Smith Contributions - Challenges for a ‘DevoSmith’ Economy

Published: 24 November 2014
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Much of the debate since the referendum has focussed on which additional powers are likely to be devolved from Westminster to Holyrood. Rather less attention has been paid to the likely impact on the Scottish economy of devolving any of the powers that have been suggested. At the time of writing, the details of the Smith proposals are not known but we can safely assume that he is unlikely to support either the most modest or the most-far-reaching of those put forward by the participating parties.

It seems reasonable to assume that the Scottish Government will have greater responsibility for raising its own revenue at the end of the process than it had at the start. It also seems likely that the power to vary income tax and, as a result, recycle that to vary public spending will be among them and that can be considered in regards to two outcomes:

1)      The result of the Scottish Governments spending being more directly tied to its ability to encourage economic growth will, in and of itself, prove to be a factor in future economic policy-making

2)      The likely impact of any changes in taxation the Scottish Government might consider resulting from those greater powers can be analysed using an appropriate model of the Scottish economy

On the first point, the greater fiscal responsibility of enhanced devolution of tax powers will simultaneously strengthen the link between Scottish economic activity and the Scottish Government’s budget. This increases the incentive for the Scottish Government (and electorate) to promote growth-stimulating policies, but also increases the downside risk of fluctuations in tax revenues and public spending.

Within that context, there are a range of options for future Scottish administrations in terms of how they choose to manage that link. Broadly, their choice would be between higher taxes and higher spend in the direction of the Scandinavian social investment model or, less likely, to the low tax and low spend Baltic model. In the event of the former, seemingly more likely, outcome, future Scottish governments will need to balance the adverse competitiveness effects of higher taxation with spending with significant supply side benefits such as greater infrastructural investment.

The adverse competitiveness effects of higher taxation can also be countered if the Scottish public can be persuaded of the importance of its social wage (not just take home pay), that is to say the extent to which voters feel the benefit of government expenditure in terms of their quality of life and, as a result, exercise restraint in wage demands. These are most likely to include health and education spending. However, what evidence there is suggests that welfare spending is unlikely to figure large (or at all) in the social wage, which is potentially problematic if a Scottish Government were to engage in a balanced budget fiscal expansion to fund such expenditure.

The effect of getting this right are significant. Were a future Scottish Government to increase income tax by three pence, it would generate approximately £1.05bn in additional revenues but if it were to introduce no significant additional supply-side spending, our model sees GDP falling by 1.71%. In a second scenario, with no increase in supply-side spend but where a growing appreciation of the social wage attracts migration and encourages wage-restraint, GDP increases by 0.49%. However, in a third scenario, where increases are used to fund significant capital spending and there is an appreciation of the social wage, then GDP increases by 2.8%.

None of these changes is inevitable and each contains a number of caveats that are set out more fully elsewhere. However, increasing the incentives for future administrations by establishing more clearly the link between economic activity and government revenue, can prove beneficial to the Scottish economy in the long term, given a policy framework that is appropriate to that new economic reality.

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