How will the general election result and new tax powers affect the Scottish budget?

With all the recent discussion about the Smith Commission and devolved taxation, it’s perhaps easy to forget that the block grant from Westminster will continue to account for the major part of the Scottish budget for the next few years at least. But how will the spending plans of the next UK Government affect the size of the Scottish grant and therefore the Scottish budget? And to what extent will Scotland’s new tax powers enable the Scottish Parliament to vary its budget further?

To answer this question, we first need to know about the spending plans of the parties which might form the next government. But before we get to this, it is worth re-visiting the mechanism by which spending by the Westminster Government feeds through to determine the Scottish block grant.

The Barnett Formula

Scotland’s block grant in a given year is equal to the grant it got the previous year, plus an increment. The increment is determined by the Barnett Formula. Effectively, the Barnett Formula says that this increment is equal to a population share of the change in comparable spending by the UK Government.

This is easiest to illustrate with a hypothetical example. Imagine the UK Government decides to increase spending on health by £100m. Health spending is 99% ‘comparable’, (which is effectively like saying that 99% of the functions of the Department of Health are devolved to Scotland) and Scotland’s population proportion relative to England’s is roughly 10%. So the increase of £100m in the UK Department of Health budget results in a £9.9m increase in Scotland’s block grant. A similar exercise is performed for each UK government department, and the sum of all these comparable changes (which can be negative) determines the overall change to the Scottish block grant.

Parties’ spending plans

What do we know about the UK Government’s spending plans for the next parliament? The Autumn Statement 2014 (AS2014) set out a fiscal target to achieve an overall budget surplus of 1% of GDP by 2019/20. Interestingly however, each of the UK parties’ own plans imply somewhat looser fiscal policy than this. The Conservatives aim to achieve an overall fiscal balance by 2019/20, while Labour and the LibDems aim to achieve current balance and cyclically adjusted current balance respectively by 2019/20 (enabling them to borrow more for capital investment).

What these different fiscal rules might imply for departmental spending depends on, among other things, the extent to which the rule is achieved through tax rises versus spending cuts, and on how spending changes are distributed between departmental spending (known as DEL) and the AME budget (which covers spending on welfare, pensions and debt interest). The IFS has reviewed each party’s spending plans for the next parliament. Its estimates of the most generous DEL settlement that would be consistent with each party’s fiscal rules are shown in the table below.

table 1

When it comes to considering the implication for the Scottish block grant, we also need to consider how these overall DEL changes are distributed across government departments. This is because different departments are associated with different comparability factors and differing baseline spending levels.

The table below shows the IFS’ estimates of each party’s implied DEL spending changes by major department. Both Conservatives and Labour plan to increase real terms spending on health, implying that other DEL budgets are exposed to greater cuts. From a Scottish perspective, this is preferential to a situation whereby cuts are distributed evenly across all departments, given that the Scottish ‘consequential’ associated with changes to UK health spending is higher than the consequential associated with, say, the Home Office (the table also shows current DEL spending and the comparability factors for each department).

table 2

 

 

 

 

 

 

 

 

Implications for the Scottish budget (1)

On the basis of the spending estimates described above, together with information on current spending and comparability factors, we can estimate how Scotland’s DEL budget might evolve over the next parliament.

The results are shown in the figure below (we are assuming here that revenues from the already devolved council tax and business rates in Scotland grow at the rate projected by the OBR in AS2014). If the AS2014 plans are implemented, this would result in a real terms fall in Scotland’s DEL budget of £2.5bn over the parliament. The Conservative plans imply a somewhat lower fall, and the Labour plans imply a relatively small real terms decline in spending. We have not shown the LibDem plans as these are not particularly different from those of Labour, but we have illustrated the implications for the Scottish budget if the next UK Government increases UK DEL spending by 0.5% per annum in real terms, the case for which was made by Nicola Sturgeon in her speech last week. As has been noted elsewhere, the difference between the Labour and Sturgeon proposals is not huge (caveat – we’ve simply assumed the 0.5% real growth suggested by Sturgeon is spread evenly across all departments; if in fact spending on health increased relatively more quickly, this would provide an additional boost to the Scottish budget).

Figure 1

So the Scottish budget could look quite different by 2019/20 depending on which party forms the UK government and how their spending plans are implemented. But in general, the reduction to the Scottish DEL budget is less severe than the overall reduction in UK DEL spending, given the ‘protection’ to health spending (and some nuances in the Barnett calculation).

Implications for the Scottish budget (2): incorporating tax devolution

The analysis thus far ignores the implications of the devolution of the Scottish Rate of Income Tax (SRIT, the 10p flat tax) which is due to be implemented in 2016/17. To what extent might this change the picture? First of all, note that if revenues from the SRIT grow at the same rate as revenues from the comparable tax base in rUK, then Scotland’s budgetary position with the SRIT is the same as it is without it. This is because of the way that Scotland’s block grant is likely to be adjusted to reflect the new tax (the reduction to Scotland’s grant will be indexed to grow at the same rate as the growth in comparable revenues in rUK).

But what if incomes in Scotland grow by 1% more each year than they do in rUK? This additional income growth in Scotland would feed through to higher income tax revenues which would be available to the Scottish budget. The figure below shows how much difference this differential tax base growth would make to Scotland’s budgetary position under each UK Government spending scenario. The message is that 1% differential tax base growth will not be sufficient to offset the spending decisions of the UK government, equating to an additional £100m by 2019 (it is worth noting that a 1% per annum differential in income growth is actually quite significant – the average annual differential between the UK and Scotland since 1997 has been 0.3%). Of course the flipside is that slower tax base growth in Scotland would result in a lower DEL budget.

Figure 2

The Scottish Government might choose to exercise its new fiscal powers by putting 1p on the SRIT (so that income tax rates in Scotland are 21p, 41p and 46p respectively). This would raise an additional £400m per year; enough to mitigate the impact of UK cuts in the early part of the parliament, but not enough by the end. (By the end of the parliament, full control of income tax is likely to have been devolved to Scotland as per the Smith Commission proposals, providing the Scottish Government with some additional room for manoeuvre, and enabling it to capture a larger share of any differential growth in income tax revenue; but also exposing it to greater budgetary risks).

Conclusions

Notwithstanding the excitement about additional tax powers for Scotland, in the immediate term the spending plans of the UK government remain the most significant determinant of the Scottish budget. This observation is important in the context of the EVEL debate. Furthermore the differences between the UK parties’ spending plans are greater than is sometimes assumed.

An important caveat is that all these scenarios are based on the projections in the OBR’s Autumn Statement as regards the growth of productivity, incomes, and revenues. There is clearly uncertainty around how these might evolve. Thus this analysis should not be thought of as a projection of what the Scottish Government’s budget will be in 2019, but an exploration of the way in which various factors might affect it.

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Endnotes

Summarising the budgetary position of the Scottish Government in 2019 for a blog-post inevitably involves making assumptions; many are mentioned in the text, but here are some that aren’t:

  • Assumed that the cuts implied by the parties’ fiscal rules are spread evenly throughout the term of the next parliament
  • Ignored the distinction between capital and resource spending;
  • Not considered the fact that the Scottish Government could use its new borrowing powers to increase capital spending
  • Ignored the fact that the Scottish budget will increase in future to account for the new welfare powers that will be devolved under Smith
  • Not considered the Scottish Government’s AME spending (the Scottish Government’s AME budget is largely for public sector pensions and is determined outwith the Barnett Formula).

 

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