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Fiscal Autonomy in Scotland: The case for change and options for reform

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2 Delivering our Purpose: Sustainable economic growth

Chapter Summary

  • The Government Economic Strategy3 set out the scale of the challenge in putting Scotland onto a higher sustainable economic growth path.
  • The challenge is even greater given the current global economic downturn which is affecting countries large and small, and economies need to respond flexibly to these challenges and consider the long-term implications for policies and institutions.
  • The Scottish Government is already taking forward a series of initiatives through the Economic Recovery Programme to meet this challenge head-on, but the Scottish Government lacks the full range of economic levers to support increased sustainable economic growth.
  • There is a growing consensus that there is a need for reform of tax, spending and borrowing responsibilities for the Scottish Parliament.
  • The view of the Scottish Government is clear. The Government believes that a fiscal framework that enables long-term competitiveness and short-term flexibility is vital to achieving the Purpose and that independence is the best option to deliver this.

Introduction

2.1 Achieving increased sustainable economic growth for Scotland means building a dynamic and growing economy that will provide prosperity and opportunities for all, while ensuring that future generations will also enjoy a better quality of life.

2.2 This chapter outlines the long-term and short-term trends for Scotland's economic growth and highlights the size of the challenge facing Scotland in the years ahead.

The Economic Challenge

Targets

2.3 The Government Economic Strategy, published in 2007, set out the scale of the challenge in putting Scotland on to a higher sustainable growth path and the targets that have been set to help meet that challenge.

2.4 The strategy identifies two clear, time-bound targets for increasing sustainable economic growth:

  • to raise Scotland's GDP growth rate to the UK level by 2011; and
  • to match the GDP growth rate of the small independent EU countries by 2017.

2.5 To achieve increased sustainable economic growth, Scotland needs to drive up its performance in relation to three key components: productivity, participation and population. This growth should also satisfy three desired characteristics - solidarity, cohesion and sustainability as illustrated in Figure 1. The Scottish Government has set targets relating to all these areas.

Figure 1 - The Economic Challenge

Figure 1 - The Economic Challenge

Source: Government Economic Strategy

Comparisons of long-term performance

2.6 Scotland's economic growth in recent decades has under-performed relative to both the UK and other European countries. Over the last 30 years (1977 to 2007), Scotland's annual average GDP growth of 1.9%, has lagged behind the UK's growth rate of 2.4%, which itself has been outperformed by comparable European countries such as Ireland, Norway and Finland, who have experienced average growth rates of 5.4%, 3.1% and 2.9%, respectively. These decades of relatively poor performance have led to missed opportunities for Scotland, and we now clearly lag behind many independent EU countries on a range of economic indicators.

2.7 For example, economic growth in Norway has been consistently higher than in Scotland over the past decade, with GDP per capita in 2007 approximately 50% higher than in the UK4. In addition, the Norwegian Government has established a significant oil fund for the benefit of future generations valued at approximately £200 billion as at September 2008 5. In contrast, Scotland - Europe's other major oil producer - does not have such a fund and instead all the tax revenues from the North Sea flow to the UK Exchequer.

2.8 Meanwhile, notwithstanding the immediate economic challenges in Ireland, the Irish economy has generated strong, sustained growth over the past three decades and GDP per capita is approximately 30% higher than in Scotland.

2.9 Table 1 summarises average GDP growth rates of the UK and a number of European countries over the period 1977 to 2007. The results show that economic growth in many European countries has been consistently higher than in Scotland and the UK over the past 30 years.

Table 1 - Economic Growth: Scotland, the UK and Comparable European Countries

Average Annual Growth Rates

5 Year (2002 - 2007)

10 Year (1997 - 2007)

30 Year (1977 - 2007)

Austria

2.5%

2.5%

2.4%

Denmark

2.0%

1.9%

2.0%

Finland

3.5%

3.6%

2.9%

Iceland

5.4%

4.5%

3.4%

Ireland

5.5%

6.9%

5.4%

Luxembourg

4.6%

5.3%

4.5%

Norway

2.6%

2.4%

3.1%

Portugal

1.0%

2.0%

2.7%

Sweden

3.2%

3.2%

2.3%

Scotland

2.3%

2.2%

1.9%

UK

2.7%

2.9%

2.4%

Source: OECD, Scottish Government

2.10 Over the long-term, independent countries have been able to use a range of economic and fiscal strategies to maximise the benefits of their respective competitive advantages: world-class performance in key economic sectors; deep pools of skills and human capital; natural resource endowments; and the targeting of any areas that need greater support.

Comparisons of short-term performance and the global economic downturn

2.11 The global slowdown and financial crisis have weakened the performance of the Scottish economy. For many, the current economic climate is the most serious for a generation. For young people, these are the worst economic conditions they have ever faced.

2.12 Scotland is not alone in this respect. Countries, both large and small, face difficult and challenging times ahead. However, despite this environment, the Scottish Government remains focused on matching or out-performing the long-term economic success of other European countries.

2.13 During 2008 a number of economies, including Germany, Japan, Denmark, Ireland, Italy, Sweden and the UK, fell into recession as a result of the global economic slowdown.

2.14 Forecasts published by the Organisation for Economic Co-operation and Development ( OECD) in November 2008 highlight that the global economic slowdown is likely to affect economies of all sizes in the coming years. The OECD forecasts that the UK economy will be particularly affected by the global slowdown 6. The International Monetary Fund ( IMF) estimates that GDP in the UK will fall by 2.8% in 2009 - the biggest drop amongst the major economies studied 7. The European Commission estimates that the economic downturn may not be so severe in some EU economies such as Finland and Austria 8. Outside the EU, the OECD forecasts that Norway will be one of the economies most insulated from the general slowdown.

2.15 It is currently difficult to determine what lasting impact the global economic slowdown will have on the future long-term economic growth performance of economies across the world. Unlike Scotland, independent countries have the opportunity to implement a wide range of flexible, short-term economic strategies to address the effects of the economic downturn on their economies and, just as importantly, put in place policies which will ensure that when the world economy recovers, they are in the best position to take advantage of new opportunities.

2.16 Once again, Norway offers a useful insight into the opportunities available to independent and dynamic economies, even in the face of a sharp global downturn. Norway's economic performance has been, and is likely to be, cushioned to an extent by its large sovereign oil fund. The principal aim of the Norwegian oil fund is sustainable long-term wealth management. However, an important feature of its design is that it can assist in stabilisation of the wider fiscal and economic position when necessary. Many other advanced economies have had to finance a fiscal stimulus package by increasing public sector net borrowing and net debt. This is not the case in Norway where, because of its prudent use of its natural resource wealth and the building of a large fund of assets, Norway is not only withstanding the global slowdown better than many other countries but it is also well placed to resume strong growth as the world economy recovers.

2.17 The global slowdown is also putting pressure on public sector finances - nowhere more so than in the UK. In November 2008, the OECD estimated that even before the effects of the fiscal stimulus announced in the UK Government Pre-Budget Report ( PBR) is taken into consideration, the UK would have one of the largest budget deficits in Europe next year. In Ireland, the only EU country anticipated to have a larger budget deficit in 2009, by 2010 the ratio of general government net financial liabilities 9 to GDP is still forecast to be only half that of the UK (19.8% compared to 43.0%) 10.

2.18 The PBR forecasts show that net borrowing will be £118 billion in 2009/10 and that total net debt will rise to over £1 trillion in 2012/13 11. The Institute for Fiscal Studies ( IFS) estimates that these forecasts may be overly optimistic. Even if the PBR forecasts are correct, the IFS estimate that UK Government spending may have to be cut by an extra £20 billion by the end of the next UK Parliamentary term to repair the public finances and public sector debt may not return to pre-crisis levels for more than 20 years 12.

2.19 As a result of the current global economic downturn and the associated financial crisis, large and important elements of economic policy and institutional systems and structures are under review throughout the advanced economies (see Box 2). There is a widespread acceptance of the need for major reforms to the framework for economic policy in the United States, the UK and other economies. It is against this backdrop that the case for greater fiscal autonomy for Scotland must also be considered, as well as the potential benefits that it could bring in terms of increased sustainable economic growth, greater responsiveness and flexibility of policy.

Box 2 - The global economic downturn and financial crisis

The causes and the impact of the global economic slowdown have raised important, wider questions about the setting of economic policy in advanced economies. This is forcing a reappraisal of policy and institutional frameworks in several areas, including: the role of the state; the scope of financial regulation; the objectives of monetary and fiscal policy; and the arrangements for international economic and financial coordination.

In terms of the role of the state, governments in many advanced economies have taken large stakes in major companies affected by the 'credit crunch'. These stakes have been mostly in the financial services sector. This expansion of the role of the state within the economy has been viewed by many governments as temporary but entirely necessary to uphold the stability of the financial system and other strategically important industries.

The UK Government has injected billions of pounds of public capital into the financial sector including direct support for three major banks ( HBOS, Lloyds TSB and RBS), following on from the nationalisation of Northern Rock and part nationalisation of Bradford and Bingley in 2008. The US Government has also injected public capital into its financial sector, including support for a major insurer. In February 2009 the U.S. Government also announced plans to establish a new $2 trillion fund to stabilise the financial sector 13. Meanwhile governments in many European states, including Germany, France, Italy, Sweden 14 and Ireland 15 have injected public capital into the banking sector. The Norwegian Government introduced a facility in November 2008 where it will offer up to NOK 350 billion (£34.4 billion) of government bonds to banks against collateral, in order to improve liquidity in the market. Two further interventions were announced in February 2009. A NOK 50 billion (£5 billion) recapitalisation fund was established to strengthen banks' core capital to help maintain normal lending activity. A NOK 50 billion (£5 billion) bond fund was created to help industrial companies access funding from bond markets 16.

Much of the disruption in financial markets during 2008 and 2009 has arisen from market failures in unregulated and poorly regulated parts of the financial services sector, including hedge funds and derivatives markets. Heavy exposure to these complex, non-transparent instruments led to major losses for banks and damaged confidence throughout the financial system. Certain parts of the financial sector that were previously regarded as innovative and largely stable are now likely to come within the broader scope of financial regulation. New regulatory initiatives may also include tougher financial reporting standards and adjustments to the capital ratios of financial institutions over the economic cycle.

Recent events in the global economy may also lead to a widespread reappraisal of the objectives of monetary policy. Policymakers and commentators have been aware for several years of the potential risks to stability arising from asset price inflation in housing and securities markets. However, controlling asset prices has not been within the explicit mandate of central banks such as the US Federal Reserve, the European Central Bank and the Bank of England. The severity of the credit crunch is likely to lead to a re-casting of the objectives of monetary policy to place greater emphasis on financial market and asset price stability.

Lastly, the arrangements for international economic and financial coordination are also coming under considerable scrutiny. For several years institutions such as the International Monetary Fund and the Bank for International Settlements have warned of the risks to stability arising from the sustained recycling of balance of payments surpluses ( e.g. from China and oil producing economies) back into economies with a payments deficit ( e.g. the United States and United Kingdom). Many commentators argue that this trend contributed to the unsustainable growth in domestic demand and in asset prices in some advanced economies. Governments and policymakers in the advanced nations have also recently invoked the need for a 'new Bretton Woods' settlement to help maintain stability and equilibrium in global flows of trade and investment.

Opportunities to meet the challenge

2.20 Higher sustainable economic growth is the key that can unlock Scotland's full potential and enrich Scotland as a whole.

2.21 The Scottish Government is already taking important steps to enhance Scotland's economic performance. The Government's aim in the current economic situation is to protect jobs and maximise investment and ensure Scotland's economy is well positioned for recovery. Focusing on sustainable growth and Scotland's strengths - a highly skilled workforce, substantial natural resources and a competitive cost base - will give Scotland a solid foundation on which to take early advantage of the recovery. Central and local government as well as the wider public sector are all focused on delivery of higher sustainable economic growth.

2.22 The Scottish Government's Economic Recovery Programme has focused resources on ensuring that the current powers of the Scottish Parliament are channelled to deliver for families and businesses across Scotland 17.

2.23 However, currently the Scottish Government is restricted in the range of policy options open to it. Opportunities are limited to set competitive policies, particularly taxation, and to use the full range of fiscal and economic policy levers to complement the specific strengths of the Scottish economy and address any weaknesses.

2.24 The Scottish Government has no doubt that Scotland would be better placed to deal with current and future economic challenges if it had greater fiscal autonomy. Indeed, without greater autonomy over the levers of the economy, generating a step-change in Scotland's growth path is made more difficult.

2.25 The Government Economic Strategy identified a broad set of economic levers that would accelerate sustainable growth in Scotland which this Government considers are vital to support the Scottish economy:

  • Devolution of full responsibility for economic and fiscal policy, allowing the Scottish Government to tailor a tax environment suited to attracting increased investment to Scotland and increasing competitiveness which, in turn, will lead to a faster growing economy, more and better paid jobs and higher government revenues;
  • The Scottish Parliament taking responsibility for oil and gas reserves, allowing optimisation of long-term production and the possibility to invest a portion of this massive resource in an oil fund for the benefit of Scotland today and in the future;
  • Further devolution of employment policy, improving accountability and providing greater coherence between economic and employment policy, allowing the balance between workers' rights, the level of minimum wage and the need for a flexible workforce, to reflect Scottish labour market conditions; and
  • Greater Scottish representation in Europe, allowing particular circumstances to be addressed in the negotiation, transposition and enforcement of EU regulation.

2.26 There is a growing consensus that there is a need for reform of tax, spending and borrowing responsibilities for Scotland and that some form of greater fiscal autonomy is desirable 18. There is, however, still considerable debate about the impact of the various fiscal autonomy options on Scotland and which is most appropriate for delivery of increased sustainable economic growth.

2.27 The success of independent European countries, as outlined above, demonstrates the potential benefits of greater fiscal autonomy. The economic success of the fiscally autonomous Basque Country relative to the rest of Spain, where GDP per capita is approximately 30% higher than the Spanish average, shows how significant autonomy within a larger state can also confer an advantage 19.

2.28 As well as evidence from international comparisons, a number of academic studies have attempted to measure the effects that decentralisation can have on economic growth 20. Although not all evidence is conclusive, some studies do show positive effects. However, what appears to be most important are the policies, type of economy and society created with fiscal autonomy in determining economic success and prosperity.

2.29 For example, a number of European countries have taken advantage of the benefits of setting a competitive corporation tax rate to make their country a more attractive location for doing business. Recent studies have demonstrated the positive impact that a competitive corporation tax strategy can have on productivity and economic growth 21. The Scottish Government has made it clear that a fiscally autonomous Scotland would pursue the full range of policies to make Scotland an attractive place for doing business, including simplification and greater certainty in our tax system and a phased reduction in corporation tax to levels significantly below the UK. In addition, Norway, Alberta and Alaska have benefited from being able to manage their natural resources in a responsible manner through the establishment of oil funds. A key objective of the Scottish Government under fiscal autonomy would be the establishment of an oil fund for Scotland for the benefit of current and future generations.

Conclusion

2.30 Sustainable economic growth for Scotland means building a dynamic and growing economy that will provide prosperity and opportunities for all, while ensuring that future generations will also enjoy a better quality of life. The Government Economic Strategy and Economic Recovery Programme set out how, within the current economic climate, the Scottish Government intends to deliver a long-term structural improvement in Scotland's economy. The experience of other countries however, highlights that more can be done with access to the full range of fiscal policies and economic levers.

2.31 The view of the Scottish Government is clear - that a fiscal framework which enables the Scottish Government to fully enhance Scotland's long-term competitiveness and to respond swiftly and decisively to short-term economic pressures and circumstances, is vital to achieving the Purpose of increasing sustainable economic growth. Independence gives Scotland that opportunity.

2.32 The next chapter will go on to examine the current fiscal framework and the constraints and limitations this places on the potential growth of the Scottish economy.