On November 27th 2014, the Smith Commission published proposals for further devolution of powers to Scotland. We now know what is to be devolved – the UK and Scottish Governments now have the more prosaic task of implementing the changes. Getting the details of how the taxes and welfare are devolved will be crucial. A new IFS Briefing Note published today analyses some of these ‘technical’ issues (and critically appraises the Smith Commission proposals more generally). In it we suggest a solution to one of the most difficult issues the Commission did not tackle – how to adjust the block grant given to Scotland when more taxes and spending are devolved. We also question some of the recommendations of the Commission – arguing that implementing them in practice might not always be feasible or fair. This observation provides a summary of these “big issues”.
Adjusting the block grant to account for further devolution
When a tax is devolved to Scotland, and the Scottish Government gets to keep the revenues raised, a reduction should be made to the block grant Scotland currently receives. Similarly, if extra spending responsibilities are devolved, then Scotland should receive additional money to account for that.
Implementing this in the first year is relatively easy. When a tax is devolved, the block grant should be reduced by the amount of revenue that is being transferred to Scotland. When further spending powers are devolved, the block grant should be increased by how much the UK would have spent on that area in Scotland.
More difficult is determining what should happen to these adjustments in subsequent years. Keeping them fixed is typically not appropriate because inflation and economic growth mean that the amount raised from a tax or spent on a particular area tends to grow over time. The Smith Commission recognises this, by stating that these block grant reductions or additions should be “indexed appropriately”. But what does this rather cryptic phrase mean?
Unfortunately, the answer won’t be the same for every area of tax or spending. That is one reason why there is a lot of work for policy-makers and analysts still to do.
One attractive option is to index the block grant reduction to what happens to revenues from the equivalent tax in the rest of the UK. This would insulate the Scottish Government’s budget from revenue or spending shocks that hit the whole of the UK – in line with the principles agreed by the Smith Commission –but still give the Scottish Government the incentive to grow revenues and limit expenditure in Scotland.
Revenues from devolved taxes, and spending on devolved areas, may evolve differently from comparable items in the rest of the UK for reasons completely unrelated to devolved government policy. Whether it is deemed appropriate for the Scottish Government to bear these risks depends on the importance of redistribution and risk-sharing across the United Kingdom. But trying to insulate Scotland from such risks while still providing it with the right incentives is complicated: it would involve isolating the effect of Scottish policy (which we would want the Scottish Government to bear) from other factors affecting devolved tax revenues and spending. Any modelling exercise like this is controversial – particularly when substantial sums could be at stake.
Is it possible to compensate for knock-on effects of policy decisions?
This brings us on to another one of the Smith Commission’s key principles: that the Scottish Government should bear the full revenue or spending consequences of its policy decisions, and the UK Government of its decisions. In particular it says:
“Where either the UK or the Scottish Governments makes policy decisions that affect the tax receipts or expenditure of the other, the decision-making government will either reimburse the other if there is an additional cost, or receive a transfer from the other if there is a saving. There should be a shared understanding of the evidence to support any adjustments.”
In principle this is sensible. In order to align incentives for policy making properly, each government should bear the full costs (and receive the full benefits) of its policy decisions. It also seems only fair to compensate (or penalise) the other government for ‘knock on effects’ of policy decisions. But implementing such a principle would be fraught with practical difficulties meaning that such transfers might often be infeasible.
Nearly all policy decisions could have knock on effects on the revenues or spending of the other government. But calculating what these are is inherently difficult, with much room for disagreement over the methods used – and different effects of the same policy might go in opposite directions. Therefore such compensating transfers might only be practical in a few simple cases – otherwise the system could quickly become unworkable and lack transparency.
Should the Scottish Government’s budget always be unaffected by changes to taxes in the rest of the UK which have been devolved to Scotland?
The next proposal from the Smith Commission could also be problematic. It says:
“Changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK. Changes to devolved taxes in Scotland should only affect public spending in Scotland”
It seems clear that, for instance if income tax were increased in the rest of the UK to fund additional spending on services in the rest of the UK, then there should be no knock-on effect to the Scottish budget: Scots would be paying the same taxes as before so should see neither a rise nor fall in the amount spent on them. Indexing the block grant reductions or additions in the way we suggest above would achieve this outcome.
But what if the UK government wanted to spend more money on defence or state pensions, or wanted to increase taxes to reduce borrowing. These are things that benefit the whole of the UK, including Scotland, even though they are not necessarily “spending in Scotland”. One interpretation of the Smith proposals would be that the UK government could not use an increase in income tax – one of the main taxes it levies – to fund these policies. This would be absurd and the Treasury has informed us that it was not the intention of the Smith Commission to constrain the UK government in this way. But if the UK government did use income tax (levied only outside Scotland) as part of its response to such UK-wide issues then the amount of grant transferred to the Scottish Government should be changed in response. For instance, if taxpayers in the rest of the UK were paying more in income tax to reduce the budget deficit it would be only fair that Scottish taxpayers also contribute to deficit reduction. Devolution of income tax powers to Scotland should give Scots more freedom of taxation and spending in future – but not the ability to avoid spending cuts or tax rises that are carried out to finance things that benefit the whole UK.
The Smith Commission has provided a set of proposals for further devolution of taxes and spending, agreed by the five main Scottish parties. This is a significant achievement. But many difficult issues remain to be addressed – not least, how the block grant will be adjusted to account for the additional revenues and spending areas that will come under Holyrood’s control. No system will be perfect. There is an inherent trade-off between providing incentives to the Scottish Government, and the degree of risk-sharing between Scotland and the rest of the UK. And, it will not be practical to devise a system where the UK and Scottish governments compensate each other for all the knock on effects of their policies as the Smith Commission recommends. That being said, it is possible to avoid some of the biggest pitfalls – and important too: our earlier analysis of the mistakes that were made when business rates were devolved shows that getting these details wrong can have big financial consequences.