How will the Scottish budget evolve?

Powers that be and powers to come

In the coming Session, the Scottish Parliament will have at its disposal the most extensive set of financial powers and responsibilities since 1999.  Once all the powers provided for in the Scotland Act 2016 are in place, tax revenues will make up broadly 50% of devolved spend (using 2014-15 data) (Figure 1).

Tax revenues as a percentage of devolved expenditure

Tax Latest GERS

Source: SPICe, data from Scottish Government 2016

Currently, most of the Scottish budget is funded through a block grant from the UK Government, with annual changes to the block grant calculated using the Barnett formula.  As the Scottish Government gains more responsibility over tax and welfare in the coming years, adjustments will have to be made to the block grant.  After lengthy negotiations, the two governments agreed that the method used to do so will be in place for a transitional period up to and including 2021-22.  It involves two models, but the outcome delivered will be that of the Scottish Government’s preferred option, “the Indexed Per Capita method.”  For tax, this will protect Scotland from the risk that its population grows more slowly than the rest of the UK but it has been criticised by the UK Government as unfair (UK Government 2016b).  There will be a review of the operation of the fiscal framework including block grant adjustment arrangements by the end of 2021.

The Scottish Government will also have additional borrowing powers to fund the Scottish Budget from April 2017 onwards.  It will be able to borrow up to £3bn for capital investment projects, with an annual limit of 15% of the overall borrowing cap, equivalent to £450m a year. As is the case at the moment, the Scottish Government will be able to borrow from the National Loans Fund, directly from a commercial bank or through issuing bonds.  The power to issue bonds was granted by the UK Government in February 2014 (UK Government 2014) but has not yet been exercised.  The Scottish Government will also have the power to borrow up to £600m for resource purposes within a statutory overall limit of £1.75bn from the National Loans Fund for in-year cash management and to buffer the impact of (real or predicted) economic shocks and shortfalls in tax revenues.

As the size of the Scottish Budget becomes more dependent on Scottish tax revenues in the coming years, Parliament will need to consider a wider range of issues.  These include:

  • Setting the rates and bands for the devolved taxes
  • Understanding the effect of behavioural change on the amount of tax collected
  • Monitoring ‘Scottish taxpayers’ and the role of HMRC on collecting income tax
  • The performance of Revenue Scotland
  • Forecasting tax receipts and GDP by the Scottish Fiscal Commission
  • The implementation of the fiscal framework (UK Government 2016a).

Shaping Scotland’s tax system

Taxation plays a central role in all modern economies and Scotland is getting a chance to reform some of its tax system.  Taxation is used to raise revenue to fund government spending and in recent times has also been justified as a mechanism for changing behaviour e.g. green taxes, sugar tax.  A tax system is generally a reflection of local values and the views of those in power.  Tax reform needs to strike a balance between politicians’ ideals and the negative economic impact it may have on the economy.

Although there is little consensus over what constitutes a “fair” tax regime, it is generally accepted that a good tax system should be efficient and progressive.[1]  According to the Mirrlees Review, which provides a comprehensive set of recommendations for tax reform, this requires that “we think hard about the kind of progressivity we want” (Institute for Fiscal Studies 2011).

Additional tax powers will allow for a debate to take place on what a distinctive Scottish devolved tax system might look like, and what the core purpose of taxation should be. For example, should tax policy primarily seek to maximise revenues for public expenditure?  Or should the aim be to reduce income inequality; maximise economic growth and competitiveness; and/or influence behaviour?

Careful consideration should be given to taxpayers’ potential “behavioural” response when changing the tax system which can have a direct impact on revenues but also a wider impact on the economy.  For example, in response to a tax increase, taxpayers might shift the timing or type of income (e.g. sell their house before an increase in Land and Buildings Transaction Tax, put more of their earnings into pensions, receive dividends rather than earnings, etc.); change the hours they work; retire early; migrate or change how or when they spend their income.

Geographic, cultural and economic proximity as well as the interconnected nature of the tax regimes between Scotland and the rest of the UK may increase the potential for behavioural responses when either jurisdiction makes a change to taxes that are devolved in Scotland.

[1] A tax is progressive when the average tax rate rises as the tax base rises.

Anouk Berthier and Ross Burnside

Sources:

Institute for Fiscal Studies (2011) Tax by design. Available at – https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/500284/CST_response_SAC.pdf [Accessed 27 April 2016]

Scottish Government (2016) Government Expenditure & Revenue Scotland 2014-15. Available at – http://www.gov.scot/Publications/2016/03/3692 [Accessed 27 April 2016]

UK Government (2014) Scotland to be given powers to issue its own bonds, News story. Available at – https://www.gov.uk/government/news/scotland-to-be-given-powers-to-issue-its-own-bonds [Accessed 27 April 2016]

UK Government (2016a) The agreement between the Scottish Government and the United Kingdom Government on the Scottish Government’s fiscal framework, UK Government and Scottish Government. Available at – https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/503481/fiscal_framework_agreement_25_feb_16_2.pdf [Accessed 27 April 2016]

UK Government (2016b) Letter from Greg Hands, Chief Secretary to the Treasury, to Pete Wishart MP, Convener of the Scottish Affairs Committee, House of Commons, 12 February 2016. Available at – https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/500284/CST_response_SAC.pdf [Accessed 27 April 2016]