Fiscal Update

For those of you who may have dropped in from Mars and who have not had the opportunity to acquaint yourself with the intricacies of Scotland’s taxation and spending, here is a potted version for the uninitiated.

In 2012-13, the most recent year for which data is available, public spending in Scotland, or for Scotland, cost £65 billion. This was from total UK public spending of £702 billion. Scotland accounted for 9.3% of UK public spending, though its population only makes up 8.3% of the total UK population. Public spending per head was higher in Scotland than in the UK as a whole. Scotland has traditionally experienced higher public spending than the UK as a whole.

Not all of this spending can be associated with activities carried on in Scotland. Spending on overseas embassies, on the national debt, and on foreign aid cannot be “identified” with Scotland. Such “unidentified” spending is allocated to all citizens of the UK equally, since they are all deemed to equally benefit from this spending. Since there is no differentiation of “unidentified spending”, comparisons of public spending within the UK are usually carried out across the “identifiable” spending categories, such as health, transport and education, which can be located geographically.

The 2012-13 estimates of identifiable public spending show public spending per head in Scotland was £10,152 compared with £8,788 in the UK as a whole. Identifiable spending per head in Scotland was therefore £1364 (15.5%) above the UK average.

There are several reasons for this extra spending in Scotland, but the main one is the way that the Barnett formula allocates funding to Scotland, Wales and Northern Ireland. Since the introduction of the Barnett formula in the 1970s, Scotland has always received more public spending per head than the UK as a whole.

Most of the identifiable public spending is under the control of the Scottish Government. The main exception is welfare spending which includes all state benefits and the state pension. Welfare spending is determined at a UK level and is distributed by the Department for Work and Pensions. Figure 1 shows the proportion of spending in Scotland on each benefit and compares that to its population share. Scotland receives relatively more than its population share of incapacity and disablement benefits because of its poorer health record and relatively less on child support due to its slower growing population, and less on housing benefit because housing is relatively cheap compared with the rest of Great Britain.

Figure 1: Scotland’s Share of Spending on Main Welfare Benefits and the State Pension 2012 – 13

Figure 1

Source: Department for Work and Pensions

How does the Scottish Government allocate the extra spending across those policy areas where it has control? Most observers assume that it is spending on health, on social care and on education where Scottish spending is much higher than in the rest of the UK. This is because the Scottish government has introduced policies such as free prescriptions, free personal care and free university tuition which are less widely available, or not available at all, in the rest of the UK. However the differential effect on public spending of these policies cannot be easily identified from the spending data.

Figure 2 shows how Scotland’s extra £1364 is made up from the different categories of spending where spending per head in Scotland differs from that in the UK as a whole. So £278 comes from extra social protection spending in Scotland, £243 comes from extra spending on transport in Scotland, and so on until the total of £1364 is reached.

Figure 2: Difference in Per Capita Spending between Scotland and the UK as a Whole by Function of Government, 2012-13

Figure 2

Source: Public Expenditure Statistical Analysis 2014

The largest difference in spending per capita is in social protection. This area covers pensions, benefits (as described above). In addition it encompasses some spending on social care, children and housing. Overall, social protection is by far the largest government spending programme in Scotland. In percentage terms, the gap in social protection spending between Scotland and the rest of the UK is relatively small (and has been declining in recent years). Scotland only spends 7.2% above the UK average for social protection spending per head and 9.2 per cent more on health. In contrast, it spends 82% more per head on transport, 106% more on agriculture, fisheries and forestry and 183% more on enterprise and economic development. These percentage differences are illustrated in Figure 3.

Figure 3: Percentage Difference in Per Capita Spending between Scotland and the UK as a Whole by Function of Government, 2012-13

Figure 3

Source: Public Expenditure Statistical Analysis 2014

There are plausible arguments why Scotland might spend relatively more on transport, environmental protection, culture, agriculture etc. but to some extent these choices must also reflect the preferences of the Scottish Government. The Scottish Government has considerable latitude to allocate its funds as it sees fit. More could be spent on health and education, but this would mean less spending in other parts of the Scottish public services.

There is another side to this story concerning the affordability of the levels of spending as described. Taxes raised in Scotland in 2012-13 amounted to £53 billion. This includes a geographical share of North Sea oil revenues. Even with oil revenues, spending clearly exceeds tax receipts  – one in every 5 pounds spent by the public sector in Scotland is borrowed. Total borrowing is equivalent to 8.3% of Scottish GDP. The UK faces a similar problem. It had to borrow £115 billion in 2012-13, equivalent to 7.3% of UK GDP. Differences in the size of the deficit between Scotland and the rest of the UK reflect changes in oil revenues on the one hand and the differences in spending per head on the other. When oil revenues are buoyant, Scotland tends to have a smaller fiscal deficit than does the UK as a whole, while when revenues are weak, Scotland’s deficit exceeds that of the UK. Figure 4 shows the pattern of oil revenues during the last five years and compares that to the aggregate extra spending in Scotland above the UK average as described previously. Thus, for example, if as was the case in 2012-13, Scotland’s spending is £1364 per head higher than the UK average, the total cost of this spending is £1364 * the size of Scotland’s population = £7.25 billion.

Figure 4: Oil Revenues Compared with Additional Public Spending in Scotland

Figure 4

Source: HMRC, Public Expenditure Statistical Analysis, Own Calculations

Over the entire period between 2008-09 and 2012-13, oil revenues exceeded Scotland’s spending advantage by £5 billion. This was mainly driven by very large oil revenues accrued during 2008-09. Since then oil revenues have been on a generally downward trend.

These data do suggest that oil revenues could play a role in maintaining Scotland’s current level of public spending. However, they would have to be maintained at or near current levels, an issue which is a matter of heated debate. And it is difficult to see how it would be possible to establish a sovereign wealth fund based on oil revenues if their main use is to shore up existing spending.

However the date on public spending and tax revenue suggest that both the public finances of the UK as a whole and those of Scotland are in a mess. Responsibility for this state of affair is widely spread, across the financial sector, regulators, politicians of all hues and also perhaps borrowers. However, the markets are less interested in why borrowing is so high than in establishing a credible repayment plan when a government asks for a further loan. Just as this maxim applies to the UK government, so it would also apply to the government of an independent Scotland.

The current UK government and its predecessor both produced plans to reduce the budget deficit. Its value has been cut, but the Coalition government has fallen considerably short of its initial intentions to reduce borrowing. It originally planned to reduce the deficit to 5.5% of GDP by 2012-13. Given that the actual deficit in 2012-13 was 7.3 per cent, it has clearly fallen well short of its ambition. Nevertheless the Coalition intends to continue with spending cuts so that by 2018-19, the deficit will have been eliminated.

There are heated debates about how quickly further spending cuts should be implemented. The current European experience illustrates the danger that too rapid a trajectory towards budget balance can lead to stagnation and possible deflation. Nevertheless, there is very little enthusiasm among the main UK political parties for returning to a situation where public spending is growing faster than is the UK economy as a whole. It is fairly clear that should Scotland stay within the UK, many difficult decisions will have to be made about spending priorities.

But would the situation be much different for an independent Scotland? Starting with a similar deficit, how would the Scottish government establish credibility with the markets and thus ensure the supply of funds necessary to maintain public services? Lenders would need to be convinced that an independent Scotland would meet its repayment obligations. One difficulty that it would face is that it lacks any credit history: since it is not responsible for repaying UK government debt, the Scottish government cannot obtain a share of the UK’s reputation for honouring its debts.

Given the need to establish credibility, an independent Scottish government would therefore find it difficult to adopt an expansionary fiscal policy in the short to medium term. Rightly or wrongly, such a strategy would be unlikely to be attuned to market sentiment. This would make it difficult for the Scottish government to avoid following the same general strategy as the Coalition of continuing reductions in public spending or increased taxes. It is difficult to envisage how a newly independent state in a difficult fiscal situation, and without a significant credit record, could avoid the pressures for fiscal consolidation – which ultimately means tax increases or spending cuts.

 

 

About David Bell

David Bell FRSE is Professor of Economics at the University of Stirling. He graduated in economics and statistics at the University of Aberdeen and in econometrics at the London School of Economics. He has worked at the Universities of St Andrews, Strathclyde, Warwick and Glasgow. His research is mainly in labour economics, fiscal decentralization and the economics of long-term care. He has been budget adviser to the Scottish Parliament Finance Committee. He is PI for the Healthy AGing In Scotland project (HAGIS).
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