Scotland's Fiscal Outlook: the Scottish Government's five-year financial strategy

6. Funding Outlook

6.1. As explained in Chapter 2, the way in which the Scottish Government is funded is changing significantly and as a result the Scottish Government's overall budget is increasingly influenced by the performance of the Scottish economy.

6.2. In 2015-16, almost all of the Scottish Budget came from the UK Government via a block grant. In 2016-17, this had fallen to around 80 per cent and in 2017-18 to 60 per cent. It is expected to fall further following the assignment of VAT in 2020‑21.

Range of factors and uncertainties affecting the funding outlook

6.3. As the Scottish Government moves away from being funded primarily through the block grant to a combination of devolved taxes and the block grant, the number of variables which will affect its longer term funding outlook will increase. UK Government spending decisions will continue to affect the Scottish Budget but, as well as these, Scottish Government policy and the relative performance of the Scottish economy will play increasingly important roles.

6.4. One of the most important parts of the new Fiscal Framework is the Block Grant Adjustment for the devolved taxes. This means that the Scottish Budget is not dependent on the total amount of tax raised through devolved taxes, but rather on whether Scotland is raising relatively more or less tax than the rest of the UK.

6.5. Broadly speaking, therefore, under the Fiscal Framework there are three key determinants that can impact upon the Scottish Budget either positively or negatively. All of these relate in some way to UK Government policy, and so are not entirely within the control of the Scottish Government:

• Changes in UK Government spending – the block grant from the UK Government remains the single largest source of funding for the Scottish Budget. Changes in the grant are determined by changes in the spending of UK Government Departments through the Barnett formula, and so remain entirely outside the control of the Scottish Government;
• UK Government fiscal policy – changes in UK Government tax policy can result in UK Government tax receipts growing at different rates from devolved tax receipts. For example, increases in property taxes in England may result in property tax income increasing faster in the rest of the UK than in Scotland, which would reduce the size of the Scottish Budget. As this occurs as a result of UK Government policy, it is outside the Scottish Government's control; and
• Scottish tax revenue relative to the rest of the UK – through the Block Grant Adjustment process, the Scottish Budget is determined by the relative amount of tax raised in Scotland compared to the rest of the UK. If the Scottish Government can successfully grow tax revenue per head for devolved taxes faster than in the rest of the UK, through better economic performance, its budget will increase. If the Scottish Government makes tax policy decisions which increase or decrease tax revenue, these will also increase or decrease the Scottish Budget.

6.6. Further uncertainty in the funding outlook is introduced through the forecast process itself and through divergence in economic performance. Risks around Scottish Government income differing from forecast can be twofold:

• Scottish devolved tax is different from forecast; or
• the rest of UK tax is different from forecast.

6.7. If Scottish and UK taxes are both different from forecast by the same amount, the Scottish Government income should be unaffected. However, it should be recognised that there is an additional risk in forecasting Scottish taxes, as there is a greater lag in data becoming available for Scotland, with the latest Scottish Fiscal Commission ( SFC) forecasts of income tax currently based on 2015-16 data.

6.8. Tax forecasts are often linked to economic forecasts. Economic variables such as employment and incomes will be important in determining decisions such as whether households decide to purchase a house, or whether businesses choose to invest. For example, the income tax forecast can be affected by a range of potential factors including:

• relative employment growth;
• relative wage growth;
• changes in income distribution in Scotland and the rest of the UK; and
• impact of policy changes.

6.9. To this extent, the tax forecasts are often viewed as being closely linked to the economy forecast, with the overall business cycle effects on employment and wage growth likely to be key drivers in the short term, although other factors such as the distribution of incomes and policy choices also play a role. Towards the end of the five year period, longer term underlying trends such as productivity, demographics, and labour market participation may also begin to affect the forecast.

6.10. It should be noted that, while tax receipts can vary, the impact on the Scottish Budget is driven by the scale of any changes relative to any changes in the rest of the UK on a per capita basis.

6.11. While the Scottish and UK economies have historically tended to follow similar paths, they do on occasion diverge. Recent data suggests that they are in a period of divergence at the moment across several areas, with GDP growth, earnings growth and employment growth currently weaker in Scotland. For example, in 2017 the Scottish economy grew by 0.8 per cent, compared to 1.8 per cent for the UK, and although employment grew in Scotland by 0.3 per cent over the year, this was slower than the 1 per cent for the UK. However, the most recent GDP figures showed UK growth of only 0.1 per cent for the first quarter of 2018, which suggests that previous growth forecasts for the UK may have been optimistic.

6.12. It is difficult to assess if and for how long this divergence will continue and to what extent it will impact on the Scottish Budget. As set out in Chapter 5, growing the economy and tax base are key priorities for the Scottish Government. These are reinforced by Scotland's Economic Strategy which presents the strategic plan for existing and future Scottish Government policy, offering a cohesive platform for building economic policy. The Scottish Government is taking a wide range of actions to build and support the Scottish economy through building high quality infrastructure, creating opportunities, driving ambition and supporting entrepreneurial talent and innovation.

6.13. The economic picture is complex. Income tax per head in Scotland has historically been lower than in the UK as a whole, representing a difference of income distributions, with relatively fewer additional rate taxpayers in Scotland.

6.14. This difference can in part be explained by the downturn in the oil and gas industry over this period. Recent evidence suggests that this sector is returning to growth. The divergence may be partly offset by the introduction of a lower higher-rate income tax threshold in Scotland in 2017-18 which would increase Scottish receipts.

Latest forecasts

6.15. The forecasts used to inform the economic modelling change over time and the Scottish Fiscal Commission has produced an updated set of forecasts alongside the publication of this document.

6.16. Table 6.1 (below) shows the SFC forecasts that were produced for the 2018-19 Scottish Budget and updated in February 2018 to reflect changes in income tax policy and compares these to the Block Grant Adjustment figures that were provided by the UK Government as part of the UK Autumn Budget 2017.

Table 6.1 – February 2018 Forecasts for Revenue and Block Grant Adjustment (as at Budget Act 2018)

£m		2016-17	2017-18	2018-19	2019-20	2020-21	2021-22	2022-23
Income Tax	Revenue forecast	11,214	11,584	12,177	12,647	13,152	13,733	14,372
	BGA forecast	11,214	11,523	11,749	12,056	12,477	12,936	13,403
	Difference	0	61	428	591	675	797	969
LBTT	Revenue forecast	483*	557	588	628	668	707	748
	BGA forecast	534*	591	600	622	650	682	689
	Difference	-51	-34	-12	6	18	25	59
SLfT	Revenue forecast	148*	137	106	88	90	82	82
	BGA forecast	131*	104	94	86	79	75	71
	Difference	17	33	12	2	11	7	11
TOTAL	Revenue forecast	631	12,278	12,871	13,363	13,910	14,522	15,202
	BGA forecast	665	12,218	12,443	12,764	13,206	13,693	14,163
	Difference	-34	60	428	599	704	829	1,039

Note 1: At the UK Spring Statement 2018, no BGA information from HM Treasury was available beyond 2021-22. The 2022-23 BGA data has been calculated by the Scottish Government.
Note 2: *The 2016-17 LBTT and SLfT revenues and Block Grant Adjustment figures are outturn figures.
Note 3: Figures may not sum due to rounding.

6.17. Since then, the UK Government has provided updated Block Grant Adjustment figures at the UK Spring Statement 2018 and the SFC has now published their updated revenue forecasts to accompany the publication of this document. Table 6.2 details the latest revenue forecasts provided by the SFC in May 2018 and the latest Block Grant Adjustment estimates from the 2018 UK Spring Statement.

Table 6.2 – May 2018 forecasts for Revenue and Block Grant Adjustment

£m		2016-17	2017-18	2018-19	2019-20	2020-21	2021-22	2022-23
Income Tax	Revenue forecast	11,267	11,467	11,969	12,345	12,805	13,335	13,936
	BGA forecast	11,267	11,626	11,930	12,215	12,612	13,015	13,531
	Net Difference	0	-159	39	130	193	320	405
LBTT	Revenue forecast	484	550	614	656	697	738	781
	BGA forecast	534	586	588	606	630	656	689
	Net Difference	-50	-36	26	50	67	82	92
SLfT	Revenue forecast	148	142	114	93	95	87	87
	BGA forecast	131	104	106	91	81	77	71
	Net Difference	17	38	8	2	14	10	16
TOTAL	Revenue forecast	11,899	12,159	12,697	13,094	13,597	14,160	14,804
	BGA forecast	11,932	12,316	12,623	12,912	13,323	13,749	14,291
	Net Difference	-32	-157	74	182	274	411	513

Note: Figures may not sum due to rounding.

6.18. These revised estimates for income tax revenues and Block Grant Adjustments for 2017-18 and 2018-19 do not have any immediate impact on the Scottish Budget. Under the Fiscal Framework, Block Grant Adjustments ( BGA) for income tax are fixed for a financial year based on the forecast at the previous fiscal event: for the 2018-19 budget the net revenues for that year were fixed based on the BGA and tax forecast in autumn 2017.

6.19. Final revenues and Block Grant Adjustments for income tax are recalculated when outturn data is available and a budget adjustment agreed at that point. In the case of income tax, this reconciliation will only take place with a considerable lag. For example, outturn data for Scottish income tax revenues in 2017-18 will not be available until July 2019, with the impact of any reconciliation being applied in the 2020-21 Scottish Budget.

6.20. The updated forecasts for future years provide an indication of the level of revenues that the SFC anticipates, but these figures will not be used to set the 2019-20 budget in December 2018, as that will make use of the next set of forecasts that the SFC produces.

Approach to modelling the funding outlook

6.21. Other countries have developed medium term financial reporting and have generally used some form of scenario or sensitivity analysis to forecast available funding, based on levels of risk and forecast errors measured on a combination of economic and fiscal variables.

6.22. Modelling Scottish Government funding scenarios is more challenging as the Fiscal Framework is still very new and there is limited information to consider on the performance of forecasts relative to outturn data. In addition, under the current UK Government Spending Review, the UK Government has not yet set budgets for UK Departments and Devolved Administrations beyond 2019-20 (2020-21 for capital), but has indicated an intention to set out an updated plan for the overall UK public spending envelope at the Autumn Budget in 2018 and to undertake a Spending Review in spring 2019.

6.23. The Scottish Government has undertaken economic modelling to develop a scenario analysis based on forecasting potential levels of funding available over the next five years and aggregating these to produce a path for total potential funding. This sets out a central scenario and then quantifies the uncertainty around the central scenario to produce upper and lower ranges.

6.24. The central funding scenario includes the following elements:

• resource budget limit (excluding new social security funding);
• social security funding;
• capital budget limit;
• Financial Transactions;
• Block Grant Adjustment;
• income from devolved and assigned taxes; and
• capital borrowing.

6.25. The economic modelling looks directly at the evidence on historical variations in the individual factors determining the Scottish Budget, such as Barnett consequentials or differences in per person income tax growth rates in Scotland and the rest of the UK. These historical variations are used to build up a probability of such differences continuing, and their impact on the Scottish Budget. The estimated uncertainty is then used to present fan charts around the central forecast. Further detail is presented in Annex B.

6.26. This modelling approach assumes that the current Fiscal Framework methodology (indexed deduction per capita) is used across the entire five year period.

6.27. It should be noted that there are a number of risks to the Scottish Budget which have not yet been captured within this modelling and scenario development, such as the assignment of VAT which will impact on the Scottish Budget from 2020-21. It is expected that further information will be built into modelling in future years as information and understanding increases, including future UK Government funding once a new Spending Review is undertaken.

Paths for the Medium Term Financial Strategy

6.28. Chart 6.1 illustrates the forecast path for the potential overall Scottish Budget. By 2022-23, the budget is forecast to reach £37.6 billion, within a likely range of between £35.5 billion and £39.7 billion. While this represents the most likely upper and lower range, there is a chance that the final budget will lie outside this range.

6.29. This 2022-23 figure includes £3.6 billion associated with the devolution of social security powers. As this additional funding is accompanied by new social security responsibilities for the Scottish Government, this increased funding will not be available for use in other areas. This social security directed funding will increase from 2019-20 onwards, with a particularly large increase in 2021-22 when the powers for some of the major benefits are expected to be devolved to Scotland.

Chart 6.1 – Outlook for the overall Scottish budget

6.30. The model uses the following assumptions for estimating the net impact of the newly devolved revenues on the Scottish Budget ( i.e. the difference between Scottish revenue and the corresponding Block Grant Adjustment ( BGA)). For the years up to and including 2018-19, we use the agreed Scottish Budget positions for each Budget Act. For income tax, these forecasts will not be revised until forecasts are reconciled to outturn data in 2020-21 and 2021-22 respectively.

6.31. For 2019-20 onwards, we use the May 2018 Scottish Fiscal Commission forecast for each devolved tax. The BGA forecast data used is based on the UK Government 2018 Spring Statement forecasts. The figures covering 2019-20 until 2022-23 are included in Table 6.2 and these figures will all be updated prior to the next Scottish Budget.

6.32. Table 6.3 illustrates this devolved tax and BGA data for 2016-17 to 2022-23 that has been used in the central scenario.

Table 6.3 – Revenue and Block Grant Adjustment in the Central scenario (£m)

£m		2016-17	2017-18	2018-19	2019-20	2020-21	2021-22	2022-23
Income Tax	Revenue	4,900	11,857	12,177	12,345	12,805	13,335	13,936
	BGA	4,900	11,750	11,749	12,215	12,612	13,015	13,531
	Net Difference	0	107	428	130	193	320	405
LBTT	Revenue	538	507	588	656	697	738	781
	BGA	500	545	600	606	630	656	689
	Net Difference	38	-38	-12	50	67	82	92
SLfT	Revenue	133	149	106	93	95	87	87
	BGA	100	119	94	91	81	77	71
	Net Difference	33	30	12	2	14	10	16
TOTAL	Revenue	5,571	12,485	12,871	13,094	13,597	14,160	14,804
	BGA	5,500	12,414	12,443	12,912	13,323	13,749	14,291
	Net Difference	71	71	428	182	274	411	513

Note 1: Tax revenues for 2016-17 to 2018-19 are as agreed in respective Scottish Budget Acts and from 2019-20 onwards are the May 2018 SFC forecasts.
Note 2: BGA forecasts for 2016-17 to 2018-19 are specified by HM Treasury ( HMT) at the time of agreeing the respective Scottish Budget Acts. From 2019-20 onwards these are the latest forecasts provided by HMT at the Spring Statement 2018.
Note 3: 2016-17 income tax revenue forecast: in this year the Scottish Rate of Income Tax applied. Full Scottish income tax powers took effect from 2017‑18. This explains the substantial increase in forecast revenues between 2016-17 and 2017-18.
Note 4: Figures may not sum due to rounding.

6.33. While indicative estimates of Scotland's net budget position, such as those shown in Tables 6.1, 6.2 and 6.3, may provide an indication of the direction of travel and potential scale of the final reconciliation, significant uncertainties remain, as experience shows that forecasts are subject to considerable change between fiscal events.

6.34. In addition, forecasts of Scottish receipts are produced by the Scottish Fiscal Commission while the Block Grant Adjustment is determined by forecasts of growth in receipts from the rest of the UK as provided by the OBR. This introduces an additional element of uncertainty, as there are many factors that may contribute to differences in these forecasts, some of which are unrelated to different views about the outlook for the Scottish and UK economies. For example, the OBR and SFC produce these forecasts at different times using different methodologies, assumptions and input data.

6.35. Once outturn data is published a reconciliation and a budget adjustment are agreed for the financial year thereafter. The Scottish Government will subsequently manage any negative or positive variance from the initially agreed budget position. The Scottish Government will closely monitor any risks arising from the net BGAs.

6.36. Chart 6.2 illustrates the potential path for the total resource budget. The increase in the resource budget in 2021-22 associated with additional social security powers is visible in the projection.

Chart 6.2 – Outlook for resource budget (including social security)

6.37. The potential path for the resource budget excluding funding for the new social security powers has also been considered and Chart 6.3 illustrates that. The profile for growth in 2021-22 is noticeably flatter than for overall resource spend. The risks are proportionately similar to the overall resource budget, with a range of ±£1,095 million.

Chart 6.3 – Outlook for resource budget (excluding social security)

6.38. Chart 6.4 illustrates the potential path for the capital budget excluding Financial Transactions. This is symmetric around the central forecast, at ±£240 million by 2022-23. This variation in the earlier years is smaller as we already have allocated capital budgets out to 2020-21, which could still vary due to spending decisions by the UK Government. The variation in later years reflects the uncertainty over funding levels ahead of the next UK Spending Review in 2019.

6.39. The capital budget also assumes that full capital borrowing (£450 million) will be undertaken in 2019-20, but that no commitment on capital borrowing has been included at this stage for any years beyond 2019-20.

Chart 6.4 – Outlook capital budget (excluding Financial Transactions)

Table 6.4 – Summary OUTLOOK FOR the Medium Term Financial Strategy, with upper and lower ranges (£m)

	2018-19	2019-20	2020-21	2021-22	2022-23
OVERALL BUDGET 1
Upper range	33,035	34,373	35,770	38,621	39,736
Central scenario	32,212	33,024	34,110	36,661	37,555
Lower range	31,704	32,201	33,026	34,774	35,447
Resource budget 2
Upper range	28,238	28,736	30,355	33,214	34,189
Central scenario	27,860	28,129	29,510	32,070	32,824
Lower range	27,481	27,522	28,664	30,926	31,458
Of which, new social security
Upper range	298	528	1,738	3,689	3,872
Central scenario	290	507	1,649	3,466	3,602
Lower range	282	486	1,560	3,243	3,332
Capital budget 3
Upper range	3,993	4,592	4,333	4,324	4,464
Central scenario	3,863	4,376	4,095	4,086	4,226
Lower range	3,733	4,160	3,857	3,848	3,989
Financial Transactions
Upper range	804	1,044	1,083	1,083	1,083
Central scenario	489	519	505	505	505
Lower range	489	519	505	0	0

Notes: 1 Overall budget: Total Scottish Government funding excluding non-cash elements.
2 Resource budget: Fiscal Resource Budget limit and the net Block Grant Adjustment; updated for the Scottish Rate Resolution; including additional adjustments for NDR, Scotland Act Implementation, Migrant Surcharge, Queen's and Lord Treasurer's Remembrancer ( QLTR), Rail Resource Grant; and social security funding.
3 Capital budget: Capital Budget limit plus Capital Borrowing.

Table 6.5 – Summary OUTLOOK FOR the Medium Term Financial Strategy, with upper and lower ranges (£m) – expressed in real terms (at 2018-19 prices*)

	2018-19	2019-20	2020-21	2021-22	2022-23
OVERALL BUDGET
Upper range	33,035	33,841	34,642	36,764	37,142
Central scenario	32,212	32,514	33,033	34,898	35,104
Lower range	31,704	31,703	31,984	33,102	33,133
Resource budget
Upper range	28,238	28,292	29,397	31,617	31,957
Central scenario	27,860	27,694	28,578	30,528	30,681
Lower range	27,481	27,097	27,760	29,439	29,405
Of which, new social security
Upper range	298	520	1,683	3,512	3,619
Central scenario	290	499	1,597	3,299	3,367
Lower range	282	478	1,511	3,087	3,114
Resource budget (exc Social Security)
Upper range	27,940	27,780	27,722	28,112	28,360
Central scenario	27,570	27,203	26,990	27,235	27,336
Lower range	27,199	26,626	26,257	26,358	26,312
Capital budget
Upper range	3,993	4,521	4,196	4,116	4,173
Central scenario	3,863	4,308	3,966	3,889	3,950
Lower range	3,733	4,096	3,735	3,663	3,729
Financial Transactions
Upper range	804	1,028	1,049	1,031	1,012
Central scenario	489	511	489	481	472
Lower range	489	511	489	0	0

*Using HM Treasury GDP Deflators as at 3 April 2018

What does this modelling indicate?

6.40. The central scenario analysis suggests that, by 2022-23, the Scottish Budget (excluding non-cash and Annually Managed Expenditure) could be around £37.6 billion.

6.41. The scenario modelling indicates that the potential range for this could be between £35.5 billion and £39.7 billion, reflecting potential growth in the Scottish Budget between 2017-18 and 2022-23 of between £4.2 billion and £8.4 billion (in cash terms).

6.42. The range of this variability amounts to around ±6 per cent of the overall budget. This reflects the uncertainty around the block grant and Scottish devolved tax income and the impact of economic uncertainty around the UK's exit from the EU, but also highlights how differences can cumulate over a relatively short period.

6.43. As Chapter 5 sets out, the Scottish Government is committed to the delivery of our Economic Strategy and on improving overall Scottish economic performance and ensuring revenues are towards the upper end of the forecasts. We are seeing positive results as our economic approach builds momentum and now see a number of positive economic indicators in Scotland including on foreign direct investment, productivity growth, international goods exports and R&D spending growth. This includes:

• the number of VAT/ PAYE registered businesses increasing to 176,400 in 2017 – the highest figure since the time series began (in 2000);
• Scotland securing 122 Foreign Direct Investment ( FDI) projects in 2016, more than any part of the UK outside London for the fifth year in a row; and
• all three of Scotland's largest cities (Glasgow, Edinburgh and Aberdeen) being in the UK's top 10 for numbers of FDI projects secured.

6.44. The analysis also suggests that the single largest source of variance in the Scottish Budget is likely to be the Block Grant Adjustment. Uncertainty around the Block Grant Adjustment is estimated at around ±£930 million by 2022-23, while uncertainty around Barnett consequentials, social security and Financial Transactions taken together is around ±£1,200 million.

6.45. As new data on income tax becomes available and as new Scottish Fiscal Commission forecasts are issued, these figures will be subject to change.

6.46. As mentioned earlier, there are also a number of variables in the Scottish Budget that are not yet captured, such as the assignment of VAT, which will impact on the Scottish Budget from 2020-21.

6.47. Annex B describes some of the background information and assumptions used to produce this modelling approach.