The Scottish fiscal framework: What you need to know

Scottish Parliament chamber
Donald-Drysdale By Donald Drysdale for ICAS

17 February 2016

With negotiations continuing between the Scottish and UK governments over a new fiscal framework for Scotland, Donald Drysdale explains the background and key debating points.

The Smith Commission

The Smith Commission, chaired by ICAS Past President Lord Smith of Kelvin CA, published its Final Report in November 2014. This recommended the devolution to Scotland of further responsibility for tax and public spending, including elements of the welfare system.

Smith advocated that this should be accompanied by an updated fiscal framework for Scotland. This would encompass a number of elements including the funding of the Scottish budget, planning, management and scrutiny of public revenues and spending, mechanisms for adjusting the Scottish block grant, borrowing powers and cash reserve, fiscal rules and independent fiscal institutions.

The Scotland Bill 2015-16

The Scotland Bill is the draft UK legislation required to put in place the Smith proposals. It was substantially amended by the House of Commons, and is now at the Committee Stage in the House of Lords.

Meanwhile, the fiscal framework which will underpin the transfer of responsibilities has become the subject of protracted secret negotiations between the UK and Scottish governments, and the passage of the Bill has been delayed while the Lords await the outcome of the talks on the fiscal framework.

The fiscal framework

Last week the cross-party House of Commons Scottish Affairs Committee published a report entitled ‘Revising Scotland’s fiscal framework’. This is helpful in understanding the issues involved.

As the report explains, a fiscal framework is needed to set and co-ordinate sustainable fiscal policy. Two key elements of this are fiscal rules – e.g. constraints on fiscal policy, typically by setting limits on borrowing and/or debt – and fiscal institutions responsible for overseeing fiscal policy decisions.

The UK’s fiscal framework, set out in the Budget Responsibility and National Audit Act 2011, stipulates that devolved authorities must work within the constraints imposed by Westminster’s fiscal policy while at the same time being allowed to exercise their devolved powers.

Scotland’s existing fiscal framework, set by the Scotland Acts of 1998 and 2012, requires Holyrood to run a balanced budget, funded primarily by a block grant determined by the longstanding Barnett Formula, with tools to manage volatility – including the ability to operate a cash reserve and limited borrowing powers to cope with variations in forecasts or fund capital expenditure. The Scottish Government has created the Scottish Fiscal Commission to scrutinise the reasonableness of its forecasts for devolved taxes.

Holyrood will be taking on the Scotland-specific fiscal risks associated with its revenues, including volatility.

The further devolution now proposed will double Holyrood’s direct revenues to some £16bn, while adding a further £5bn in assigned VAT revenues – together accounting for over half the Scottish Government’s annual budget. But with revenues come risks. Holyrood will be taking on the Scotland-specific fiscal risks associated with its revenues, including volatility. To manage these effectively and smooth any fiscal shocks, Holyrood will need greater borrowing powers. Agreeing those powers is a key element of the negotiations on revising the fiscal framework.

The block grant from Westminster is Scotland’s other main source of funding. When taxes are devolved to Scotland, receipts are paid directly into the Scottish budget and the block grant is reduced by the amount of revenue forgone by the UK Government. To make this work, both governments must agree how to calculate the initial reduction – without detriment to Scotland or the rest of the UK. Even more problematic – they must agree how to index this adjustment over time to ensure it is not eroded by inflation and economic growth, in a way that is fair to taxpayers across the UK.

Scottish Affairs Committee conclusions

The Committee’s report concludes with the following recommendations:

  1. The key task of economic forecasting should be done by the independent Scottish Fiscal Commission, which should be given enhanced powers for this purpose.
  2. Like the UK Government, the Scottish Government should have a commitment to run a balanced budget over the economic cycle, subject to clear fiscal targets.
  3. The Scottish Government should borrow from the markets, underwritten by the UK Government, to instil market discipline and transparency. A specific limit on current borrowing should be set and published to indicate additional risk being taken on by the Scottish Government and to measure performance.
  4. The initial adjustment of the block grant should be based on average out-turns over several years to avoid the distorting effects of an atypical year in the economic cycle.
  5. The fiscal framework must not leave Scotland facing risks which it does not have sufficient powers to mitigate.
  6. Both governments should work together to ensure that the partial devolution of welfare benefit powers does not cause confusion and uncertainty to claimants.
  7. The Scottish Government should retain any additional VAT intake from improved economic performance.
  8. The operation of the fiscal framework should be reviewed after four years.

Conspicuously, the Committee stated that the way the Scotland Bill and fiscal framework have been progressed has been unsatisfactory. Substantial changes are going to be made to the relationship between Scotland and the rest of the United Kingdom, and it is to the detriment of everyone who will be affected that the process will not have been subject to the level of examination it deserves.

The political timetable

The fiscal framework was to have been agreed by 12 February. This target and the Lords consideration of the Bill have now been postponed until next week.

The Scottish Parliament will be dissolved on 23 March, ahead of the Scottish elections on 5 May. The original expectation was that the Scotland Bill would be enacted and the fiscal framework agreed before those elections, but this seems increasingly unlikely.

Article supplied by Taxing Words Ltd.


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