Fiscal framework has the potential to make or break the new devolution settlement.

Deputy First Minister should refuse to sign up to Fiscal Framework unless the right block grant adjustment can be agreed.

 

STUC General Secretary Grahame Smith today warned that key new powers enshrined in the Scotland Act could become a poisoned chalice if the Fiscal Framework currently being negotiated between the Scottish and UK Governments fails to meet the ‘no detriment’ principle as agreed by the Smith Commission.

 

The STUC has been an advocate for strong additional powers for the Scottish Parliament, particularly in the area of taxation.

 

“However, we have always been absolutely clear that the value of the new powers, particularly those relating to new welfare spending and tax raising, were dependent on an appropriate Fiscal Framework.  We recognise that negotiations between the two governments are sensitive and ongoing, but there has been far too little public debate on this issue.

 

Over the next couple of weeks we will be assessing three key elements of the Fiscal Framework all of which will impact on the calculation of the Scottish Block Grant in years to come:

1. How, will the Scottish block grant be adjusted to take account of additional spending flowing from the devolution of new powers - primarily welfare?
2. What mechanisms will be put in place to allow the block grant to be adjusted to reflect specific UK and Scottish Parliament spending decisions where they have a direct impact on the finances of the other body.
3. Following the initial adjustment of the block grant to compensate for the devolution of taxes to the Scottish Parliament, what method of will be used for block grant adjustment in future years.  How will this impact in Scotland?
    
4. Today we make comment on the impact of the devolution of new taxes, primarily income tax and raise serious concerns that if the method applied for year on year adjustments to the block grant is not right, very severe detriment could result.  This would call into severe question whether the Scottish Parliament should accept the new tax powers.
5.  
   “We have reviewed some of the relevant literature on this subject and conclude that Scotland could find itself disadvantaged to the tune hundreds of millions in a relatively short space of time if the wrong method is applied and that this figure could reach the billions over a longer time period.
    
   “In this context, it would be completely wrong for the Deputy First Minister to sign up to a mechanism for block grant adjustment which would structurally disadvantage Scotland. It would also be entirely wrong for the Scottish Government’s political opponents to characterise an appropriately firm bargaining position as the Government ‘dragging of feet’ on new powers. The Fiscal Framework is absolutely central to the impact of further devolution and it would be entirely wrong to sleepwalk into a bad deal.”
    
    Fiscal Framework
    

1. The STUC has argued, in a view taken during the referendum and prior to the ‘Vow’, Smith Commission and subsequent Scotland Act, that the Fiscal Framework surrounding the new powers over tax and spending had the potential to ‘make or break’ the new devolution settlement.
2. This concern is amplified by the nature of the powers finally agreed for transfer; the transfer of income tax powers isn’t balanced by a sufficiently wide basket of other tax powers.
3. Key factors include the fact that Scotland’s share of the UK total income tax revenue is below its population share due to the concentration of high income tax earners in London and the South East of England; and that the Scottish population is predicted to grow more slowly than that of the rUK.
4. The ‘no detriment’ principle is very difficult to apply and remains the subject of varying interpretations.
5. The three key questions are.

1.  How will the Scottish block grant be adjusted to take account of additional spending flowing from the devolution of new powers - primarily welfare?
2. What mechanisms will be put in place to allow the block grant to be adjusted to reflect specific UK and Scottish Parliament spending decisions where they have a direct impact on the finances of the other body.
3. Following the initial adjustment of the block grant to compensate for the devolution of taxes to the Scottish Parliament, what method of will be used for block grant adjustment in future years.  How will this impact in Scotland?
    

1. This paper deals with the third of these questions and concludes that, if the wrong adjustment method is adopted, severe reductions in Scottish Parliament revenues can be predicted which would infringe the ‘no detriment’ principle and call into question whether the devolution of income tax as laid out in the Scotland should be accepted by the Scottish Parliament.
2. The year one calculation is reasonably simple.  The Block grant will be increased by the quantum of spending currently attached on the UK responsibilities to be devolved and then decreased by the amount of revenue the Scottish Parliament would have raised if it already had the new tax powers – primarily income tax.
3. The calculation for following years is far more complicated and outcomes are very sensitive to the methods applied.
    
   No detriment and the devolution of powers
    
   The STUC recognises that the Smith Commission’s recommendations on ‘no detriment’ are subject to variable interpretation and can be applied in different ways.  In the STUC’s view, the application of ‘no detriment’, as it relates to the calculation of the future block grant, are:
    

1. The initial adjustment to the block grant to reflect changes in tax and spending powers should be revenue neutral. For the tax revenue component of this, the initial calculation should be a deduction from the Scottish block grant of the sum that will be derived from the newly devolved Scottish taxes.
2. The adjustment in subsequent years should allow for different impacts where Scottish Parliament tax and spending policies differ from that of the UK Parliament.  This implies that if Scottish tax revenue should rise or fall consequent to policy decisions to alter rates or thresholds; or if there are differing levels of economic growth, the benefit/detriment should be retained by the Scottish Parliament.
3. The adjustment in subsequent years should employ a method which guarantees (as closely as is possible) that had there been no changes in policy or variation in relative growth, the block grant deduction would retain maintain parity with the tax raised in Scotland through newly devolved taxes.  In short, if there is no difference in economic performance or tax rates between Scotland and the rest of the UK, public spending in Scotland should be no higher or lower than under the current funding framework.
    
   Thus, the principle of ‘no detriment’ as it applies to the adjustment of the block grant to reflect the devolution of tax revenue streams is maintained initially and in future years without impacting on the principle that the effect of differing fiscal policy decisions should impact on the Parliament which takes such decisions.
    
   Indexing options
    
   Clearly, the revenue derived from taxation will differ year on year.  Over a period, revenues can be expected to increase as a consequence of overall growth.  Thus, in most years, the quantum of both UK and Scottish income tax should increase, leading to an increase in revenue for the Scottish Parliament from income tax and a larger deduction in the block grant reflecting overall growth in tax receipts. 
    
   The initial adjustment figure is a lump sum, which requires no formula save an agreed figure for what constitutes the Scottish share of income tax receipts (principle a).
    
   Subsequent adjustments cannot be made using the same method otherwise the calculation would fail to recognise potential policy variations (principle b) and therefore a formula is required by which changes in UK tax receipts and Scottish tax receipts can be reconciled with the appropriate deduction to the block grant.
    
   The STUC has reviewed the currently available literature on methods of adjustment[1] There is more than one way in which this future adjustment can be calculated. Remembering that the overall figure might vary as a consequence of different growth rates or tax policy, it is still possible to predict how the various methods for the adjustment would impact on the revenues of the two parliaments assuming no divergence in policy or growth (principle c).
    
   All of the options for indexation retain the same Year 1 adjustment figure as is consistent with principle a), but take a different approach to how the increase in the block grant deduction is calculated.
    
   Option 1 – Level deduction (population share of rUK change in tax receipts is added to baseline deduction each year)
    
   This option would calculate the additional amount by which the block grant is to be reduced by each year based on Scotland’s population share of the change in comparable tax receipts in the rest of the UK (rUK). 
    
   This method would create a disparity between the block grant deduction and the increase in Scottish Parliament income tax receipts. This is because Scottish income tax receipts are lower per capita than across the UK as a whole (largely driven by the concentration of higher rate tax-payers in London and the South East).  Scotland accounts for 8.3% of the UK population but 7.3% of UK income tax receipts, the annual block grant deduction will therefore be greater than the growth in Scottish income tax receipts – even when income tax receipts are growing at the same rate in Scotland and the rest of the UK.  This indexation method therefore guarantees that even when Scotland matches the economic performance of the rest of the UK its budget will be smaller than that provided under the current funding framework.
    
   This breaches the no detriment principle outlined earlier that the effect of the devolution of income tax should be revenue neutral, assuming comparable growth rates and non-divergent tax policy.
    
   The effect of using this method would be that, over a period, Scotland’s public spending relative to the rUK would be significantly damaged.
    
   Option 2 – indexation against relevant UK tax receipts in the rUK
    
   Option 2 would index the annual block grant deduction to the overall increase in comparable tax revenue in the rUK.  However, as rUK population growth is expected to exceed Scotland’s, the annual block grant deduction will, over time, exceed the growth in Scottish income tax receipts – even if per person receipts in Scotland and the rest of the UK grow at the same rate. 
    
   Scotland does not have key devolved powers such as migration policy, which might enable it to proactively increase its population relative to rUK. This method of indexation therefore also conflicts with principle c), that all other factors being equal, Scotland’s relative fiscal position should not deteriorate. 
    
   Option 3 – indexation against relevant UK tax receipts in the rUK adjusted for population growth
    
   The best, and in the STUC’s view, fairest approach, is to index the initial baseline adjustment to the growth in relevant rUK tax receipts (Option 2) but to make a subsequent  adjustment taking into account the change in relative population growth between rUK and Scotland.  In the case of income tax, this would mean indexing the initial block grant adjustment to the growth in per person income tax receipts in the rest of the UK.
    
   This method gets closest to compensating for the disparity in tax base between Scotland and rUK which is [largely?] a consequence of UK macro-economic and fiscal policy; and the predicted slower rise in Scotland’s population relative to the rUK, a trend the Scottish Parliament does not have the powers to substantially influence.  It means that if income tax receipts per person grow at the same rate in Scotland and rUK, and tax rates are the same in both countries, public spending in Scotland will be exactly the same as it is under the current funding framework.  This therefore achieves the Smith Commission’s no detriment principle
    

 

Appendix 1

 

Level Deduction Worked Example	Year 1	Year 2
Rest of UK Income Tax Receipts[2]	£145 billion	£167 billion (15% growth)
Scotland – Income Tax Receipts[3]	£11 billion	£12.7 billion (15% growth)
Block Grant Adjustment (BGA)	£11 billion	£13 billion
Impact on Scottish budget (Scottish Income Tax – BGA)	£0	-£300 million
Calculation for the BGA in year 2 is as follows Year 2 BGA = Year 1 BGA + (Scotland’s population share[4] of change in rUK receipts)) Year 2 BGA = £11 billion  + (9.1%* (£167bn - £145bn))

 

Indexed Deduction per capita Worked Example	Year 1	Year 2
Rest of UK Income Tax Receipts	£145 billion	£167 billion (15% growth)
Scotland – Income Tax Receipts	£11 billion	£12.7 billion (15% growth)
Block Grant Adjustment (BGA)	£11 billion	£12.7 billion
Impact on Scottish budget (Scottish Income Tax – BGA)	£0	£0
Calculation for the BGA in year 2 is as follows Year 2 BGA = Year 1 BGA * Growth in rUK Income Tax Receipts per capita, multiplied by Scottish population growth Year 2 BGA = £11 billion  * (1.15/1.06) * 1.06   Notes For simplicity, the calculations assume that the population grows at the same rate in Scotland and the rest of the UK (0.6%). In this case, tax receipts per head would also grow at the same rate in Scotland and the rest of the UK and indexed deduction and indexed deduction per capita yield the same result.

 

The above examples illustrate the differences between the level deduction and  indexed deduction methods under the assumption that population growth is similar in Scotland and the rest of the UK.  However, latest population projections indicate that Scotland’s population is expected to grow less quickly than in the rest of the UK. In this case, if tax receipts per capita grew at the same rate in Scotland and the rest of the UK, Indexed Per Capita Deduction  would ensure that Scotland’s budget is no better or worse off following the devolution of income tax whilst Indexed Deduction would not. This is because even if per person receipts in Scotland grow in line with the rest of the UK, aggregate receipts may not due to slower population growth.


Dave Moxham

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[1] http://scotfes.com/2014/11/20/how-should-the-barnett-formula-be-adjusted-to-reflect-devolved-taxes-a-question-of-allocating-risk-wonkish/

https://mail.stuc.org.uk/OWA/redir.aspx?C=a634f6d5f5d041809fb2c62cc7188360&URL=http%3a%2f%2fwww.ifs.org.uk%2fuploads%2fpublications%2fconferences%2fpresentations%2fPhillips_Scottish_Finance_Committee.pdf

http://data.parliament.uk/writtenevidence/committeeevidence.svc/evidencedocument/economic-affairs-committee/the-devolution-of-public-finances-in-the-united-kingdom/written/21826.pdf

[2]GERS, Table 3.1. Rest of the UK is defined as UK minus Scotland.

[3] ibid.

[4]ONS2013-14 population estimates for UK and Scotland. Rest of the UK calculated as UK minus Scotland.