The latest GDP figures were released today. They show the Scottish economy grew by 0.1% in 2015 Q3. This is a fairly weak performance. The UK economy as a whole grew by 0.4% in the same quarter; it grew by 2.1% over the previous year compared to Scotland’s growth of 1.7%.
The slowdown has been concentrated in the production sector, with some contribution from weakening output in government and other services.
Given this relatively poor performance in 2015, what are the prospects for 2016? We have been constructing a small statistical model based on interactions between the Scottish and UK goods and labour markets. Later in this blog, we describe forecasts for Scotland based on this model.
However, it is first worth reflecting why the importance of such forecasts is increasing. Starting with the forthcoming financial year (2016-17), Scotland will retain a share of its income tax revenues. If the Scotland Bill 2015 passes through the parliamentary process, the share of tax revenues retained within Scotland will increase further. Hence, the ability of the Scottish government to spend money on public services will be much more closely linked to Scotland’s economic performance than has been the case when Scotland’s funding was almost wholly determined by the Barnett formula. From now onward, forecasts of Scotland’s future economic performance have relevance not only to households’ private incomes, but also to the ability of the Scottish government to fund public services.
The Scottish government’s budget will depend not only on its tax revenues, but also on the size of the adjustment made to its block grant: this adjustment is intended to ensure that neither Scotland, nor the rest of the UK suffers “detriment” as a result of the transfer of tax powers. This mechanism is part of the so-called “fiscal framework” which has yet to be agreed between the Scottish and UK governments.
However, it is clear that the overall size of the Scottish budget will depend on the relative performance of the Scottish and UK economies. If Scotland grows its tax revenues more quickly than those in the rest of the UK, the increase in its tax revenues is likely to outpace the reduction in its block grant from Westminster. If Scottish tax revenues grow more slowly, then there will be downward pressure on the Scottish budget.
Thus, when considering how to make forecasts for the Scottish economy, it seems reasonable to recognise that point forecasts are inevitably subject to error and that, in the light of the changes to tax powers described above, the key issue for the planning of Scotland’s public spending is whether Scotland’s tax revenues will grow faster than those in the rest of the UK. One of the first order determinants of this outcome is whether Scotland’s economic growth rate will exceed that of the UK as a whole.
In seeking to answer this question, we have gone beyond the usual point forecast by applying a technique known as “stochastic simulation” to our statistical model, which gives us estimates of the probability that Scotland’s growth rate will lie within a particular range of possibilities.
For the UK as a whole, we have used the OBR forecasts of quarterly GDP. In the light of recent events, such as the slowdown in the Far East, continuing uncertainty in Europe and high levels of consumer indebtedness in the UK, these may seem somewhat optimistic. Nevertheless, if they err on the side of overoptimism, this will also be translated to the Scottish forecasts due to the goods and labour market linkages which form part of the model structure. The model does not take account of Scotland-specific shocks which have not yet had an impact on the GDP estimates. Clearly, these would include any further negative outcomes associated with the decline in the oil industry.
Our results are shown Figure 1. It shows actual and forecast growth rates in GDP for Scotland and the UK as a whole over the period 2014 Q1 to 2018 Q4. The shaded area shows the range within which we would expect that 95% of potential outcomes for Scotland’s growth rates would lie, conditional on the OBR’s forecasts for the UK as a whole being accurate.
The forecasts suggest that there will be some recovery of the Scottish economy in 2016. However, the qualifications mentioned above could exert a further drag on economic performance.
However, even without these effects, nearly all of the simulations show Scotland growing more slowly than the UK as a whole. This implies that the probability of the Scottish economy generating faster growth than the UK between now and 2018 is small. In turn, this is likely to lead to relatively slower growth in income tax revenues in Scotland compared with the UK as a whole. And this will put downward pressure on the Scottish budget.
With new tax powers comes the possibility of increased revenues and increased public spending: but there are also increased risks, such as those associated with slower growth in tax revenues. It seems likely that the Scottish government will have to deal with the more negative of these outcomes in the immediate aftermath of the transfer of tax powers.