Implementing Smith: lessons from federal countries

David Eiser reports from a seminar at the Centre on Constitutional Change led by Carlo Cottarelli of The International Monetary Fund. Carlo shed light on how devolved fiscal powers are operationalised across a sample of 13 federal countries.

The Smith Commission report sets out the broad terms of Scotland’s future fiscal arrangements within the UK, in terms of which new tax and spend powers will be devolved. But many of the detailed implementation arrangements required to make these fiscal powers workable remain to be resolved, for example on issues such as revenue forecasting, borrowing powers and fiscal rules, the framework for inter-governmental cooperation, and accounting and monitoring.

A recently published IMF book “Designing a European Fiscal Union: Lessons from the Experience of Fiscal Federations” sheds light on how devolved fiscal powers are operationalised across a sample of 13 federal countries. As the title suggests, the book aims to draw lessons from these countries for further fiscal integration within the EU. But many of the lessons are equally informative for those of us interested in understanding the detailed arrangements that will be needed to underpin the headline recommendations from Smith.

Carlo Cottarelli, the book’s editor presented the key findings from the book at a seminar organised by the Centre for Constitutional Change on Monday. Carlo’s presentation was followed by reflections from Jo Armstrong and David Eiser, and a lively discussion among attendees. Carlo’s presentation and the subsequent discussion raised a number of inter-related issues and questions, some of which I summarise here.

Given the level of tax revenues being devolved, the Scottish Parliament will clearly need access to some form of borrowing powers to smooth fluctuations in its budget in the event of particular shocks. But the scope and form of this borrowing will depend on the shocks or risks the Scottish budget will be exposed to through the grant allocation process – and we don’t yet know exactly what this grant allocation process looks like.

The book makes clear the advantage of sub-national governments being able to borrow from the market (rather than through the central government). But if markets perceive that the UK Government would bailout the Scottish Government if it got into difficulty, this is likely to lower the cost of sub-national debt relative to national debt, acting as an implicit subsidy to the Scottish Government.

To address this issue, most sub-national governments in federal countries face one or more fiscal rules which are often (but not always) imposed by the centre. As Carlo described, thee rules can take many forms (e.g. on the total debt issued or the overall deficit), with recent debate focussing on the merits of cyclically adjusted v. headline targets.

A common theme throughout the book and Carlo’s presentation is the importance of an independent fiscal commission. Given the level of tax revenues being devolved to the Scottish Parliament, the importance of reliable, timely tax revenue forecasts is paramount, and there will be a critical role for independent scrutiny of such forecasts by the Scottish Government. The independent fiscal commission might also play a role scrutinising the use of any “Rainy Day Funds”, if such a reserve is established (US states make use of Rainy Day Funds as a way of managing budget fluctuations, limiting the need for borrowing).

Another theme that runs throughout the book is the importance of inter-governmental coordination. Most federal countries have mechanisms in place to facilitate coordination on a variety of fiscal issues, including budgeting, forecasting, accounting, monitoring, and the broad direction of fiscal policy. The degree of this coordination varies significantly across federations.

Coordination is likely to be particularly important in Scotland/Smith case not least because of the high proportion of income tax revenues are devolved. The Smith report deals with this issue in part through its ‘no detriment’ clauses, which state that, where one government makes a policy choice that effects the tax receipts of the other, some mechanism exists for agreeing the magnitude of this effect, and an inter-governmental reimbursement takes place. Some interesting discussions took place around what type of coordination and negotiation frameworks might need to be in place to operationalise this ‘no detriment’ clause (with a general agreement that it would be extremely difficult!)

An over-riding message from the book is that there is no one right way of doing things, and each federation has adopted a slightly different set of rules and coordination mechanisms to ensure that decentralised fiscal policy is stable and coherent at the macro-level. But the book nonetheless gives a great deal of food for thought in the Scotland/ UK case. Ultimately, many of the issues boil down to a question of how to balance sub-national fiscal autonomy with budgetary risks at sub-national and national levels. How this balance is struck is not just a question for economists.

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David Eiser's picture
post by David Eiser
Fraser of Allander Institute
13th January 2015
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