Scotland's Fiscal Framework does not satisfy Smith's "Taxpayer fairness" principle

Scotland's Fiscal Framework – an essential part of the devolution of new tax and welfare powers – was finally agreed one month ago, after many months of tortuous negotiations. The most difficult thing to agree was how to adjust the Scottish Government’s block grant funding to account for its new revenues and spending responsibilities.

The Fiscal Framework Agreement states that for the first five years of devolution the block grant adjustments (BGAs) will first be calculated using the UK government's Comparable Model but then adjusted to "achieve the outcome delivered by the Indexed Per Capita (IPC) model".

All this means, of course, is that it is the IPC approach that will ultimately determine the BGAs. Under this method, if Scotland's devolved revenues and welfare spending per person grow at the same percentage rate as those in the rest of the UK (rUK), then the Scottish Government’s budget will be exactly the same as if devolution had not happened.

This is the approach that the Scottish Government wanted and satisfies its interpretation of the Smith Commission’s principle that there should be ‘no detriment [simply] from the decision to devolve’ a power.

But it does not satisfy the Commission’s ‘taxpayer fairness’ principle, which the UK government placed more weight on. Scotland’s budget could fall a little if income tax rates are cut (or thresholds increased) in rUK and vice versa.

The Agreement also means that part of the growth in devolved tax revenues in rUK will continue to be redistributed to Scotland to help fund its higher levels of government spending: something that the UK government said should no longer happen once a tax is devolved. This means that compared to today, by 2021–22 around £900 million of additional revenues from rUK could be redistributed to Scotland (as would also happen without tax devolution).

Use of the IPC method means Scotland’s budget may be around £300 million a year more by 2021–22 than it would have been had the UK Government’s proposed Comparable Model been used instead. There seems little rationale for adopting the convoluted process of adjustments set out in the Fiscal Framework other than to highlight this difference.

These are among the findings of a new report released by researchers at the Institute for Fiscal Studies and the University of Stirling, funded by the Nuffield Foundation and the Economic and Social Research Council. The report appraises Scotland’s new Fiscal Framework, considering whether it meets the Smith Commission’s principles, which government got the deal they wanted, and the impact that tax and welfare devolution could have on Scotland’s budget and the budget risks it faces.

The report also finds that:

• The deal agreed will protect the Scottish budget from revenue and welfare spending risks associated with Scotland’s lower population growth. Equally, Scotland will not benefit from the higher revenues that might result if its population grows more quickly than expected.
• The method agreed for adjusting the block grant also largely insulates Scotland from the impact of any shocks that hit the whole of the UK – such as the global financial crisis and associated recession.
• But the Scottish Government’s budget will be exposed to long- and short-term economic risks that affect Scotland differently from the rest of the UK. Illustrative scenarios (based on historic data) show that if Scotland’s devolved revenues and welfare spending per capita grow more or less quickly than those in rUK, the potential impacts on the Scottish budget could be sizeable: over £500 million a year after five years and over £2 billion a year after 15 years.
• Borrowing would not be an appropriate response to long-term declines in revenues or increases in welfare spending, but it can be an important tool in managing shorter-term risks. The Scottish Government got less in the way of new borrowing powers than it hoped for: capital borrowing limits were barely increased, for instance.
• Recent experience suggests the resource borrowing limits and reserves limits agreed should be large enough to smooth temporary fluctuations in devolved revenues. But two issues may arise. First, Scotland will only be allowed to borrow to cover forecast falls in its revenues when Scottish GDP growth is less than 1% and at least 1 percentage point lower than UK growth – this could be constraining, as Scottish revenues may be temporarily depressed even if these conditions do not hold. Second, the borrowing limits are currently fixed in cash terms: there is a case for increasing these limits in line with the growth in devolved revenues and spending (i.e. the amounts of cash at risk).

David Phillips, a senior research economist at the IFS and one of the authors of the report, says "It was never going to be possible to design a Fiscal Framework that satisfied all the Smith Commission’s principles: they are mutually incompatible. In the end, the Scottish Government’s preferred approach was chosen, which prioritises the ‘no detriment’ principle. During the negotiations, the UK government had claimed this approach was unfair because it violates the ‘taxpayer fairness’ principle. This begs the question of whether the UK government has changed its mind or merely conceded the point."

"The Scottish Government did not get everything it wanted though", says Professor David Bell of the University of Stirling and the Centre on Constitutional Change. "It has had to agree to economic and fiscal forecasts being made by the independent Scottish Fiscal Commission, rather than its own economists as it had wanted. And it has much lower borrowing limits than it had hoped for. These limits look like they should be enough to cope with fluctuations in its revenues and welfare spending. But the rules about when the borrowing powers can be used may be more constraining."

David Eiser, also of the University of Stirling and the Centre on Constitutional Change and another of the report's authors, says "Many features of Scotland's funding regime look unusual in an international context. The Scottish block grant will continue to be determined largely by historical accident through the Barnett Formula, and will still bear no relation to Scotland's relative spending need. The Scottish budget will be protected from the effects of UK-wide economic downturns and the Scottish Government will have some powers to borrow during short-term shocks that hit Scotland disproportionately. However, the Fiscal Framework Agreement offers virtually no protection against the risk of Scotland’s devolved revenues under-performing, or its welfare spending growing more rapidly than in the rest of the UK in the longer term."