The Scotland Bill, currently making its way through the Houses of Parliament, will transfer a range of tax and spending powers from Westminster to the Scottish Parliament. At the same time, an adjustment will have to be made to Scotland’s block grant funding from Westminster. Alongside things like changes to borrowing powers and fiscal institutions, these block grant adjustments (BGAs) form a key part of the new “fiscal framework” Scotland will require when these powers are transferred.
Unlike the tax and welfare powers, the fiscal framework is not part of the Scotland Bill. The report of the Smith Commission, on which the Bill is based, did not have the time to design the fiscal framework. Instead, it laid down a number of principles for its design.
The House of Lords Economic Affairs Committee, in its report “A Fracturing Union?” published today, argues that the process for determining the fiscal framework is flawed and that its design principles may not be workable and are not mutually compatible.
A new joint paper by researchers at the Institute for Fiscal Studies (IFS), the University of Stirling and the Centre for Constitutional Change, funded by the Nuffield Foundation, confirms that it is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett Formula remains in place.
It also finds that the precise way in which the BGAs are indexed over time could mean differences of over a billion pounds a year in the Scottish Government’s budget. And it concludes by suggesting the time may now have come for a more fundamental reassessment of devolved finance – including the Barnett Formula.
This Observation article summarises some of our key findings. In what follows, we focus on tax devolution but many of the same issues arise for welfare devolution.
The options for the block grant adjustment
The Smith Commission committed to retain the Barnett Formula as the mechanism for determining Scotland’s block grant. But Scotland’s Barnett-determined block grant will clearly need to be adjusted to reflect both the new tax-raising powers and new expenditure responsibilities being devolved.
In the first year that new powers are devolved, this adjustment should be relatively straightforward, at least in principle. The initial reduction in the block grant for devolved taxes should be equivalent to the revenue forgone by the UK government.
In future years however, the process of adjusting the Barnett-derived grant becomes more complicated. The BGAs have to be indexed. If the BGAs were not indexed but fixed at the year 1 amount, then, in the face of inflation and economic growth their relative value would be eroded over time. In the case of tax BGAs, this would result in the Scottish Government gaining and the UK government losing out as time goes by. The indexation of the BGA is thus critical to achieving the spirit of the Smith Commission principle that there should be ‘no detriment [to either government] from the decision to devolve’.
Our report considers three specific options in detail.
The first approach to indexing the BGA is Indexed Deduction (ID). This indexes the change in the BGA to the percentage change in total comparable tax revenues in the rest of the UK (rUK). For example, if comparable revenues in rUK grow by 5%, the BGA also grows by 5%. Increases in income tax revenues can come about from two sources: more tax-paying workers and/or more tax per worker. Under this adjustment method, growth in either of these sources of revenue in rUK would lead to an increase in Scotland’s BGA (a fall in its block grant). This approach therefore exposes Scotland to the risk of relatively slower population growth than in rUK, assuming that increases in population will lead to higher tax revenues. On the other hand, this mechanism would allow Scotland to capture the reward of relatively faster population growth. Scotland would therefore gain from attracting and retaining more income tax payers, for instance.
The second approach is Per Capita Indexed Deduction (PCID). This indexes the BGA per capita to the percentage change in comparable rUK revenues per person. This option clearly protects the Scottish budget from the risk that its population grows relatively more slowly than the rUK’s. But equally the Scottish budget would not benefit from revenue increases that resulted from population growth. The Scottish Government would therefore lack incentives to boost growth through attracting more people to Scotland.
The third approach is the Levels Deductions (LD). This calculates the change in the BGA as a population share of the change in comparable revenues in rUK. For example, if income tax revenues increased by £10 billion in rUK, then if Scotland’s population was 9% of rUK, Scotland’s BGA would increase by £900m. The rationale for the LD approach is that, by being based on a population share of a cash terms change in revenue, it is symmetric with the spending side of the Barnett Formula (which calculates the change to Scotland’s block grant as a population share of the cash terms change in English spending).
Comparing these options: when tax rates change in the rest of the UK
This symmetry property is useful when it comes to changes in rUK tax rates. Changes in UK tax rates for taxes that are devolved are likely to lead to a change in spending by the UK government. To the extent that this spending is likely to benefit Scottish taxpayers in some way (either because it leads to an increase in the Scottish block grant via the Barnett formula, or because it leads to an increase in ‘reserved’ spending in Scotland), the block grant to Scotland would need to be adjusted to ensure that increases in taxes in rUK do not fund higher spending in Scotland, without a corresponding increase in Scotland’s tax effort. This is the ‘taxpayer fairness’ element of the Smith Commission’s ‘no detriment’ principles.
When the additional rUK revenues are spent on services like health or education that are devolved to Scotland, Scotland gets an equivalent population share of this spending via the Barnett Formula. An increase in taxes and spending of £10 billion in rUK would, for instance, feed through into approximately £900 million more for Scotland via the Barnett Formula. Under the LD approach, Scotland’s BGA also increases by a population share of the change in UK revenues: again £900 million. So the increase in the BGA exactly offsets the increase in the underlying block grant, leaving Scotland unaffected. The ‘taxpayer fairness’ principle is satisfied.
In contrast, under the ID or PCID approaches, Scotland would gain from such a tax increase. This is because tax revenues per person are lower in Scotland than in rUK. A percentage increase in the BGA is therefore smaller than a population-share based increase. Our report shows that for a £10 billion income tax increase in rUK, equal to about 2p on each income tax rate, such gains to Scotland would amount to over £100 million a year, even though Scots were paying no more tax themselves. Or vice versa for an income tax cut. These methods therefore do not fully satisfy the ‘taxpayer fairness’ principle.
Comparing these options: underlying revenue growth
Tax revenues change not only because of policy changes though. Underlying growth in the economy and the tax base also affect revenues. Depending on the initial starting levels of revenues per person, revenue growth per person and population growth, the different options we consider can have markedly different effects on the Scottish Government’s budget.
Consider the following situation: revenues start off lower per person in Scotland, grow at the same percentage rate per person as in rUK, but the population grows less quickly than in rUK. (That is a rough approximation to what has happened in recent years).
Under the PCID approach, the BGA increases in line with the rate of growth in revenues per person, which is the same in Scotland and rUK. Hence Scottish revenues grow at the same rate as the BGA – meaning it does no better or no worse than if taxes were not devolved. If we consider the situation where revenues are growing at the same rate per person as in rUK as a benchmark against which the Scottish Government’s performance should be judged, this method therefore satisfies the spirit of the principle that there should be ‘no detriment from the decision to devolve’.
On the other hand, Scotland does lose out somewhat under the ID approach because of its lower population growth. And, under the LD approach it loses out even more, at least initially, because a given rate of growth in its revenues translates into less than a population-based share of the equivalent growth in rUK revenues (because rUK revenues started off higher per person). The LD approach therefore does not seem to satisfy the spirit of the principle that there should be ‘no detriment from the decision to devolve’: there will be detriment to Scotland under this approach, unless revenues in Scotland grow at a faster rate both per person, and in aggregate than in rUK. This might be seen as an unfair challenge for Scotland to meet.
It therefore turns out that it is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett Formula remains in place. Some methods better satisfy the first and others the second principle.
In our paper, we estimate what would have happened if each of these approaches had been in place between 1999–00 and 2013–14 to get an idea of just how big a difference they could make.While these figures are approximate and refer to the past rather than the future, they show these differences can be substantial.
Relative to the LD method, the ID method could have resulted in the Scottish Government’s budget being around £1 billion a year higher after 14 years, with the PCID approach delivering an even bigger budget. These are quite sizeable numbers in the context of a block grant to Scotland equal to around £30 billion a year in 2013–14.
Our analysis also shows that eventually though, if relative population decline continues, Scotland would start to do less well under the ID method than the LD method. Indeed, because the ID method never gets updated to reflect the fall in Scotland’s relative population, it can eventually imply a negative budget for Scotland if one looks far enough in the future. Clearly such an outcome would never be allowed to come to pass. But it illustrates that the ID method would not represent a sustainable long-term compromise between the PCID and LD methods that, in the short term, would be most beneficial to the Scottish Government and UK Treasury, respectively.
The difficulty of compensating for policy knock-on effects
Our paper also considers another part of the Smith Commission’s principles: the idea that one government should compensate the other if its policies have knock-on effects on the other’s revenues or spending. While this seems eminently reasonable in theory, we have significant concerns about its workability in practice. In particular, the way that individuals change their behaviour in response to tax rate changes means that the counterfactual “no change” scenario cannot be observed or easily modelled.
Calculating the knock-on effects would therefore require a series of assumptions, each subject to significant uncertainty, opening up the potential for frequent disagreement between the governments.
This therefore raises questions about the institutional arrangements for such calculations – who estimates revenue loss, and what mechanisms exist for the governments to negotiate around this – that are likely to be extremely complex to resolve. It does not seem likely that this no detriment principle can be achieved at the same time as achieving another one of the Smith Commission principles – that Scotland’s fiscal framework should be simple, transparent and as far as possible, automatic, in its operation. Indeed, if too much attention is paid to compensating for every example of knock-on effect, then the arguments and tricky negotiations that result could cause the whole system to become unworkable and unsustainable.
Just how the block grant will be adjusted following the devolution of tax and welfare powers to Scotland is currently being negotiated by the UK Treasury and Scottish Government. These discussions are taking place behind closed doors with little information publically available about the options being considered and the effects of these options. Our paper helps fill that gap and shows that which option is chosen can have a significant effect on the Scottish Government’s spending power, and the types of risks and incentives the Scottish Government will face. It also shows that the principles set out by the Smith Commission, against which the negotiated framework will likely be judged, cannot be met in full.
For these reasons, the options available for calculating the BGAs, and other elements of the fiscal framework, should be part of the public and parliamentary debate, as much as the tax and welfare powers set out in the Scotland Bill itself have been.
Indeed it may now be time for a more fundamental reassessment of how the devolved governments are financed: including whether the Barnett Formula should be retained. Reform of Barnett may remove some of the conflicts between the Smith Commission’s principles. The Smith Commission parked these issues to one side by stating that the Barnett Formula should be retained. Making the UK’s fiscal framework sustainable for the long term may require reopening the debate.
David Bell and David Eiser are at the University of Stirling and the Centre for Constitutional Change.
David Phillips is a senior research economist at the IFS