Tax: What the Scottish Budget needs

Edinburgh cityscape
Donald-Drysdale By Donald Drysdale for ICAS

9 October 2017

The Fraser of Allander Institute has reported on Scotland’s economy and its public finances, and Donald Drysdale explores what it has said.

Introduction

As heralded in an earlier article, the Fraser of Allander Institute has now published its annual briefing, ‘Scotland’s Budget Report 2017’, on the state of the Scottish economy and the country’s public finances.

A pervasive theme of the report is that Scotland faces considerable public spending restraint.  We should expect changes in the balance and scale of public spending; how public services are delivered and prioritised; and how devolved revenues are raised.

Outlook for the Scottish economy

Amidst Brexit concerns, the report sees a fragile economic outlook for Scotland and the UK. Economic growth in Scotland has lagged behind that of the UK – with annual Scottish growth currently just 0.4% compared to 1.9% for the UK.  Scottish employment growth has outpaced the UK as a whole, but it is unclear how much of the recent employment growth is sustainable.

Under the Fiscal Framework, key fiscal decisions are made by Westminster but it will be crucial for Scotland how its total tax revenues grow (per head) compared with the rest of the UK.  The report suggests that the Scottish Fiscal Commission, forecasting Scottish GDP and tax revenues for the first time, may be cautious in its projections for growth and Scottish taxes over the next few years. 

Tax devolution: a view from ICAS

Justine Riccomini, Head of Taxation (Scottish Taxes, Employment and ICAS Tax Community) at ICAS, participated in the seminar at which the report was unveiled, and spoke on ‘Scotland's Tax Powers: Understanding the practical and administrative tax issues’.

Scotland’s new fiscal powers, whilst giving Holyrood significant autonomy, are intertwined with UK taxes.  Scottish income tax is only partly devolved, and revenues from other devolved taxes are relatively insubstantial.

Behavioural responses by taxpayers may limit some options, though not in cases where Scottish tax policies are considered attractive – for example, where they may achieve a better economy, desired redistribution, or better public services.

It is important that tax measures should not put Scottish businesses at a disadvantage. While some degree of intra-UK tax competition may be desirable, care is needed to avoid a ‘race to the bottom’, ultimately reducing revenues for everyone.

A five-year roadmap setting out objectives of Scottish tax policy would be helpful in developing public faith in Holyrood’s fiscal powers.  To date, wholly devolved taxes have aligned closely with UK taxes and a more distinctive Scottish approach may be needed to meet spending commitments.  The budget processes need to be changed so that tax policies are given an equal weighting to spending plans.

Outlook for the Scottish Budget

The report considers possible changes in the level of Scotland’s block grant from Westminster. In 2017/18 this increased by 0.5% in real terms, based on UK Government plans, but by 2020/21 it is expected to be 8.4% lower in real terms than in 2010/11, before any adjustments for devolved powers.

For each devolved or assigned tax, a block grant adjustment is made to reflect tax revenues forgone by Westminster on transferring the tax to Holyrood.  It is hard to estimate the extent to which Scottish revenues will differ from the respective block grant adjustments in any future year, and small variances in economic performance may contribute to significant differences over time.

The report offers differing scenarios under which the total Scottish resource budget (block grant plus Scottish tax revenues) might fall by different amounts in real terms between 2016/17 and 2020/21.  Aggregate reductions throughout that period of 1.2%, 2.3% or even up to 3.8% are discussed. It seems clear that the balance of probability points towards cuts in real terms.

If emergency borrowing powers provided within the Fiscal Framework are triggered by the relative fragility of the Scottish economy, the Scottish Government might choose to use them.  Such borrowing could boost the budget for 2018/19 by up to £600 million, arguably justifiable in view of Brexit uncertainties, but this would have to be repaid with interest at a future date – thus postponing rather than avoiding tough decisions.

The Scottish Government has greater flexibility on its capital budget, with its capital block grant set to increase by 5% a year up to 2019/20.  By the end of the parliament in 2021, it will be close to its peak in 2010/11.

Spending commitments and constraints

The Scottish administration has committed to various budget priorities over the next few years.  These include increasing health spending by £500 million above inflation by 2021; maintaining spending on policing in real terms; doubling free childcare provision; and investing an additional £750 million in a school attainment fund.

These priorities alone mean that over half the Scottish budget is ‘protected’, leaving non-protected spending facing real term cuts of 9% to 14% over the period from 2016/17 to 2020/21.  However, other commitments and priorities include free higher education tuition; protecting college places; free personal and nursing care; funding for school education; and lifting the 1% public sector pay cap.

As a result, non-education elements of local government can expect a severe squeeze, renewing questions about how local government services should be funded.

The report also highlights Scotland’s new social security powers, which bring opportunities and risks: opportunities to link them with existing devolved services to produce better outcomes at lower cost; and budgetary risks relating to set-up, administration and whether they can deliver on policy commitments.

Long-term fiscal challenges

With cuts in real terms in the value of public spending across the UK, the report estimates that Scottish Government’s resource spending is likely to be 10% lower in real terms by 2020/21 compared with 2010/11.

This conceals a forecast that health resource spending will have increased by 10% over that period, while non-health resource spending will have fallen dramatically. In real terms, resource spending per capita is expected to be 20% lower in 2020/21 than in 2010/11.

With demographic change and other cost pressures, the future health resource budget will need to increase in real terms just to stand still.  This means that further spending reductions will be required elsewhere, or new sources of revenue found.

The report concludes that a strategic review of the long-term financial sustainability of Scotland’s public finances is needed.  As possible options on spending, it mentions reforms to the way public services are delivered; better allocation of scarce public sector resources; and a reappraisal of services provided by the state.  On revenue it observes that some options are available, especially around Scottish income tax, but notes that there are also significant constraints.

Substantial changes are already happening to the balance of and scale of public spending, and the way in which devolved revenues are raised.  The Fraser of Allander Institute calls for an open and transparent debate among all political parties in Scotland about the sustainability of the public finances and the options for reform.

Conclusion

The Fraser of Allander Institute, as a leading economic research institute, is in pole position to comment authoritatively on the Scottish economy.  This report makes valuable reading for Derek Mackay, Scotland’s Cabinet Secretary for Finance and the Constitution, before he delivers the Scottish Government’s draft Budget for 2018/19 in December.

Article supplied by Taxing Words Ltd

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  • Tax

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