An immediate response to the Scottish Fiscal Framework review

The devolution of tax revenues and social security spending to the Scottish Government has required adjustments to the block grant funding it receives from HM Treasury. Exactly how these block grant adjustments (BGAs) are calculated and updated (or ‘indexed’) over time can make a big difference to the Scottish Government’s budget – to the tune of hundreds of millions and, over time, even billions of pounds a year. Rules are also needed for borrowing and reserve powers that enable the Scottish Government to deal with volatility in its budget due to the difficulty in accurately forecasting tax revenues and social security spending.

An agreement (termed a Fiscal Framework) on these issues for the first five years of devolution was reached in 2016 following months of negotiation between the Scottish and UK governments. This agreement said that after five years the Fiscal Framework would be reviewed and potentially changed. After a long delay, the two governments have concluded their review and decided to stick with the current approach to calculating the BGAs and modestly boost borrowing and reserve drawdown limits. This comment discusses the implications of these decisions. But first, some background on the tricky trade-offs between the principles supposed to guide the government’s decisions.

The Smith Commission principles

The Smith Commission, which recommended the devolution of additional tax and social security powers to Scotland, also set out a series of principles that the BGAs (and the wider Fiscal Framework) should meet. These are that:

• There should be no detriment (or benefit) to the Scottish or UK governments’ budgets simply as a result of the initial transfer of tax and/or spending powers – the ‘no detriment’ principle. In defining this principle, the Commission also stated that the BGAs should be ‘indexed appropriately’, suggesting it felt that this applied not just in the very first year of devolution, but also in subsequent years, ruling out methods of indexation that could reasonably be expected to increase or reduce the Scottish Government’s budget even if it followed tax policy in the rest of the UK (rUK).
• The devolved Scottish budget should benefit in full from policy decisions by the Scottish Government that increase revenues or reduce expenditure, and the devolved Scottish budget should bear the full costs of policy decisions that reduce revenues or increase expenditure – the ‘economic responsibility’ principle.
• Changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK; changes to devolved taxes in Scotland should only affect public spending in Scotland. This has often been referred to as the ‘taxpayer fairness’ principle, although that terminology was not explicitly used by the Smith Commission.
• The UK Government should continue to manage the fiscal risks and shocks that affect the whole of the UK for the newly devolved tax revenues and spending responsibilities – the ‘UK economic shocks’ principle.

Last year, HM Treasury and the Scottish Government commissioned me (David Phillips), alongside David Bell and David Eiser, to produce an independent report on the extent to which different ways of calculating the BGAs meet these principles. This report has now been published alongside the conclusions of the two governments’ wider review of the Fiscal Framework.

No method satisfies all principles

We conclude that no method of calculating the BGAs fully satisfies all of the principles set out by the Smith Commission. The fundamental tension is between the ‘taxpayer fairness’ principle and the ‘no detriment’ principle. The interaction between the BGAs and the Barnett formula used to allocate funding to the Scottish Government means these two principles are incompatible.

To see this, consider what would happen if the UK government increased income tax rates in rUK and used this to increase spending on the NHS. Under the Barnett formula, the Scottish Government would receive a population-based share of the increase in English NHS spending. To stop Scotland benefiting from a tax increase only applying in rUK, i.e. to satisfy the ‘taxpayer fairness’ principle, the income tax BGA (a deduction from the block grant) would also have to increase by a population share of the increase in tax revenues in rUK. That way, the increase in block grant funding via the Barnett formula and the increase in the income tax BGA would exactly offset.

But under this method of indexing the income tax BGA, even if Scottish income tax revenues per person grow at the same percentage rate as in rUK, the Scottish Government would, over time, lose more and more from income tax devolution. This is because Scottish income tax revenues per person are lower than those in rUK – so if revenues per person grow at the same percentage rate, their lower absolute level means that the extra amount raised per person in Scotland would be less than the additional amount raised per person in rUK. Scottish revenues could therefore be reasonably expected to fall further and further behind the income tax BGA, reducing the Scottish Government’s funding and violating the ‘no detriment’ principle. 

Our report reviews a wide range of different options for how to calculate and index the tax and welfare BGAs over time. We find some methods better satisfy certain principles, while others better satisfy others.

We also use the forecasts of tax revenues and welfare spending in Scotland and rUK that were available when we were writing the report last autumn to simulate how big a difference the choice of indexation method could make to the Scottish Government’s funding – and find some striking differences. For example, we find that if the so-called ‘levels deduction’ method (which is most consistent with the ‘taxpayer fairness’ principle) had been used to index the income tax BGA from the point of devolution in 2016–17, the Scottish Government’s funding could be around £2.5 billion lower by 2026–27 than under the so-called ‘indexed per capita’ (IPC) method actually being used so far (which is more consistent with the ‘no detriment’ principle). That is no small beer – it is equivalent to over 6% of the Scottish Government’s anticipated funding for day-to-day spending in that year.    

How the BGAs will be calculated going forwards

Given the large sums of money involved, it is perhaps not surprising that the UK and Scottish governments took so long to reach an agreement. In the end, they have decided to continue with the IPC method.

This method indexes the BGAs to the percentage change in revenues (or spending) per capita for the same taxes (or social security benefits) in rUK – hence its name. This approach means that if, for example, devolved income tax revenues in Scotland grow at the same percentage rate per capita as comparable revenues in rUK, the Scottish Government’s budget is neither lower or higher as a result of income tax devolution: the change in revenues is exactly offset by the change in the BGA. If Scottish income tax revenues grow at a faster percentage rate per capita, the Scottish Government’s budget is higher, while if they grow at a slower percentage rate per capita, its budget is lower.

If one thinks it is reasonable to expect income tax revenues to grow at the same rate per capita (so that they neither fall further behind nor close the gap with those in rUK), this method is consistent with the ‘no detriment’ principle.

However, it is not consistent with the ‘taxpayer fairness’ principle. That is because when tax revenues in rUK increase – whether as a result of tax policy changes or economic growth – Scotland would generally benefit from its population share of the increased spending funded by those revenues. If they were spent on services devolved to Scotland, the Scottish Government would receive a population share of the increase via the Barnett formula. And if they were spent on non-devolved items such as benefits or defence, Scotland would again benefit by an amount that would average close to its population share of the spending increase. In contrast, the IPC method would increase the BGA by less than Scotland’s population share of the increase in income tax revenues in rUK – because Scotland has lower revenues per capita so a given percentage increase is smaller in cash terms. Scotland would therefore benefit, at least to some extent, from income tax revenue increases in rUK – including those funded by tax rises only applying in rUK.

The sums being transferred are significant – recall the £2.5 billion a year figure, by 2026–27, highlighted above. Whether this is a problem or not depends on how much one thinks that tax devolution should be accompanied by a reduction in redistribution and risk-sharing across the UK. If one thinks this redistribution and risk-sharing are a key feature of the UK, one should presumably be relaxed about it – indeed, it could be seen as a good thing. If one views tax devolution as a fundamental change, whereby the Scottish Government should take responsibility for closing the gap in tax revenues per capita over time – and lose out financially if it does not – one may be less happy with the decision taken by the two governments.

Changes to borrowing and reserves limits

While the Fiscal Framework has decided to continue with the method to calculate the BGAs agreed back in 2016 – apart from increasing the BGA for Crown Estates revenues to avoid Scotland gaining twice over from offshore wind licences, both in its own waters and in English and Welsh waters – modest changes are being made to borrowing and reserves powers.

Capital borrowing limits will, in future, be increased in line with inflation (as measured by the GDP deflator). The amount the Scottish Government can borrow to address devolved tax and social security forecast errors will be doubled from £300 million to £600 million, and limits on how much of its reserves it can draw down in any given year will be abolished. These resource borrowing and reserves limits will then be increased in line with inflation too.

These changes are an important step in the right direction – inflation has already eroded around 20% of the real-terms value of the existing limits since they were set – and will provide some extra flexibility to the Scottish Government to respond to forecast errors and financial shocks. Incidentally, they reflect the recommendations of another report David Bell, David Eiser and I published, in 2021, considering how the Fiscal Framework could be made more robust post-COVID. However, rather than link the limits to inflation, it would make more sense to link them to the amount of revenue and social security spending at risk, which will typically grow faster than inflation.

David Bell, David Eiser and I also recommended granting the Scottish Government powers to be able to borrow a small amount of money to cover shocks other than tax and social security forecast errors. This could include unexpected shocks to public service spending, or falls in tax revenues or rises in social security spending that are forecast in advance. Presently, it is only by building up and drawing down reserves that the Scottish Government can smooth out these types of issues.

Therefore, while a revised Fiscal Framework has been agreed, it is unlikely to be the final say on this issue.