Scotland's Fiscal Framework

The Scottish Government's new capacity to borrow is a vital, if little-discussed, power. However, says Angus Armstrong, the details of how this will work may have been dodged by the Smith Commission but cannot long be avoided by the Scottish Government and HM Treasury. 
Scotland’s future borrowing power is the most important issue in the devolution debate. While on the surface a dry subject, consider that differences in US state finances were central in the escalation to civil war and Europe’s current tragedy arises from sub-central borrowing powers within a monetary union.
The inevitability of further changes to Scotland’s borrowing powers, and the irreducible problems which arise, are understood in Westminster and Holyrood. Yet so far there has been no serious discussion from either side of what these powers will be. The Smith Commission ducked this most important issue by calling for “additional borrowing powers consistent with a sustainable overall UK fiscal framework.” Amen, but what does this mean?
Let’s start with an update of Scotland’s current powers. In April the Scotland gained new borrowing powers under the Scotland Act (2012). In any single year the Scottish Government can borrow up to £200mn for current spending and 10% of its capital budget. This year the Scottish Government will borrow the maximum allowed for capital spending (£304mn). The government is allowed to borrow in total £2.7bn. 
To put these figures into context, Scotland’s local authorities have borrowings of £14.8bn. Under the Smith Commission Scotland will one of the most powerful sub-central governments in the OECD. While the UK is not a federal state, comparator sub-central governments in the big five federal nations have less tax raising powers but all have far greater borrowing powers than suggested for Scotland (sometimes without limit).  1
It is difficult to imagine that the Scottish Government is comfortable with effectively a balanced budget rule for almost half of its total public spending in all economic conditions. Even Chancellor Osbourne’s proposed budget surplus rule allows some relaxation in ‘not normal’ conditions. Nearly half of Scotland’s budget will operate under a balanced budget rule and crucially with no flexibility. Is this really what is intended?
Scottish borrowing counts as Public Sector Net Borrowing (the definition used in the UK fiscal framework). Chancellor Osborne’s existing rule of falling net debt and proposed new fiscal surplus law includes borrowing for investment. Presumably the new law cannot apply in Scotland as the Scottish Government has authority to borrow for capital spending. Indeed, the more that Scotland borrows, the more consolidation for the rest of the UK would need to endure.
The Scottish Government has the option of borrowing from the National Loan Fund (NLF), commercial lenders and, as of April this year, issuing Scottish Government bonds. Borrowing from private investors would be the most transparent mechanism. However, the preferred method of borrowing is the NLF which provides subsidised borrowing rates paid for by tax payers from the whole of the UK.
The solution might seem to include (a) increase (or remove) the limits on the Scotland’s borrowing capacity, (b) exclude the Scotland from the fiscal rules set by the Westminster, and (c) prohibit any borrowing from the UK. However, Scotland's fiscal deficit, the subsequent fall in oil price and clear intention to spend more are likely to attract the attention of credit rating agencies.
One can now see why the Smith Commission ducked this most important issue. But Westminster and Holyrood governments do not have this luxury. Negotiations will have to begin soon to be included in the Scotland Bill (2015-16). Avoiding the issue and falling back on an inflexible budget would be a recipe for future failure.
The difficulty of granting fiscal power to Scotland comparable to a federal government while not being within a federal UK system is the key point of Armstrong and Ebell (2014), Real Devolution: The Power to Borrow.

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Angus Armstrong's picture
post by Angus Armstrong
National Institute of Economic and Social Research
22nd June 2015

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