Dangers posed by imminent fiscal trap

Although negotiations on the fiscal settlement to underpin the Smith reforms are being conducted in secret between Scottish and Westminster governments, the broad scope of what is currently being considered has become clear. The picture emerging is disturbing indeed.

All of the options on the table involve Scotland having to participate in a fiscal race with the rest of the UK, (rUK). Here, Scotland would have to grow its income tax revenues at least as fast as rUK. If Scotland manages to keep up, it would get the same funding as under the Barnett formula. But if it doesn’t, it’ll be penalised. The penalties could be severe: public expenditure per head on devolved services in Scotland could well fall to 50% or less of comparable spending in England.

Scotland’s chances of avoiding being penalised in the Smith fiscal race depend critically on whether the Scottish government has adequate powers to grow the economy. Given the Scottish government’s lack of powers, our chances in the race don’t look good.

A senior unionist negotiator argued Scotland will have the powers it needs, namely, to outcompete rUk on income tax by lowering the upper rates to below those in rUK. Thus, Scotland would become so attractive to wealthy individuals it would increase its tax revenues, winning the fiscal race. Therefore, while John Swinney affirmed his resolve to use the income tax powers under Smith to construct a more progressive tax regime, the other side let slip that the new fiscal arrangements will only work if Scotland becomes more regressive than rUK, and a haven for the rich.

Let’s look at why we are in this situation. The Smith report didn’t spell out the detail of the fiscal settlement which should operate once its reforms were implemented, instead setting out broad principles, leaving detail to be determined by negotiations between the two governments.

At their very core is a technical sounding, but vital, issue: how abatement to the Scottish government’s block grant (BG) should be adjusted. Under Smith, the Scottish government will receive its funding from a) devolved or hypothecated tax like income tax (devolved), half of VAT (hypothecated) and b) Westminster BG. The starting point in calculating BG will be the existing Barnett formula with the formula BG reduced (i.e., abated) to allow for revenue the Scottish government will now receive directly. So how should abatement be adjusted?

Late last year, the Institute for Fiscal Studies (IFS) published a view on this. One thing it got right was the impossibility of simultaneously satisfying all the guiding principles which Smith had laid down. This means the Smith principles will inevitably have to be modified by identifying which principles are vital, and which others can be relaxed, and by how much.

Yet the IFS report didn’t do this in a judicious and even-handed fashion, instead giving certain principles primacy on arbitrary or ill-considered grounds while entirely neglecting others. For example, it concentrated on analysing three methods for indexing BG adjustment: indexed deduction (ID); per capita indexed deduction (PCID); and level deduction (LD).

All three assume growth in BG abatement is linked to the growth in income tax revenues in rUK. The decision to concentrate on methods related to growth in rUK tax revenues has crucial consequences. (Other indexation options are possible like growth of the tax base, i.e., aggregating taxable incomes: or use of an indexation factor fixed in real terms.) Tax revenue indexation was not envisaged by the Smith report or the then Westminster coalition government, where indexation on tax base was taken as the starting points.

Growth in tax revenues depends not just on growth in the size of tax base but also on the richness of the tax base, i.e. whether more people are paying the higher bands. If BG is indexed on tax revenues, what this means is Scotland has to grow its tax revenues as fast as rUK if it to avoid being penalised: so Scotland is exposed to the risk not just that the size of its tax base might not grow as fast as rUK, but also that the tax richness of the tax base might not grow as fast either. So indexing on tax revenue, not tax base, exposes Scotland to new risk of adverse differential movement in the tax richness.

Additionally, the risks involved vary greatly between the three methods. To see how, considering under what conditions the different methods would be neutral is instructive, namely, what would Scotland have to do to obtain the same funding that it would have obtained if the Barnett formula remained in operation. Under PCID, Scotland would have to grow its income tax receipts per head at the same rate as rUK. Under ID, Scotland would have to grow its income tax receipts per head about 0.35% faster than rUK. Under LD, Scotland would have to manage to grow its income tax receipts a whopping 14% faster than rUK.

Moreover, penalties are severe if Scotland fails to keep up in this economic race with rUK. If Scotland’s per capita tax receipts grow slower than in rUK, its public expenditure will ultimately turn negative under ID, and will be reduced to around half rUK levels under PCID and LD.

This then brings us to the arena of economic powers. If Scotland is forced to participate in an economic race, facing stringent penalties if it doesn’t keep up, does it have adequate economic powers to give it a sporting chance? Well, Scotland post-Smith will lack many of the most important economic powers like control over monetary policy, corporation tax, borrowing as well as competition policy, international trade development, licensing of North Sea oil, utility regulation and labour markets.

Operating under the IFS kind of indexation rules, the risks of Scotland falling behind, and being penalised would far outweigh the potential benefits if Scotland were to outperform rUK. It is a striking lapse of judgement that the IFS report concentrates on indexation arrangements which imply such grave risks for Scotland, without examining or acknowledging the resulting asymmetry between risk and potential reward given Scotland’s limited economic powers.

What’s become clear is the IFS options now define the grounds for current negotiations. From the unionist side, this is perfect because there are influential elements there who think Scotland has already done too well in public expenditure, and who want to squeeze public expenditure per head in Scotland down relative to rUK. Other elements clearly do not trust the Scots, wanting to see a firmly rule based system in place, where the Scots will suffer in silence and others would be delighted with a system which forces Scots to implement regressive tax policies to avoid fiscal collapse. This would be disastrous for majority of Scots who want to implement a programme of greater social justice, and a taxation system which is more, not less, progressive.

It looks as if Scottish negotiators are committing the classic mistake of letting the enemy choose the ground on which battle will be fought, especially as this lets the Treasury’s preferred option, the LD method, onto the negotiating table. The Treasury cannot be serious about trying to foist on us a system requiring growing our income tax revenues 14% faster than rUK. Therefore, it’s is clear it’s pushing this option as a negotiating tool. The danger is, when it eventually gives up on the LD approach, this may be claimed by the Scots as a significant concession wrung from the Treasury: and the Scots may then be prepared to settle for one of the other, still disastrous, options involving revenue indexation.

Other viable options are available. There’s no need to agree to any indexation arrangement which pitches Scotland, with its limited economic powers, into an economic race with rUK – whether this race involves matching rUK on tax revenues, or just on tax base. A perfectly viable alternative would involve indexation on a low, fixed real indexation factor, accompanied by regular reviews, under agreed ground rules which would provide adequate incentives for Scotland to develop its economy.

But the immediate requirement is to strip away the secrecy currently clouding the fiscal settlement negotiations. ‘Trust me, I’m a politician’ is not good enough justification for maintaining secrecy, especially when the indications are so clear Scotland has been manoeuvred into fighting on a disastrous part of the battlefield. This is not Flodden – yet. We can still march our troops back up the hill to fight for better.

Jim Cuthbert is an independent statistician and economist. He was formerly Scottish Office Chief Statistician. See his http://reidfoundation.org/2015/12/scottish-fiscal-settlement-negotiations/ for further detail and the Jimmy Reid Foundation for a forthcoming paper on the credible options.