals seek to increase the powers of the Scottish Parliament and to secure a corresponding increase in the Parliament’s accountability and responsibility for the effects of its decisions and their resulting benefits or costs.

How has this ambition been translated into concrete proposals for fiscal responsibility? On the spending side, the Scottish Parliament will control benefits associated with long-term disability and sickness, along with some relatively small benefits for older people, and the Work Programme – the UK Government’s key programme for supporting people into work. In total, this will transfer benefits worth around £2.5bn to the Scottish Parliament (in addition the Scottish Parliament would gain some limited ability to vary the housing cost elements of Universal Credit, and top-up other benefits).

On the revenue side, the Scottish Parliament will gain the ability to vary income tax rates and thresholds (but not the personal allowance). Half of VAT revenues raised in Scotland will be assigned to the Scottish Parliament (the VAT rate and exemptions cannot be varied). And Air Passenger Duty (APD) and the Aggregates Levy will be fully devolved. Continue reading

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How should the Barnett Formula be adjusted to reflect devolved taxes? A question of allocating risk (wonkish)

David Bell and David Eiser

The UK parties have committed to retaining the Barnett Formula to allocate grant to Scotland. The way in which the Barnett Formula is adjusted to reflect devolved taxes will have important implications for the budgetary risks facing the Scottish and UK Parliaments. This blog discusses two possible approaches to adjusting the Barnett Formula. It shows that the adjustment approach proposed in relation to the Scotland Act powers exposes Scotland to a different set of risks on the spending side relative to the revenue side which seems inconsistent. This approach also exposes Scotland to UK policy decisions, and these could affect Scotland positively or negatively. An alternative approach is discussed which overcomes these problems, but exposes Scotland to a higher rate of convergence in per capita spending with rUK.

Tax devolution and the Barnett Formula

The Smith Commission is expected to propose devolving a basket of tax powers to the Scottish Parliament. It seems extremely unlikely that the revenues from the devolved taxes will be sufficient to cover Scotland’s spending budget, and there will therefore be a continuing requirement for the Scottish Parliament to receive some form of block grant from Westminster.

The UK parties have committed to retaining the Barnett Formula to determine this grant. But the way in which the Barnett formula is adjusted to reflect the taxes devolved to Scotland will have important implications for the budgetary risks that the Scottish Government will be exposed to, and those from which it will be protected. How the Barnett Formula is adjusted to reflect devolved taxes is therefore important.

In the first year that a tax is devolved, the adjustment to the block grant is straightforward. It simply entails deducting from Scotland’s existing block grant the value of the devolved tax in Scotland. But how should the grant be adjusted in the future to take account of changes to the tax rates or base?

A key principle underpinning the grant adjustment is presumably to ensure that Scotland faces the budgetary consequences of its policy decisions. But concern has been raised that this principle may be difficult to realise within the context of the Barnett Formula.

As an illustration, consider the following scenario. Imagine that income tax has been wholly devolved to Scotland. What would happen if the UK Government increased the rate of income tax in the rest of the UK (rUK) to raise an additional £10bn of revenue, and used this £10bn additional revenue to fund increases in health or education spending in England? Under the existing Barnett Formula, Scotland would receive an increase in its block grant equal to a population share of £10bn (approximately £1bn). The fact that Scots had received a funding consequential without facing any of the tax consequences would strike many as being unfair[1].

How might the Barnett Formula be adapted to ensure that this apparently perverse situation does not arise? The obvious approach to dealing with this issue is to treat devolved taxes as being ‘comparable’ in the same way that devolved spending is considered ‘comparable’. But there are at least two ways of doing this, each with different consequences for the budgetary risks that Scotland faces.

Defining Comparable Taxes: the Indexed Deduction method

The first approach indexes changes in the devolved revenue in Scotland to ‘comparable’ revenues in rUK. This is the approach that has been proposed in relation to the Scottish Rate of Income Tax (SRIT) introduced by the Scotland Act, and is known as Indexed Deduction (ID). In the first year that the tax is devolved, the value of revenues from the devolved tax is deducted from Scotland’s block grant; this is known as the Block Grant Adjustment (BGA). In future years, Scotland’s revenues from the devolved tax are indexed to the growth rate of comparable revenues in rUK. For example, if the ‘comparable’ devolved revenues in rUK grow by 5% in year 1, then the value of Scotland’s block grant deduction grows by 5%. If Scotland’s revenues grow by more than 5% it will be better off than it would have been without the devolved tax, but if its revenues grow by less than 5% it will be worse off.

One of the implications of the ID approach is that Scotland is exposed to demographic risks. If its population (or working age population) grows more slowly than rUK’s, its tax revenues may grow more slowly as well, even if incomes per head in Scotland have grown relatively more rapidly. One might question whether it is fair for Scotland to face such demographic risks when policy levers on migration are not devolved.

Indeed, it should be noted that, on the spending side of the equation, the Barnett Formula protects Scotland from demographic risks. This is because Scotland receives a population share of spending increases in England. There is therefore something of an inconsistency in protecting Scotland from demographic risks on the spending side of the adjusted Barnett Formula, but exposing it to these risks on the revenue side.

What about the hypothetical scenario described above, where income tax is wholly devolved to Scotland, and taxes are raised in England to fund spending on health/education in England? Imagine that income tax had been devolved to Scotland in 2013/14. To keep things simple, assume that there has been no growth in population or incomes in England, but that in 2014/15 income tax rate is raised in England so as to raise tax revenue by £10bn. This £10bn is used to fund additional health/education spend in England. This provides Scotland a funding consequential of £1bn (its population share of the additional spend). The question that then arises is how much of this £1bn additional grant is clawed back through the block grant adjustment?

The £10bn increase in tax revenues in England equates to around 7% of England’s income tax revenues in 2013/14. So Scotland’s block grant adjustment (BGA) will also rise by 7%. Given that Scotland’s income tax revenues in 2013/14 were £11bn, this amount would be deducted from Scotland’s block grant in the first year that income tax is devolved. In the second year, this amount will rise by £11bn*7% which equals £0.8bn. So Scotland’s overall grant increases by £0.2bn (the £1bn increase in spending due to the Barnett consequential minus the £0.8bn increase in BGA).

The reason for this apparently bizarre effect (i.e. Scotland benefitting from a balanced budget increase in comparable English revenues and spending) arises because of the way that the Indexed Deduction method combines a population share of a levels change on the spending side with a rate change on the revenue side. Scotland will benefit from an increase in English spending if this is funded through a devolved tax which raises less per capita in Scotland than in England. This is because Scotland’s population share of the change in nominal spend will always be greater than the proportionate change in Scottish revenues required to finance this. Of course, the corollary that if England cuts the devolved income tax in order to cut spending on health and education, then Scotland will receive a reduction in its grant. Finally, note that if Scotland’s per capita revenues from the devolved tax are higher than England’s, then the effects are reversed: Scotland would lose from a balanced budget increase in English spending and gain from a fall.

Defining Comparable Taxes: the Levels Deduction method

An alternative method of adjusting the Barnett Formula to reflect devolved taxes is to adjust it in levels terms. As before, in the first year Scotland’s grant is reduced by the value of the devolved revenues. In future years, Scotland’s grant is equal to its grant the previous year, plus a population share of the change in comparable spending, minus a population share of the change in comparable revenues.

This approach has a couple of advantages. One is that of symmetry of risks: Scotland is protected from demographic risks on both the spending and revenue sides. The other advantage is that an increase in the devolved tax in England to fund devolved spending in England has no budgetary effect on Scotland. To see this, return to our earlier scenario in which income tax is devolved. If England raises an additional £10bn in revenue to fund devolved spending, Scotland receives a population share of the spending increase minus a population share of the tax revenue increase; these two are identical and thus cancel out – Scotland receives no change in its grant.

This approach is however likely to have a long-run cost for Scotland, and that is of an increase in the rate of convergence towards equal per capita spending in Scotland and England. Aficionados of the Barnett Formula will know that it should theoretically induce convergence in per capita spending between Scotland and England over time. This is because, for a given nominal increase in ‘English’ spending, the per capita spending increment is the same for Scotland, and thus the effect of Scotland’s higher initial per capita spending should become proportionately less over time. The levels deduction method also introduces this convergence property to the revenue side of the equation: assuming Scotland starts from a position of lower revenue per capita than England from the devolved tax, by subsequently assuming that Scotland’s revenues increase at the same per capita level as those in England, the initial divergence becomes less over time.

Summary

This discussion highlights some of the difficulties involved in adjusting the Barnett Formula to reflect devolved taxation in a fair and sensible way. On the one hand, major tax devolution would provide a good opportunity to reform Scotland’s grant mechanism more fundamentally, but the leaders of the main Westminster parties seem to be committed to maintaining the Barnett Formula. On the other hand, many of the tricky issues raised in this blog – which budgetary risks should Scotland be exposed to for example – would remain to be resolved under any alternative grant system. And in this blog we have not even considered how grant might be allocated to Scotland to reflect any benefit spending powers that might be devolved following Smith; this will be the subject of a future post.

This blog has discussed two ways of adjusting the Barnett Formula to take account of devolved taxation. One partially exposes Scotland to demographic risks, and results in spillover type effects from balanced budget increases in the devolved tax in England, which may or may not advantage Scotland. The other protects Scotland from demographic and spillover risks, but does imply a faster rate of convergence towards equal per capita spending. The approach that a Scottish Government would prefer will depend on factors including: Scotland’s per capita revenues relative to England’s for any tax that is devolved; relative rates of population growth in England and Scotland; and likely growth rates of comparable spending and revenues in England.

[1] Wales and Northern Ireland would also receive a funding consequential, but assuming income tax had not been devolved to Wales and Northern Ireland, taxpayers in these countries would pay a higher rate of tax.

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Submission to Smith Commission, 2

Many people have interpreted Gordon Brown’s comments prior to the referendum, as well as the so called “Vow” made in the Daily Record, as some commitment so “Devo Max”. My submission to The Smith Commission on further devolution for Scotland assumes that we are indeed aiming for the maximum level of devolution possible, and asks where this must fall short of the common understanding of Devo Max.

Devo Max is usually interpreted to mean full Home Rule for Scotland within the UK, so that the only governmental functions for Scotland that remain at the UK level are defence, foreign affairs, as well as a single currency and free trade area. Scotland would raise all its own taxes and pay the UK government for the services it provides, such as defence.

However, this framework runs into many of the same criticisms that afflicted the proposals for an independent Scotland sharing the pound Sterling with the rest of the UK. The question now is different, since it is unambiguously the case that enhanced devolution for Scotland will mean retaining a common currency area with the rest of the UK: so Scotland WILL be sharing the pound. However, to make a success of divergent polities within a common currency area, it is a requirement that we learn the lessons of the Eurozone crisis and seriously consider the constraints imposed on these divergent polities by the need to maintain macroeconomic stability.

My submission argues that whilst devolution can be extended greatly from its current form, an automatic, formulaic system needs to be built that responds to business cycle fluctuations and asymmetric shocks. Such a system is necessarily “less devolved” than Devo Max.

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Submission to Smith Commission

Our submission to the Smith Commission is available here: Smith submission Final

Desire to increase the tax and spending powers of the Scottish Parliament is often driven by an aim to improve the accountability of the parliament to the electorate. The submission discusses what might be meant by accountability in this context, and the extent to which different powers – and the way they are exercised – can be said to improve the accountability of the parliament. It also discusses the inevitable trade-offs between accountability and budgetary risks and uncertainty.

The submission argues that in a first best world, the Scottish Parliament’s revenue control would match its spending responsibilities, but that this is unlikely to be achievable because many taxes are not appropriate for devolution for practical, legal or institutional reasons. Therefore the advantages of tax devolution for Scotland (greater accountability) have to be weighed against the disadvantage for Scotland (the risk of a potentially less generous or more volatile budget in the longer-term) and the risk to the UK and Scotland that tax devolution might lead to tax competition that is in the interests of neither.

There may also be a case for devolving aspects of welfare spending to the Scottish Parliament, but this should be underpinned by a set of clear principles, consistently applied.

The submission also argues that control over minimum wages would also increase the accountability of the Scottish Parliament.

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Scotland’s Fiscal Future

The referendum on Scottish independence indicated that a majority of the Scottish people wish to remain within the UK. They have been given commitments that additional fiscal powers will be granted to the Scottish Parliament in the near future. In the paper Scotland’s Fiscal Future David Bell and David Eiser explore some of the issues that follow from this commitment and from the proposals that have already been tabled.

Continue reading

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Bookies 1 Opinion Polls 0

The referendum campaign lasted more than 2 years. Over that time, more than 100 opinion polls addressed the question “should Scotland be an independent country”. Many thousands of pounds have been spent on collecting the data and analysing the results. Yet in the month of September, at the business end of the campaign, the average poll gave Yes  48 per cent support and No 52 per cent support, if don’t knows are excluded. The narrowness of the margin panicked politicians into making promises about further devolution that may be very difficult to keep. Yet the outcome was Yes 45 per cent, No 55 per cent.

Continue reading

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Final polling and betting data

The implied probability of a No vote based on bookmakers odds up to 7pm on the 17th of September and the opinion poll probabilities of a No outcome (eliminating the don’t knows) are shown in Figure 1 below. The odds on a No outcome shortened throughout the 17th. The final observation was taken at 7pm.

A number of opinion polls were  also published on the 17th. They tended to show the No campaign having a tiny lead over the Yes campaign. Once the standard errors and the possible impact of the undecided voters are taken into account, there would seem to be little to choose between the likelihood of a Yes or No outcome. Yet this contradicts the bookmakers assessment of the odds, with the implied probability of a No vote now creeping up to 80 per cent.

Figure 1: Opinion Poll and Betting Market Implied Probability of a No vote

both_combined_17-09-14

Sources: What Scotland Thinks, Oddschecker.com, own calculations

A betting market on the share of Yes votes in the referendum is also open. The distribution of these is shown in Figure 2. The most likely range of Yes votes is 45-49 per cent. The chance of an outcome above 50 per cent (a Yes win) is 0.15, which is consistent with the overall odds of a Yes outcome, which can be deduced from Figure 1. However, the implied probability of Yes outcomes in the 35 to 44 per cent range is over 0.4, higher than the probability of a Yes win.

Figure 2: Likely Yes Vote Percentage

Majority

Sources: Oddschecker.com, own calculations (omitting overlapping intervals)

Nevertheless, taken together, the evidence from the betting odds is suggestive is of a No victory with a majority of between between 2 per cent and 10 per cent.

Finally, a market has developed in the local authorities most likely to vote No. These are mainly dominated by the more affluent areas, those close to the Scottish-English border and interestingly, Orkney and Shetland, which are located close to Scotland’s main oil fields.   These are closely followed by Edinburgh, Scotland’s capital city. Clearly a Yes outcome where Edinburgh votes No would also pose significant political challenges.

Those areas least likely to vote No include Scotland’s more depressed former industrial cities – Dundee and Glasgow. These are joined by a group of authorities in central Scotland and the Western Isles (Na h-Eileanan Siar), which has always had close ties with Scottish nationalism.

Figure 3: Area Most Likely to Vote No

Area Most Likely NoSources: Oddschecker.com, own calculations

The probabilities implicit in the betting odds provide an interesting set of predictions for the outcomes of the referendum. But they are just predictions: nothing more, nothing less. What will be fascinating in the post-referendum analysis is how they perform compared with the opinion polls. This referendum has produced a wealth of data and a unique challenge to both methods of foretelling the outcome.

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Last labour market data for Scotland before the referendum

Today (Wednesday), the Office for National Statistics posted the final set of labour market data for Scotland that will be released before the referendum. So how is Scotland faring?

Scotland’s unemployment rate for the period May-Jul 2014 was 6 per cent. This was a good performance in both an historical and a comparative sense. Figure 1 shows the unemployment rate for Scotland from 1992 to 2014. The unemployment rate peaked at 8.9 per cent in June 2010. Since then unemployment in Scotland has fallen by 33 per cent.

Over this period, which straddles the establishment of the Scottish Parliament, the main event impacting on unemployment was the financial crisis of 2008, which led to a rapid rise in unemployment.  Since then, as the economy has recovered from recession, the Scottish unemployment rate has dropped sharply.

Continue reading

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Eyes on Thursday night’s results

Normally when watching election results come in, there are a few well known “bell-weather” results from which the overall result can be gauged. For the Independence Referendum though, what do we look for as the early results are announced (council by council) to forecast the overall Yes or No result?

Based on the General Election 2010 results, the Arc of Prosperity blog makes some reasonable assumptions to calculate a propensity to vote Yes or No for each local authority. The assumptions made are not so important, they just need to be reasonably correlated with the propensity to vote Yes or No, and be consistent across council areas. I’ve reweighted the propensities to show the percentages required in each council area for a 50:50 result , assuming relative populations from wikipedia and, obviously, the same percentage turnout in each council area.

This is just a quick and dirty calculation – just a bit of fun for Thursday night (as if we needed any more excitement!) The percentages for Yes in each council area consistent with a 50:50 result are in the table below. At 50.3% for a 50:50 result, the results from Glasgow and Fife look like being indicative of the overall result.

Council Population % Yes % req. for 50:50
Aberdeen 4.2% 48.4%
Aberdeenshire 4.7% 52.3%
Angus 2.1% 56.3%
Argyll and Bute 1.7% 52.3%
Clackmannanshire 1.0% 54.3%
Dumfries and Galloway 2.8% 42.4%
Dundee 2.8% 55.3%
East Ayrshire 2.3% 54.3%
East Dunbartonshire 2.0% 43.4%
East Lothian 1.9% 48.4%
East Renfrewshire 1.7% 39.5%
Edinburgh 9.3% 42.4%
Falkirk 2.9% 53.3%
Fife 7.0% 50.3%
Glasgow 11.4% 50.3%
Highland 4.2% 53.3%
Inverclyde 1.5% 48.4%
Midlothian 1.6% 52.3%
Moray 1.7% 59.2%
Na h-Eileanan an lar 0.5% 57.3%
North Ayrshire 2.6% 52.3%
North Lanarkshire 6.3% 52.3%
Orkney Islands 0.4% 55.3%
Perth and Kinross 2.8% 50.3%
Renfrewshire 3.3% 51.3%
Scottish Borders 2.2% 46.4%
Shetland Islands 0.4% 55.3%
South Ayrshire 2.1% 42.4%
South Lanarkshire 6.0% 50.3%
Stirling 1.7% 46.4%
West Dunbartonshire 1.7% 55.3%
West Lothian 3.3% 54.3%
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A conversation, between economists, on the economics of independence

Surely there are solid arguments for negative effects from being a small country relative to being a large country? Economies of scale, the existence of border effects, liquidity premia, and so on?

Yes. Economic theory has proposed many plausible mechanisms that mean that large size should be associated with greater productivity and greater wealth. Further, when attempts are made to estimate the size of these effects, they turn out to be not insignificant. For example, see my own work which suggests that if the only change on Scottish independence were that it traded with the rest of the UK in the way that Ireland seems to trade with the UK, then this should be associated with a 5.5% fall in Scottish GDP.

However, these effects apply to all countries, not just Scotland, and if this were all that was going on then we should expect to see larger countries richer than smaller countries. As shown by Rose (2006), the economic literature on this generally finds no effect of size on growth or level of income (some papers even find a negative correlation e.g. Alouini & Hubert (2010)). This null result can be explained by supposing that there are non-GDP benefits of independence and richer and more productive regions, which can afford the trade-off, choose independence. This selection effect would mask the true relationship between size and GDP.

This selection effect however does not convince me. Given the persistence of national borders, then the randomising effect of technological change on productivity of different regions over time should mean that a small productive region which made the choice to be independent several hundred years ago is expected to be no more or less productive than another region that was poor several hundred years ago and made the choice to remain as part of a large country. Given random productivities, the benefits of size should be visible. They are not.

This either means that the benefits of size are wrong (I don’t believe this) or that there are countervailing effects. Perhaps small countries are better run or function at a more appropriate scale (convex costs of complexity?). Perhaps there are spillover benefits to running a country rather than being a peripheral region of a larger country like the ability to attract talent (high status government employment, and many international firms want at least a small office presence in your region) which leads to a more diverse business ecology, which involves the provision of the full range of support services that new and growing businesses require.

In any case, if the correlation between size and income is approximately zero, then it suggests that the (GDP-related) costs and benefits of size roughly cancel out. This does not, itself, provide a case for independence or for union. It just suggests that if we value independence for other, non-GDP reasons, then there does not appear be any significant GDP cost/benefit to pay/gain in general. Of course, there may be issues specific to Scotland and the UK could lead to the expectation of GDP costs or benefits of independence.

If there is no relationship between country size and long run growth/wealth then surely this is bad for independence, given transition costs?

Usually, yes. But Scotland already has most of the infrastructure of a state. HMT’s estimates of the transition costs were rubbished by the author whose research they relied upon. In any case, even if HMT’s figures were appropriate, this is a one off cost which should be met by extra government borrowing and amortised over a very long period. If we, extremely pessimistically, assume £3bn cost at 5% borrowing rate, then this is an annual cost of £150m or 0.1% of GDP. This is not a big issue.

Lumping lots of disparate countries together produces this zero correlation between size and income. Would it not be more valid to consider subsets of reasonably similar polities? For example biggest is richest for Spanish-speaking Latin American countries (excluding Puerto Rico which is really part of the United States). And for English-speaking countries, the largest, the USA, stands out as the richest, in spite of the fact that it does not appear to have better institutions or national endowments per capita than Canada, Australia or New Zealand.

Interesting points. I’m glad you thought of making comparisons across countries which, other than size, have some similarities. I contend that a suitable comparison group for looking Scotland and the UK is the EU members of northern Europe which have never been communist. For these 11 countries (Ireland, UK, France, Belgium, Luxembourg, Netherlands, Germany, Austria, Denmark, Sweden, & Finland), there is a significantly negative correlation between size and income. Set against the Spanish speaking Latin American countries, or the worldwide English speaking countries, this isn’t something that nails the argument – but it does show that your other two examples certainly don’t nail the argument either.

More interestingly, looking at these countries may allow us to make a specific point about Scotland and the UK rather than considering only the general size of countries issue. Eurostat has data that divides these countries up into 48 “NUTS1 regions” (*). These are shown in the graph below. I know of no reason to expect that 7 of the 12 UK regions should occupy the bottom 7 places in the ranking, with 11 of the 12 in the bottom half. The UK is not less fertile, it is not landlocked, nor is it lacking in natural resources (indeed it has the largest oil and gas reserves of any of these 11 countries). This may be indicative of institutional problems in how the UK is run: perhaps to the benefit of London which is one of the richest regions in Europe, despite the poverty of the rest of the UK (indeed, the UK has the highest regional inequality in Europe) [though France is also a centralised state and German decentralisation may be more symbolic than real]. If there is only an institutional reason, rather than some structural or fundamental reason, for the low position of all the regions in the UK other than London and its environs in this ranking, then institutional change (such as independence or radical devolution/federalism) may be accompanied by an expectation that Scotland can gain – in GDP terms. This is of course in addition to the non GDP benefits of  this institutional change, like electing political parties more closely aligned with preferences of the Scottish electorate.

(*) All NUTS1 regions of these 11 countries excluding 1 region from France: French overseas territories – not in northern Europe; and 6 regions from Germany: the East German Länder – formerly communist.
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