Delaying the real crunch on fiscal framework

So the fiscal framework has been agreed. Or has the can just been kicked down the road? Both interpretations are consistent with last week’s last-minute agreement between the Scottish and UK governments. There is now no significant obstacle to the passage of the Scotland Bill. As a result the Scottish Parliament will take control over the setting of the rates and bands of income tax from 2017 and a raft of welfare powers will be introduced when the administrative arrangements can be made.
 
The agreement settled the way that Scotland’s grant from Westminster will be cut in the light of Scotland’s new tax powers. Or at least it did so for the next five years. During that time, the reduction in Scotland’s block grant will be linked to the growth in tax revenues per head in the rest of the UK. This protects Scotland from the risk that its population might grow more slowly than rUK’s. It also shields Scotland from the implications of its income tax revenues per head being around 10 per cent lower than in rUK.
 
Several different methods were proposed for adjusting Scotland’s block grant during the protracted negotiations over the fiscal framework. Each attempted to satisfy the principles set out by the Smith Commission for the adjustment mechanism. But because these principles are not mutually consistent, there was no clear winner so the respective governments argued for the method that gave the best financial outcome from their own perspective.
 
The selected method has the sexy title “Per Capita Indexed Deduction”. Among the options, it is the outcome that best protects Scotland’s block grant. The Scottish Government can justifiably argue that it has protected Scotland’s interest, for at least the next five years.
 
The UK and Scottish governments have agreed to review this method in 2021. By then, it is likely that there will be considerable resentment in other parts of the UK to the agreement. The most likely reason will be its failure to meet the “taxpayer fairness” criterion of the Smith Commission, which holds that changes to UK taxes for which responsibility has been devolved to Scotland should only affect spending in the rest of the UK. And changes to Scotland’s taxes should only affect spending in Scotland.
 
Suppose that there is a crisis in the health service on both sides of the Border. Scotland raises income tax by 1p and directs all of the revenues to the NHS in Scotland. Clearly, there is no effect on public spending in rUK.
 
The UK Government also raises income tax by 1p and directs the extra revenue to health. But because of the Barnett Formula, the block grant from the Westminster Government to Scotland will be increased by Scotland population share (around 9 per cent) of the extra revenue. So Scotland gains from the increase in rUK taxes.
 
Only if the amount taken away from Scotland by the block grant adjustment exactly equals the increase resulting from the Barnett formula could it be argued that the increase in rUK taxes had no effect on Scottish spending. But, in most circumstances, this will not happen because the chosen adjustment method will take less away from the Scottish budget than it gains from the extra Barnett allocation. So Scotland will be able to spend more on health when income tax is raised in rUK. The taxpayer fairness principle is breached.
 
Data for 2013-14 show that Scotland spends £2,151 per person on health, while England spends £1,994 and Wales £19,92. By the time of the review and given the generosity of the agreement, Scotland’s extra spend may have increased further. This will be clear to both sides because the fiscal framework agreement also includes a commitment to calculate the block grant adjustment by one of the other methods – one that gives a less favourable outcome to Scotland.
 
So the review is likely to be no less acrimonious than the path to last week’s agreement, which is desperately short of detail on how the review will be constituted, what its terms of reference will be, and who will be involved. This can only add to the potential for acrimony. However, for the Scottish Government, there is one key clause that will likely allow it to hold on to the advantage that it has just gained. Any change to the adjustment mechanism will have to be “jointly agreed” by both governments while adhering to Smith principles, such as “taxpayer fairness”. So if the Scottish Government doesn’t like any proposal to change the block grant adjustment mechanism and the political circumstances are right, it may be able to once again pay lip service to the “taxpayer fairness” principle, while once again kicking the can down the road.
 
 

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David Bell's picture
post by David Bell
University of Stirling
3rd March 2016

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