Show us the money

There was a moment at the SNP conference in Perth that seemed to shine a spotlight onto one of the Scottish Government’s most important figures.

It was during Alex Salmond’s farewell speech to the party – his last as First Minister. The outgoing FM listed the policies he was most proud of – the council-tax freeze, ‘1,000 extra police’, cuts to business rates and free education. 

Then: “All this, friends, is thanks to a financial magician at the heart of Government. Let’s hear it for a man who it has been my privilege to work alongside, Scotland’s Merlin – John Swinney – the only Finance Minister in Europe who has successfully operated a balanced budget.”

Magician may not have been the word that Swinney himself would have used but the response from the hall was clear, with party members giving the Cabinet Secretary for Finance and Sustainable Growth a loud and sustained round of applause.

But while the Government has boasted of ‘balanced books’ for the past seven years, the claim is slightly misleading.

After all, with the power to raise revenue having been reserved to Westminster, the Scottish Government’s role has – at least in the past – always been limited to spending revenues, not collecting them. John Swinney could not rack up a debt even if he wanted to.

But the budget is still, nevertheless, under pressure – with austerity measures introduced by the UK Chancellor flowing downstream to Scotland and impacting on spending decisions.

Fiscal Affairs Scotland has examined the effect of future spending cuts and their impact on the Scottish budget. 

Its report shows that while the first decade of the Scottish Parliament’s life saw the Scottish budget increase by about five per cent in real terms each year, those that followed have coincided with a drop in spending of around two per cent every year. 

In fact with the UK Government now only halfway through its planned spending cuts – with an eventual view towards a balanced budget – the pain is likely to worsen for the foreseeable future.

The report states: “Both Scotland and the UK are in the midst of a revolutionary change in terms of the path and composition of its public sector budget. This is the first time post-World War II that budgets have declined, in real terms, over an extended period. 

“We are only halfway through this transitionary phase and while budgets may then start to rise, most will remain at funding levels very much lower than at their 2009-10 peak. This means our governments will also need to think in more ‘revolutionary’ terms about how public services in the future are best provided. We may have to reset our spending priorities to accord better with what we can afford, or be willing to pay through increases to general taxation. 

“Even the NHS budget, protected as it has been, appears to be under threat, as it tries to keep up with underlying demand pressures and meet key delivery targets.”

In short, the next few years look to be pretty gloomy in terms of public spending.

As Fiscal Affairs Scotland executive director John McLaren puts it: “For the first decade of devolution public services in Scotland benefitted from unusually large annual increases in the level of funds available. This feast turned into a famine in the devolved Parliament’s second decade, with budgets seeing year-on-year cuts on an unprecedented scale. At present we are only halfway through this period of rapid adjustment. Future cuts, coming as they do on top of already deep retrenchment of budgets, and being concentrated on day-to-day spending rather than on investment, may be even harder to manage than in the past.”

And the situation is further complicated by the prospect of further devolution, with new revenue-gathering powers already on their way as part of the changes brought by the 2012 Scotland Act.

Revenue Scotland – the new non-ministerial body – will come into existence in April 2015, responsible for administering landfill tax and Land and Building Transaction Tax (formerly known as stamp duty). 

Then, in April 2016, the Parliament will be given the power to vary key income tax rates – reducing the 20 per cent, 40 per cent and 45 per cent bands by up to 10 pence in the pound and with no upper limit on any increase. 

During the Smith Commission, everyone is talking about what taxes to devolve, but no one is thinking about the less sexy question, but equally important one, of how to devolve them, and what the purpose of that devolution is.

However, this would not apply to savings income and the revenue will still be collected by HMRC, not Revenue Scotland. 

These changes alone give the Scottish Government new borrowing powers, but with the Smith Commission the transfer is set to go further. Exactly which new powers will be devolved is yet to be seen.

Speaking to Holyrood, Elspeth Orcharton, director of taxation for the Institute of Chartered Accountants Scotland (ICAS), emphasised the difference in scale between the changes brought by the 2012 Act and those that are being talked about within the Smith Commission. 

She said: “The tax changes brought by the 2012 Act are simpler because you have a certain tax base – if you are buying or selling a house in Scotland there is no debate over where the house is – but they have also managed to build on the systems that are already devolved in Scotland, for example, through the Land Registry. So it is these pre-existing structures that allow Revenue Scotland to be run by 30 or 40 people. HMRC at the moment has something like 60,000 for the whole of the UK, so there are completely different scales between the two.”

Another part of the ‘vow’ – pledging further devolution – was a promise to maintain the Barnett formula. But if Scotland is given further revenue-raising power, what will that mean for the block grant? The Smith Commission will devolve further areas of taxation and spending – including handing over control of new areas of welfare – so how will the Barnett formula need to change to accommodate that?

To David Phillips, Senior Research Economist at the Institute for Fiscal Studies (IFS), the details of how further revenue-gathering power is devolved will be crucial. 

Speaking to Holyrood, he said: “During the Smith Commission, everyone is talking about what taxes to devolve, but no one is thinking about the less sexy question, but equally important one, of how to devolve them, and what the purpose of that devolution is. Talk is focused on the particular powers, not how to hand over these powers and how to give them in a way that gives Scotland the control it needs to boost the economy. 

“Only some taxes are devolved and Scotland has less freedom than Westminster to change other taxes to make up for potential shortfalls. If they devolve income tax and revenues fell then the UK Government can change National Insurance, whereas the Scottish Government cannot, so devolution has to work in a way to stop Scotland taking risks that it cannot mitigate.”

He adds: “The precise ways that you devolve the tax and the adjustments to make to the Barnett formula and the block grant affects the types of risks faced by the Scottish Government. When you devolve a tax you need to reduce the block grant to account for the fact that Scotland is now keeping those tax revenues itself, rather than them going to Westminster. You have got to reduce the block grant – you can’t get the same grant and keep the tax revenues.” 

One option would be to adjust the Barnett formula so that Scotland takes the full risk of gathering revenues. In this scenario, if tax revenues rise faster than public spending, Scotland would have more money relative to its situation before devolution. If tax revenues go up less than devolved spending, Scotland would be worse off. This comes with risks: during a recession income tax revenues could collapse and Scotland would lose out. This is what the IFS calls devolving the full risk.

A second option would be to tie the block grant reduction to changes to tax revenues in England – meaning only a relative risk for the Scottish Government. 

Phillips says: “Say, for instance, that initially the block grant reduction is £2 billion and that tax revenues in England from that same tax go up ten per cent, the next year that block grant reduction would go from £2 billion to £2.2 billion. Now if revenues in Scotland go up more, to £2.3 billion, then Scotland is better off – it is gaining £100 million compared to not having devolution. If on the other hand the revenue goes up less, to £2.1 billion, Scotland has lost £100 million. 

“What this would mean is Scotland bearing the relative risk from the devolution of tax revenues, not the full risk. So the UK Government bears the risks of the economic cycle – of boom or bust – while the Scottish Government would bear the risk of Scotland being better or worse than the UK average due to its tax policy.”

Whatever approach is taken, the changes will be complex. And with the Smith Commission forced to operate to a very tight timetable, creating an airtight system that the public accepts will be a real challenge. The timeframe is a concern because of the complexity of the system involved, with experts long frustrated by constant tinkering by politicians.

Orcharton says: “One of the things that ICAS has come up with is that, whatever the outcome is, it is really sensibly timeframed – that there is a road map to say this is the direction and manage everyone’s expectations.”

She adds: “There are a number of things to consider here – one is that there has been a strong will to promise things to voters and we are not sure that expectations have been properly managed as to when the voters will see these changes – because nothing new can be brought in by 2016.”

Concerns over the timeframe are echoed by Akash Paun, Fellow at the Institute for Government, who suggests looking at previous devolution as a guide for future changes to revenue-gathering powers.

“The last Scotland Act was passed in 2012 and the first tax powers are coming in April – that took years for some pretty minor taxes in fiscal terms – and then the income tax-varying powers are coming a year after that, so it gives a sense of the sort of timeframe you might be looking at. That was four years just to do that so if it is more complicated form of devolution then you might surmise it would take even longer than that.”

Just how much longer, though, depends on the amount of power that is devolved. With recommendations varying enormously between different proposals, the Scottish public – along with John Swinney – must wait and see.