Deconstructing Jack by Edmund SmithNot that you would know it from the present deafening silence: but Scotland is currently in the run up to a decision which is likely to be second in importance, over the past 300 years, only to the recent referendum – namely, whether or not to sign up to the post-Smith fiscal settlement.

The fiscal arrangements which will be put in place in the light of the Smith report will probably play a more important role than any other single factor in determining Scotland’s economic and social future, and also in determining the timing of the next referendum. Despite this, vital details of the fiscal arrangements post-Smith were left unspecified in both the Smith Report and in the Scotland Bill: instead, they are currently being negotiated behind closed doors between the Scottish government and the Treasury. No-one outside of a charmed circle knows what direction these negotiations are taking. But when details of the proposed fiscal settlement do become public, (and that should be well before next May’s Scottish Parliament elections), the Scottish Parliament will have the opportunity to veto the proposals if it wishes. At that stage, it is essential that the Scottish people are fully aware of the implications of whatever is proposed.

This note has been prepared without inside knowledge of the current negotiations. What it does is to look at some of the most likely options for the post-Smith fiscal settlement: and assesses their implications. In doing this it builds upon the modelling work reported on in my Bella paper of 26 June: and also on further work undertaken in relation to evidence given to the House of Lords Economic Affairs Committee in September: (see Reference 1 for more details.)

Let’s start with what we do know about the fiscal arrangements post-Smith, before moving on to the critical details we don’t know. Scotland will have control of certain taxes, (mainly income tax), and will also receive about half of VAT revenues raised in Scotland, (though it will have no control over VAT rates.) In addition to its devolved tax revenues, Scotland will continue to receive a block grant from Westminster. The starting point in calculating the block grant will be the original Barnett formula: but there will be an abatement to the block grant, (that is, an amount will be subtracted from the block grant), to allow for the Scottish tax revenues Westminster will no longer receive.

This abatement will initially be calculated on the principle of “no-detriment”: i.e., to start with it will exactly equal the tax revenues raised in Scotland and foregone by Westminster. The abatement will, however, be increased through time. And one of the critical elements which we don’t know at present is the mechanism by which this abatement will be increased.

What was proposed when the previous UK coalition government set out its plans for implementing Smith was that the abatement in the block grant because Scotland now controls income tax should be increased by a procedure known as Holtham indexation. Holtham indexation involves increasing the abatement each year in line with the growth in the overall UK income tax base. (The indexation methods for the other abatements for VAT etc were not spelled out.) It is useful to look at Holtham indexation under two particular headings: namely, what are the conditions for it to be neutral, and what are the penalties if Scotland fails to meet these conditions. What is meant by this?

Suppose Scotland post-Smith continues with the same income tax rates as the rest of the UK. Then under what circumstances would it continue to receive exactly the same funding, through its own taxes plus the abated block grant, as it would have done if the original Barnett formula had been maintained? (We call this a neutral position.) The answer is that Scotland’s income tax base, (i.e., the sum of taxable incomes in Scotland), would have to grow at exactly the same rate as the tax base in the rest of the UK. This is the condition under which Holtham indexation, as originally proposed, would be neutral.

Are we likely to be in a neutral position? Scotland’s population has historically grown more slowly than that of the rest of the UK: so if this continues, then in order to grow our overall income tax base at the same rate as the rest of the UK, we would have to grow our per capita tax base faster than the rest of the UK. Further, the only way Scotland can grow its income tax base is by growing its economy. However, under the post-referendum settlement, the Scottish government will lack many important economic powers: (the Scottish government will, of course, have no control over monetary policy; it will have control of only a single major tax, income tax; it will have restricted borrowing powers; and it lacks control of competition policy, international trade development, licensing of North Sea oil, utility regulation, and a number of labour market responsibilities). Even worse, growing the economy is a necessary, but not a sufficient, condition for growing the income tax base. Developing a successful industry, (e.g., in renewable energy), might have relatively little effect on Scotland’s income tax base, if all that happens is that the profits of the industry are sent abroad, rather than being spent in the Scottish economy. So it is not just that Scotland lacks economic powers: in addition, it lacks the powers to influence the ownership of Scottish industry, and to encourage profits to be spent and re-invested within the Scottish economy. Given all this, meeting the neutrality condition for Holtham indexation looks an extremely challenging task.

And what happens if Scotland fails to meet this neutrality condition? In this case, public expenditure per head in Scotland would be pushed down to levels well below those in England. In fact, (as shown in Reference 1), if Scotland’s tax base chronically grows at a slower rate than in the rest of the UK, then ultimately public expenditure in the control of the Scottish government would dwindle to nothing, before turning negative. Of course, this won’t actually happen – something would have to give: but this long-term scenario indicates the unsupportable pressures which would start to build up. Overall, therefore, Holtham indexation implies both an inequitable neutrality condition, and the possibility of a grotesquely severe penalty if we fail to meet that condition.

The failure of Holtham indexation to allow for relative population change suggests an alternative approach, denoted here as adjusted Holtham indexation. Under adjusted Holtham, the income tax abatement to the block grant would be indexed in line with the growth in the UK tax base, divided by the relative rate of population growth between the UK and Scotland.

Looked at in terms of the same two criteria, namely, neutrality condition, and eventual penalty, adjusted Holtham performs somewhat better than crude Holtham. The neutrality condition is that the Scottish tax base per head has to grow at the same rate as the per capita tax base in the rest of the UK. The long-term penalty if Scotland grows its per capita tax base at a slower rate than the rest of the UK is that levels of public expenditure per head in Scotland on devolved services would tend to about half of the levels of per capita expenditure on the corresponding services in England: (a proof is given in Reference 1.) While adjusted Holtham may be better than crude Holtham, therefore, it is nevertheless still the case that, given Scotland’s lack of economic powers, both the neutrality condition, and the eventual penalty, appear unacceptable.

Another possible variant of Holtham indexation is known as the Level Deduction method. This was outlined in a paper by Bell and Eiser, (Reference 2), and may well be under consideration in the current negotiations. Under this approach, the increase to the abatement to the block grant on account of income tax would be calculated as the same per capita amount by which income tax revenues in the rest of the UK had increased over the relevant period. In terms of its neutrality condition, this method is exceptionally severe: to be neutral, Scotland would have to increase its income tax base some 14% faster than the increase in the tax base in the rest of the UK. (This arises because Scotland has a significantly smaller income tax base per head than the rest of the UK: so the same per capita change represents a much bigger percentage increase for Scotland.) In terms of the long run penalty if Scotland fails to grow its tax base as fast as the rest of the UK, the penalty under the Level Deduction method is very like the penalty under adjusted Holtham.

So all of the three variants of Holtham indexation which are likely to be under consideration just now are unacceptable. But this is not surprising. Despite all the fine words in the Smith report, what Scotland is actually being invited to take part in is the great Smith handicap race. We will hobble you by denying you the most important economic powers. Then we will set up a fiscal system where you have to engage in an economic race with the rest of the UK. And if you fail to win in that handicap race, then you will be severely penalised. So much for the famous vow.

Viewed in this light, the fundamental flaw in the Smith fiscal settlement becomes very clear. The logic of the union contains an implicit bargain. Yes, you will have less economic powers: but in exchange for that, you will have various benefits. And one of the benefits, explicitly stated in the vow, was the Barnett formula. But under Holtham type indexation arrangements, to attain neutrality of funding with the Barnett formula we have to match, or outperform the rest of the union – despite our lack of economic powers. Smith, in combination with Holtham, in effect breaches the bargain implicit in the union.

It need not be thus. There is no law of nature which says that outperforming the rest of the UK has to be part of the deal if we want to benefit from the union. An alternative approach to adjusting the abatement to the block grant would, for example, involve increasing the abatement by some fixed percentage increment in real terms every year. More details of such an arrangement are set out in Reference 1. It is not ideal: but then, no arrangement is going to be ideal within the constraints of the current unbalanced union. But it would be a good deal better than any of the possible Holtham variants.

For present purposes, however, what we need to do is to be fully conscious of the magnitude of the decision which will have to be taken on the Smith fiscal settlement: to be ready to scrutinise the final proposals rigorously when they emerge from the current negotiations: and to stand ready to veto them if necessary. And when we are looking at the final proposals, two of the key aspects we should be checking are: what are the neutrality conditions, and what are the penalties if we fail to meet them.

Reference 1. J. Cuthbert. “Note for House of Lords Economic Affairs Committee following evidence session on 9th September”: accessible at

Reference 2. D. Bell and D. Eiser: “How should the Barnett formula be adjusted to reflect devolved taxes”: posted on Scottish Fiscal and Economic Studies website, 20 November 2014.