Fiscal Framework Review: Independent Report

Executive summary

The devolution of tax and social security responsibilities has required adjustments to be made to the Scottish Government's block grant. The Smith Commission's Agreement, which recommended the tax and social security powers to be devolved, also identified a number of principles it believed should guide the operation of the Scottish Government's fiscal framework following tax and spending devolution, including these block grant adjustments (BGAs).

This report evaluates the current and alternative methods for calculating BGAs. It assesses the extent to which different methods for calculating BGAs are consistent with the Smith Commission's principles. It also considers the balance of fiscal risks and incentives faced by the Scottish Government under the different BGA approaches, and whether these differ from the balance of fiscal risks and incentives under the Barnett formula, which continues to be used to calculate the underlying Scottish block grant.

Main conclusions

1 The BGAs must be indexed to the change in equivalent revenues or spending in the rest of the UK (rUK) if the principles identified by the Smith Commission are to be met in broad terms. Indexing the BGAs to some other variable will result in outcomes that are inconsistent with the Smith Commission's principles. The key questions then are how to measure the change in equivalent rUK revenues/spending, and what adjustments to make, if any, to account for differences in fiscal and/or demographic structures and trends between Scotland and rUK.

2 No single BGA method can simultaneously achieve all of the Smith Commission's principles in full, especially when the 'no detriment' principle is interpreted dynamically, as some of the principles are mutually incompatible with each other.

3 The fundamental tension is between the taxpayer fairness principle on the one hand, and the no detriment principle on the other. Achieving the taxpayer fairness principle requires that BGAs are indexed using the 'Barnett Formula' (or 'Levels Deduction') approach, which changes the Scottish Government's BGAs in line with a population share of the change in equivalent rUK revenues or spending. But this approach takes no account of Scotland's generally lower revenues per capita, or higher spending per capita, compared to rUK. As a result, its application would tend to cause detriment to the Scottish budget over time, in a way that would not be compatible with the 'no detriment' principle in a dynamic context in the years following devolution. The Smith Commission's reference to 'appropriate indexation' when defining the 'no detriment' principle suggests they saw this principle dynamically.

4 The two BGA methods for tax cited in the existing Fiscal Framework achieve the different Smith Commission principles to varying extents. While neither fully satisfy the 'taxpayer fairness' principle, the CM method is closer to satisfying it, as it treats population growth in the same way as the Barnett formula.

5 In contrast, the IPC method arguably better satisfies the 'no detriment' principle in the years following devolution as it adjusts for the fact that relative population growth – which the Scottish Government may have little control over – is an important determinant of aggregate tax revenue growth.

6 Both the CM and IPC methods broadly achieve the economic responsibility principle, although the CM method achieves it more comprehensively. This is because, unlike IPC, the CM approach does not insulate the Scottish budget from the effects that its policies might have on revenues via increases or decreases in population.

7 The IPC method is arguably more consistent with the principle that the UK government should bear the risk of shocks affecting the whole of the UK. This is because a common shock across the UK as a whole is more likely to have a common effect on revenues or spending per capita, rather than aggregate revenues or spending.

8 The existing Fiscal Framework for social security cites two approaches for indexing the social security BGAs: IPC and the Barnett Formula. The Barnett Formula approach is not consistent with the 'no detriment' principle in its dynamic sense (post devolution), since it takes no account of differences in initial spending per capita, or in relative population growth. The taxpayer fairness principle does not apply directly to social security, but only a Barnett Formula approach – adopted for both tax and spending BGAs – will be fully consistent with the taxpayer fairness principle.

9 Similar to the conclusion on tax, when it comes to social security, IPC slightly better achieves the economic shock principle, whilst the Barnett Formula slightly better achieves the economic responsibility principle

10 A number of alternative BGA mechanisms for tax have been proposed. These take into account the implications for revenue and spending growth of factors such as: differences in the structure of the Scottish and rUK tax bases at the point of devolution; and differences in the rate of change of population age structure between Scotland and rUK post-devolution. These approaches generally come closer to achieving the 'no detriment' principle in the period after devolution, since they control for factors which are known about with reasonable certainty before devolution happens, and which the Scottish Government has relatively little influence over. However, such approaches would generally violate the 'taxpayer fairness' principle to a greater extent than existing approaches, since they would imply even larger effects on the Scottish budget of tax changes in rUK for taxes which are devolved in Scotland.

11 There may be a case in principle to incorporate some element of fiscal insurance explicitly into the BGA process. But it is very difficult to design a fiscal insurance mechanism that would work satisfactorily in practice once tax policy divergence exists, in particular risking violating the Smith Commission's 'economic responsibility' principle.

12 The extent to which some approaches are preferred over others may ultimately depend on one's views of the type of fiscal union that exists between Scotland and rUK in respect of taxes and social security benefits that are devolved. In particular, the extent to which the continuation of some revenue pooling and sharing of 'devolved' taxes is appropriate after devolution, and the extent to which the implications of divergent economic growth in Scotland should be borne in full by the Scottish budget.

13 Given that no single BGA method can achieve all Smith Commission principles simultaneously, the process of selecting a specific BGA to use in the Scottish Fiscal Framework will inevitably require some compromise. Both governments should aim to set out transparently the rationale for whatever compromise solution is ultimately agreed, and the implications of that for the way in which various fiscal costs and risks are shared.