Tax: Brexit, devolution and Barnett

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Donald-Drysdale By Donald Drysdale for ICAS

22 August 2017

Donald Drysdale finds support for the idea that the Barnett formula will no longer be fit for purpose post-Brexit.

Report on Brexit and devolution

As a tax specialist, I was mystified at first by a report entitled ‘Brexit: Devolution’ published on 19 July by the European Union Committee of the House of Lords.  Why did I feel compelled to study 92 pages in which only two paragraphs make even passing references to tax?

On closer examination it became apparent that the document sheds crucial light on the potential effects of Brexit on the UK devolution settlements – impacts which may affect future spending requirements of the devolved administrations and thus their need for tax revenues and other funding.

The complexities of devolution

Since 1997, differing powers have been devolved to Scotland, Wales and Northern Ireland on a piecemeal basis.

This report by the EU Committee finds that the supremacy of EU law and the role of the European Court of Justice (ECJ) have played an important part in ensuring consistency of legal and regulatory standards across the UK, including those relating to policy areas which Westminster has devolved variously to Edinburgh, Cardiff and Belfast.

It observes that the UK internal market has been upheld by the rules of the EU internal market, and concludes that the complex overlapping competences within the UK could become increasingly unstable as a result of Brexit.  This presents fundamental constitutional challenges to the UK as a whole.

Constitutional challenges

The EU Committee notes that the Westminster Government, in its pre-election statements on Brexit and the Repeal Bill, failed to address fundamental constitutional challenges now facing the UK.  It calls on the Government to do so now, working in partnership with the devolved administrations.

Before Article 50 was triggered, Prime Minister Theresa May seemed keen to achieve four-nation co-operation on Brexit through her Joint Ministerial Committee (European Negotiations).  Indications are that this initiative has been in some disarray, and the EU Committee urges the Government to raise its game in making the Joint Ministerial Committee more effective.

The report describes the impact on the UK’s devolution settlements as among the most technically complex and politically contentious elements of Brexit.  Without changes to the devolution settlements, policy areas already devolved but exercised largely at EU level – notably environment, agriculture and fisheries – will fall automatically to the devolved jurisdictions.

With the UK Government negotiating international agreements, there will be increased risks of conflicts and disagreements between Westminster and the devolved administrations. There might also be regulatory divergence – for example in environmental standards – and these could create new barriers to intra-UK trade.

These challenges are compounded by political uncertainties: in Scotland, strained relations with Westminster, even though the immediate prospect of another Scottish independence referendum has receded; in Wales, fears that the country’s interests might be overlooked in a whole-UK Brexit deal; and in Northern Ireland, instabilities caused by the lack of a power-sharing agreement, the absence of nationalist MPs from Westminster and the controversy surrounding the Conservative/Democratic Unionist agreement.

Funding the devolved jurisdictions

The public spending budgets of the devolved administrations are funded partly by block grants from Westminster, and increasingly by a variety of partly- and wholly-devolved taxes.

North of the border, Scottish income tax, land and buildings transaction tax and Scottish landfill tax will together contribute around £12.5 billion this year, funding some 40% of the country’s public expenditure.  Wales will introduce its new land transaction tax and landfill disposals tax in April 2018, and seems likely to assume control of income tax from April 2019.  Across the water, plans are afoot to introduce a new Northern Ireland rate of corporation tax but the starting date for this is not yet known.

Another piece of the jigsaw is that the EU currently provides substantial direct funding, not only to the devolved jurisdictions but also to many regions of England; this includes farming subsidies from the Common Agricultural Policy, and support to economically deprived areas through structural funds.

There are no arrangements currently in place under which the respective block grants and other local financing will automatically adjust to compensate when these EU funding arrangements come to an end on Brexit.  Chancellor Philip Hammond has committed to match agreed EU funding until at least 2020.  However, the areas in question may face funding shortfalls unless satisfactory plans are in place for substitute aid.  The impact might prove particularly harsh in the devolved jurisdictions unless their true needs are taken into account.

The Barnett formula

Currently, annual changes to the block grant payable to each devolved jurisdiction are determined using the Barnett formula – a population-based approach introduced as a temporary measure in 1978.

As explained in a House of Commons Briefing Paper entitled ‘The Barnett formula’, published in April 2016, the formula reflects ‘need’ only by taking into account changes in population.  It fails to recognise many other factors – including population characteristics, density and deprivation – which can affect the cost of providing public services.

The EU Committee heard compelling evidence that the Barnett formula will not adequately recompense the devolved administrations in the long term for the loss of EU funding.  The report concludes that it is time a needs-based funding arrangement replaced Barnett.

The Barnett formula has been criticised for giving the devolved jurisdictions higher levels of public spending per head than England.  The Commons briefing paper recites various arguments justifying such variations: sparser populations increase the cost of providing the same level of public services; the nature and scale of public sector activities differ between UK countries; and the demand and need for public services are higher in some areas than in others.

There have been frequent calls for a new approach that would take greater account of need.  In June 2009 the Calman Commission on Scottish Devolution observed that this could not be done for Scotland alone but would require a needs assessment applying across the whole UK.

Interestingly, the requirement for a Brexit deal that balances the needs of all four nations is not simply financial.  For instance, the EU Committee notes the significant reliance of the devolved jurisdictions on EU migration.  It calls on the UK Government to look for opportunities to enhance the role of the devolved institutions in managing EU migration in ways that meet their specific needs.

Conclusion

Existing and planned devolution of tax powers provide each devolved administration with the potential to influence its tax revenues.  However, the UK’s existing block grant system will continue to define and underpin the financial relationship among the four nations, but it relies on the Barnett formula which will not be fit for purpose in a post-Brexit world.

The EU Committee concludes that the UK, Scottish and Welsh Governments, and (if it is formed) all parts of the Northern Ireland Executive, should set aside their differences and work constructively together to achieve an outcome that protects the interests of all parts of the UK.

The political courage and skills that this will require should not be under-estimated.

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