We are testing a new beta website for gov.scot go to new site

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

Listen

4 Devolution of tax and spending: options for reform

Chapter Summary

  • The Scottish Government believes that there are five main options for fiscal reform:
  • current framework;
  • assigned revenues;
  • enhanced devolution;
  • devolution max; and
  • independence.
  • Each option has different levels of revenue and expenditure autonomy.
  • The National Conversation is open to considering all the options for reform.

Introduction

4.1 Having demonstrated the need for improvements to the current arrangements for tax, spending and borrowing in Scotland, this chapter examines the different forms that greater fiscal autonomy can take and the potential options for change.

Definitions of Fiscal Autonomy

4.2 Fiscal autonomy for Scotland is broadly defined as giving greater fiscal authority and responsibility to the Scottish Parliament, over the taxes raised in Scotland and over the level of public sector spending and borrowing.

4.3 Given the balance of spending and revenue autonomy at present, the fiscal autonomy debate in Scotland has tended to focus on revenues and the current funding framework for devolved expenditure, the Barnett Formula.

4.4 Greater fiscal autonomy can take a number of forms ranging from changes to the current devolution settlement through to independence. There is clearly a spectrum of possible options, however, for succinctness, five options for reform are explored within this paper:

  • current framework;
  • assigned revenues;
  • enhanced devolution;
  • devolution max; and
  • independence.

Options for Reform

Current Framework

4.5 Retention of the current framework would see the majority of the Scottish Government Budget financed by a transfer from the UK Government through a Scottish Block Grant. Given the analysis in Chapter 3, the Scottish Government does not foresee this as a realistic option over the long-term because it places a limit on Scottish success and gives no further fiscal responsibility to the Scottish Parliament.

4.6 Within the current framework, the UK Government could decide unilaterally to replace the present funding mechanism, the Barnett Formula, with an alternative grants mechanism whilst still retaining the current range of policy responsibilities. Pressure may well come from outside Scotland to see such a change 37.

4.7 The UK is unique in operating a funding mechanism for the devolved administrations which is based entirely on population shares and historical spending allocations 38. In most European countries such grants are based on a combination of 'needs assessment' and revenue raising capacity.

4.8 Australia also has a system of grants based on a 'needs assessment', with the funding allocated to states based upon an assessment undertaken by an independent body - the Commonwealth Grants Commission. The Australian model combines both expenditure and revenue measures in assessing the level of grant allocated to each state. This leads to a more sophisticated allocation of funding than the Barnett Formula, though as with any method of intergovernmental transfer, it does have disadvantages 39.

4.9 Therefore, one possibility for reform could be to move towards a revised grant based funding framework which is more closely linked to a 'needs' assessment exercise. In this scenario, the level of funding for the Scottish Government would be linked to pre-determined measures of 'need' and/or revenue capacity including measures of economic activity, geography, demography and assessed 'needs' in key areas of public services such as health care and inequality.

4.10 The Scottish Government believes that there would be significant political pressure to reduce Scotland's Budget. For example, if a 'new' grant mechanism was constructed to more closely equalise devolved expenditure levels between English regions and the countries of the UK, then the block grant transferred to Scotland might decrease, leading to potential real cuts in funding without fully taking into account the full range of Scottish priorities and needs. Moreover, as any such assessment would be largely subjective, alternative assessments using different measures of need would lead to significant variations in funding outcomes, contributing to significant uncertainty in planning future budgets.

4.11 In fact, the HM Treasury publication Public Expenditure Statistical Analyses (2008) shows that for 2006/07 Scotland received less (identifiable) public spending per capita than Northern Ireland and slightly less than London 40. Furthermore, such figures do not include so-called 'non-identifiable' expenditure which, while for the benefit of the UK as a whole, can have a significant positive impact on the location in which they are actually spent or procured. For example, it is forecast that expenditure in preparation for the 2012 Olympic Games in London, deemed by the UK Government to be for the benefit of the UK as a whole, will rise to approximately £1.5 billion a year for each year in 2008/09 to 2010/11. A significant share of this total spend is on infrastructure, such as new transport links and housing, concentrated in the east end of London.

4.12 A number of alternative options lie between independence and devolution max on the one hand and the current fiscal arrangements on the other. Within this spectrum there are a wide range of possible options. These have been examined extensively in the 'Fiscal Federalism' model recommended by the 2006 Steel Commission 41. It is important to note that not all options necessarily imply an increase in real autonomy and the Scottish Government believes that some options, particularly assigned revenues, would in fact diminish devolution.

Assigned Revenues

4.13 Under assigned revenues, the budget available to the Scottish Government would be determined by the amount of revenue collected in Scotland. The Scottish Parliament would not have the authority to alter the tax rate or base but would simply be allocated the taxes raised in Scotland with, or without, the addition of a block grant to provide a top-up and/or degree of equalisation. With no ability to change rates on individual taxes or to alter the base upon which the tax is levied, the Scottish Government would not have the authority to pursue distinctive policies relative to the rest of the UK.

4.14 Not only would this represent no material increase in the autonomy or responsibility of the Scottish Parliament but it would leave Scotland in a worse position in terms of funding than under the current framework - especially with regard to risks and uncertainties arising from day to day changes in tax revenues. Without the ability to respond effectively to these risks, such as through changing tax rates and/or the tax base or greater borrowing autonomy, this would have serious implications for the delivery of public services in Scotland. In effect assigned revenues would be little more than Barnett with greater uncertainty and volatility.

4.15 The Scottish Government believes that this option would have detrimental effects on the provision of public services in Scotland and in the ability of the Scottish Government to deliver a stable policy framework to ensure long-term sustainable growth.

Enhanced Devolution

4.16 It is envisaged that enhanced devolution would give the Scottish Parliament and Scottish Government a greater degree of revenue responsibility coupled with a smaller fiscal transfer from the UK Government and limited authority to borrow. Particular elements of spending and policy responsibility may also be transferred, for example welfare and/or energy policy, but this would depend on the particular circumstances of the revised framework.

4.17 The revenue aspect of enhanced devolution could take one (or a combination) of many forms. The basic principles behind two likely options are outlined below.

  • Under enhanced tax devolution, the Scottish Parliament would be granted the authority to alter the tax rate and/or base for certain taxes, with the UK retaining control of all remaining taxes. This would therefore mean a transfer of some, but not full, fiscal responsibility to the Scottish Parliament. For example, a combination of various business, environmental and personal taxes could be set, collected and administered in Scotland, independently of the rest of the UK - with the UK Government retaining responsibility for all remaining sources of revenue. This model is used extensively elsewhere. For example in Canada, Provinces have responsibilities in income tax, consumption tax, natural resource and property taxation amongst others.
  • An alternative option would be the creation of tax sharing arrangements between the Scottish and UK Governments. Tax sharing occurs when two or more tiers of government split the total national tax yield from a particular tax. For example, the UK Government could conceivably receive 50% of total Scottish income tax receipts for spending on reserved issues with the Scottish Government receiving the remaining 50% to finance devolved spending. Within their respective allocated share, each layer of government could be granted limited authority to vary the tax rate or base. Without this additional policy option, tax sharing would not necessarily increase autonomy and would be more akin to partial assigned revenues. Tax sharing is a popular system of government finance in a number of Federal countries, most notably Germany where the revenue raised from certain taxes is shared between the Federal and Länder Governments.

4.18 A key determinant of real autonomy would be the type of taxes devolved. For example, devolution of corporation tax would represent a far more significant step forward in autonomy than devolution of many smaller taxes such as aggregates levy and betting and gaming duties. Any enhanced devolution framework would have to be consistent with EU State Aid law and EU rules and regulations more generally.

4.19 In summary, the more extensive the authority to vary taxes, the greater the degree of actual fiscal autonomy provided by enhanced devolution.

4.20 Under either form of enhanced devolution, there would be a strong argument for a proportionate increase in borrowing autonomy, particularly to assist in the management of yearly budgets and cash flows. Borrowing autonomy could take a number of forms including:

  • the ability to borrow for certain types of expenditure such as public infrastructure investment but not for others ( e.g. current expenditure such as wages and salaries);
  • the ability to borrow but subject to limits ( e.g. an 'internal' UK Growth and Stability Pact); or
  • full borrowing autonomy.

4.21 In their first annual report, the Scottish Council of Economic Advisers recommended that the Scottish Government explored the possibility of new means of borrowing to help finance public sector infrastructure. In addition, the Council took the view that off-balance sheet transactions should be avoided in favour of cheaper and more transparent methods of financing 42.

'Devolution Max'

4.22 Devolution max - full fiscal autonomy within the UK - would make the Scottish Parliament and Scottish Government responsible for raising, collecting and administering all (or the vast majority of) revenues in Scotland and the vast majority of spending for Scotland.

4.23 By collecting all tax revenues in Scotland, a payment from Edinburgh to London would be required to cover common UK public goods and services ( i.e. 'shared services'). The range of services included in this basket of 'shared services', how they would be paid for, and the authority the Scottish Parliament would have over such policies, would be subject to negotiation at the time of any revised settlement. In essence, this framework is the maximum form of tax and policy devolution short of independence.

4.24 This option broadly reflects the system in Spain for the Basque Country and Navarre. Here, the devolved administrations have responsibility for raising and collecting all direct taxes, including corporation tax, but to conform with EU legislation and retain a largely harmonised social security system, indirect taxes and payroll taxes remain centralised. In addition, the Basque and Navarre Governments pay a contribution to Madrid (the 'cupo') for centralised services such as defence and foreign affairs. The two regions have used their powers to lower certain taxes below that of the rest of Spain, including creating a more competitive tax regime relative to the rest of Spain.

4.25 Whilst devolution max would give the Scottish Parliament greater responsibility for economic policy, a number of factors would continue to constrain fiscal policy under this framework:

  • Intra-national rules and guidelines - In particular, EU laws governing taxation policy both between and within Member States (including EU State Aid Laws). For example, EU directives on harmonisation of sales taxes would require that Scotland did not diverge from UKVAT policy (including rates, allowances and derogations).
  • Rules/agreements with UK Government - In practice, it is likely that even with apparently full fiscal autonomy a range of rules and commitments may exist which are likely to constrain the Scottish Government's ability to pursue fiscal policy that was significantly different from elsewhere in the UK43. These rules might be explicit - for example, limits on annual borrowing requirements - or implicit - as in the case of the 'economic agreement' governing fiscal policy in the Basque Country. Here a series of general principles guarantees a degree of harmonisation between the Basque tax system and the system in the rest of Spain 44.
  • Economic Policy - While devolution max would convey significant fiscal autonomy on the Scottish Parliament, without independence it is likely that certain key aspects of economic policy would remain reserved. For example, financial regulation, employment and competition law are likely to remain centralised at the UK level. Monetary policy would also continue to be set for the UK as a whole.

Independence

4.26 Independence - full fiscal autonomy - would see Scotland with the same responsibility for fiscal and economic policy as other, similar countries.

4.27 This option would return responsibility for raising and collecting all revenues (including North Sea revenues) to the Scottish Parliament, as well as the full range of government expenditures (including welfare and defence). As the government of an independent nation, the Scottish Government would be able to borrow on international capital markets subject to the usual free market constraints faced by other governments.

4.28 Independence would also mean that the Scottish Parliament could determine how it wished monetary policy to be conducted in Scotland. The Scottish Government would retain Sterling on independence and a decision on joining the Euro would be taken based upon economic conditions and only with the approval of the Scottish people in a referendum. This would mean that the decision on the best monetary policy framework for Scotland would be determined by what is in the best interests for Scotland rather than the current situation where the UK Government makes the decision for Scotland.

4.29 In practice, fiscal policy under independence would be subject to intra-national rules and regulations, such as EU directives on competition, tax harmonisation and the EU Single Market. However, unlike the other options outlined above, Scotland's relationship with the international economic and financial community would take place within the context of Scotland acting as an independent sovereign state. Scotland would therefore have the ability to shape and influence policy at the international level ( e.g.EU fisheries policy) - something that is currently not possible.

Summary

4.30 The following table provides a brief summary of the options considered in this chapter:

Table 2 - Fiscal Autonomy: Options for Reform

Principal funding source

Revenue autonomy

Expenditure autonomy

Current framework

Block Grant (Barnett)

Low autonomy

Limited to devolved responsibilities

Assigned revenues

Tax assignment

Low/diminished Autonomy

Limited to devolved responsibilities

Enhanced devolution

Mixture of shared taxes/devolution of taxes

Limited autonomy

(at margin)

Limited to devolved responsibilities

Devolution max

All (or vast majority) of taxes devolved

Significant (subject to EU and UK laws)

Full (except for 'shared services' and certain aspects of economic policy)

Independence

Full spectrum of public finances

Full

Full

4.31 The next chapter will review how well these different options for reform help Scotland to realise its economic potential.