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The Scottish Resource Spending Review: will the government choose axing or taxing?

Published on 27 May 2022

In its upcoming Resource Spending Review, the Scottish Government will have to choose between spending cuts, tax rises, or hoping for extra UK government funding.

On Tuesday (31st May), the Scottish Government will present its Resource Spending Review, setting out spending plans for day-to-day spending on devolved public services for the next four years. This observation explains how this Review will have been no easy task. Expensive policy commitments and relatively slow forecast growth in income tax receipts, not to mention the recent increase in inflation, mean that it is unlikely that revenues will keep pace with spending pressures. The Scottish Government will therefore have to either take the axe to certain areas of spending, signal higher levels of taxation – or ignore the issue for now, hoping for extra funding or borrowing powers from the UK government. 

It would be difficult for the Scottish Government to set multi-year spending plans even in the best of times…

The Scottish Government’s intent to set out spending plans for the next four years is laudable: multi-year budgeting can help provide certainty and stability for departments, which enables more effective planning. It is not without challenges, however, and it is worth recognising up front that the Scottish Government faces an especially tricky task when setting multi-year budgets, even in the best of times. In particular, the amount it can spend in future years is less easy for it to control than the UK government, due to two aspects of its funding regime. First, a large part of its funding reflects UK government decisions on spending and tax via the Barnett formula and system of block grant adjustments made to reflect tax devolution. Second, it has very limited powers to borrow or save. Just how much funding will be available in future years is therefore hard for the Scottish Government to predict accurately. For example, if the UK government decided to trim (or top-up) its spending plans, that would mean a fall (or rise) in funding for the Scottish Government via the Barnett formula. Without borrowing (or significant saving) powers, the Scottish Government could only address this by changing its own plans for spending or devolved taxes. In contrast, when the UK government’s revenues fluctuate, in the short-term at least, it has the power to address this through borrowing more or less than initially planned. 

This means that while the multi-year spending plans set out in the Spending Review will provide important information on the Scottish Government’s priorities, the amounts that will eventually be spent on different services will almost certainly differ from the plans set out next week – potentially quite substantially. This means Scottish schools, hospitals and councils will still face substantial uncertainty about the amount of funding they will receive over the next four years – though perhaps less than if budgets were set on a rolling annual basis. The Scottish Government should acknowledge this uncertainty to departments when setting out these plans.

… and these are far from the best of times

Of course, the next four years will be far from the best of times. A series of factors have heightened the already delicate trade-offs facing the Scottish Government.

Some of these are of its own making. In particular, the Scottish Government has made a number of expensive policy commitments, especially in relation to recently devolved social security powers. This includes: doubling the value of the means-tested Scottish Child Payment and its expansion to older children; reforms to disability benefit payments that are expected to increase the number of beneficiaries; and a number of smaller benefit enhancements. Such measures mean that as of last December, the Scottish Fiscal Commission was forecasting that Scottish social security spending was set to exceed the funding provided by the UK government by at least £750 million and potentially more like £1 billion per year by 2026-27. This means less money for public services or higher taxes than otherwise would be the case.

But factors that lie largely or entirely outside of the Scottish Government’s control also create difficulties.

First, relatively slow growth in the income tax base in Scotland relative to the rest of the UK is an increasing drain on the Scottish Government’s budget. For example, despite changes to devolved income tax rates that overall were estimated to raise an additional £500 million, the Scottish Fiscal Commission forecast in December that the revenues the Scottish Government will receive this year will be £190 million lower than if income tax had not been devolved. The Commission expects slower growth in employment in Scotland – partly linked to a more rapidly ageing population – to increase this shortfall over the next few years. And added to that, the Scottish Government will have to repay funding it received as a result of recent Scottish tax forecasts being overly optimistic – with an estimated repayment of £470 million in respect of 2021-22 falling due in 2024-25. The Scottish Government will be able to borrow up to £300 million to help cover the cost of addressing these forecast errors, but that borrowing will have to be repaid eventually.

Second, public services are still struggling to recover from the COVID-19 pandemic. The Scottish NHS (like that in England) is a case in point. In the final quarter of 2021, the number of completed treatments was 20% lower than during the final quarter of 2019, before the onset of the pandemic. This struggle to return treatment volumes to their pre-pandemic levels is partly why the number of people on a waiting list for an NHS outpatient appointment in Scotland stood at 419,230 at the end of 2021, up almost 50% from 281,926 at the end of 2019. This has also translated into longer waiting times: just 74.4% of patients completed their treatment within 18 weeks in December 2021, down from 79.9% in December 2019, and well below the 90% standard. Addressing these issues will add to funding pressures.  

Third, inflation has risen considerably over the last year, and is likely to remain elevated for some time. Higher inflation means that the same cash budgets can buy fewer goods and services, creating pressure for top-ups in order to preserve real spending power. Precisely how much less generous spending plans have become depends on how you measure inflation. The measure of inflation typically used for such calculations is the GDP deflator. On the basis of the Office for Budget Responsibility (OBR)’s March 2022 forecasts for this measure, the average real-terms growth in the Scottish Government’s resource funding between 2021−22 and 2024−25 has dropped from 1.4% a year (at the October 2021 Spending Review) to just 0.9% a year. To maintain the originally planned real growth rate in 2022−23 (the first year of the three-year period covered by the latest plans), funding would need to be topped up by around £550 million. This could even be on the low side, as there are good reasons to think that the GDP deflator will understate the ‘true’ cost pressures on government services over the coming year.

Current funding plans are insufficient to meet Scottish Government commitments and underlying spending pressures

Even prior to the recent surge in inflation becoming fully apparent, the combination of underlying spending pressures, income tax revenue shortfalls, and expensive policy commitments, implied that the Scottish Government faced a funding gap over the next few years. Indeed, it projected a gap of £3.5 billion in 2026-27 under its middle scenario: a sizeable amount equivalent to 8% of its projected budget for day-to-day spending in that year, or £640 for every person in Scotland.

Underlying this figure of £3.5 billion is a series of assumptions, all of which are uncertain. In some cases, the funding pressures may turn out to be greater than assumed, and in others they may turn out to be smaller. The Scottish Government recognises this uncertainty by producing high and low scenarios for both funding and spending pressures, although the resulting range of projections (from a £10 billion shortfall to a £4 billion surplus) almost certainly overstates the degree of uncertainty.

Focusing on the Scottish Government’s middle scenario, one factor that would likely lead it to overstate the pressures it faces is the baseline it has chosen to project future spending pressures from. In particular, it has chosen to project forward spending in 2022-23, and applies its long-term assumptions about growth in demands and costs from that year onwards. However, part of the spending in 2022-23 is related to the ongoing impacts of the COVID-19 pandemic, most notably on the NHS and the cost of running public transport networks. At least some of these costs should abate over the next five years as pandemic-related pressures recede and passenger numbers recover.

On the other hand, the Scottish Government likely underestimates the pressures arising from underlying health spending pressures. Drawing on the Scottish Government’s Health and Social Care Medium Term Financial Framework, its middle scenario assumes that health expenditure would need to grow by around 3.5% per year in cash-terms. Given the current rate of inflation, growth in demand for healthcare services, and the challenges of boosting productivity in a labour-intensive service, this is low. For context, the English Department of Health and Social Care saw an annual average cash-terms increase of 3.7% a year between 2009-10 and 2019-20 – a decade which saw the slowest growth on record in NHS funding and worsening waiting times.

Another area where it would initially appear that pressures may be underestimated is public sector pay. The Scottish Government’s middle scenario includes an assumption of 2% annual pay awards, which would now entail large real-terms pay cuts for public sector workers in Scotland, which may not be sustainable. However, careful reading of the Scottish Government’s spending projection methodology suggests pay pressures may have been double counted: once as part of general pay pressures, and again as part of the health spending pressures projections. It is not clear why this was done, but it means that in reality its middle scenario is actually consistent with pay rises of closer to 3 – 4%. But even these would leave public sector workers facing a real-terms pay cut in the coming year.

Finally, on the revenue side of the budget, the Scottish Government’s projections exclude revenue from and spending funded by business rates. These revenues are expected to increase as temporary pandemic-related reliefs end, which would help reduce the funding gap identified.

So what are the options?

Nevertheless the gap will still likely be substantial. So what are the options open to the Scottish Government? Because it is not in general allowed to borrow to fund day-to-day spending, it will have to choose some combination of axing, taxing, and hoping for the UK government to top up its spending plans.  

First, axing. One way to address the funding gap is to cut back services it deems a lower priority in order to focus resources on services and policies it is particularly committed to or that are facing the most acute pressures. If reality is close to the Scottish Government’s middle scenario (with a funding gap equivalent to 8% of its overall budget), finding sufficient cuts from lower priority services that already bore the brunt of austerity during the 2010s will be extremely difficult. To get a sense of the scale of the issue, £3.5 billion is around £500 million more than is planned to be spent on higher education and student support this year. Or more than £600 million more than is planned to be spent on the police, fire, courts and prison services combined. The Scottish Government may also be forced, therefore, to consider taking the axe to some of its policy commitments if it cannot find sufficient savings elsewhere in its Budget.

Second, taxing. The devolution of income tax powers gives the Scottish Government an important new lever to raise revenues. The Scottish Government has yet to confirm tax plans for 2023-24 and beyond, unlike the UK government which has said it will freeze the higher rate threshold (and personal allowance, which also applies in Scotland) until April 2026, but cut the basic rate of income tax by 1 percentage point to 19% from April 2024. Mirroring the higher rate threshold freeze would raise around £500 million by 2026-27. Conversely, not following the UK government by cutting the income tax rate could provide around another £400 million in additional funding (because the block grant adjustment will fall following the tax cut in the rest of the UK but Scottish revenues would not). Income tax policy could therefore relatively straightforwardly yield almost £1 billion, although the Scottish Government would then no longer be able to claim the lowest income half of taxpayers pay less than in the rest of the UK (although at a maximum of £20, this has always been more about the politics than the substance of the tax system).

Potential reforms to council tax, to make it more progressive and up to date, could also be used to raise revenue from higher value properties, allowing the Scottish Government to redirect some of the funding it provides to councils. A forthcoming Citizens Assembly on local tax reform could provide the political impetus for such a plan.      

Third, hoping. The Scottish Government could also choose to set spending plans that exceed expected funding under current policy in the hope that the UK government either boosts its funding or gives it enhanced borrowing powers. Some additional funding and borrowing powers may be forthcoming but unlikely on the scale required to close up the funding gap faced by the Scottish Government.

On borrowing, there have been growing calls to enhance the borrowing powers of the devolved governments, most recently from the Northern Irish Fiscal Commission. Even if the UK government heeds these calls, the figures discussed (for example, an additional, 1% of day-to-day spending) would only address part of the shortfall, and only temporarily as borrowing has to be repaid eventually.

On additional funding, the Chancellor has indicated that he would like to see the ‘marginal pound’ go towards tax cuts for households and businesses, rather than higher public service spending. The Treasury may also be reluctant to re-open its 3-year Spending Review settlements so soon after agreeing them with departments. Some top-ups could come down the line, especially if inflation and big falls in the real wages of public sector workers start to cause major problems for service delivery, but banking on them being of the scale needed to plug the Scottish Government’s funding gap would be risky. For example, in order for Scotland to receive the £3.5 billion the Scottish Government has projected would be needed to bridge the funding gap in its middle scenario, the UK government would need to increase its spending by over £40 billion.

Difficult choices on Scottish tax and spending over the next few years will eventually have to be faced. Political considerations – including those related to the Scottish Government’s desire for another independence referendum – will undoubtedly play a role in whether those choices are made clear next week or not. Announcing them could be delayed, but they can’t be avoided for long.