Deconstructing Jack by Edmund SmithIn my Bella article of 16th November (‘Time to get ready for the second biggest decision in 300 Years‘), I pointed out the importance of the decision which will have to be taken shortly on the post-Smith fiscal settlement: and the dangers for Scotland of a wrong decision. Since then, there have been two important public developments. One is the publication on 20th November of the House of Lords Economic Affairs Committee Report on the implications of financial devolution. This report argued that the fiscal settlement was so important that the scrutiny of the Scotland Bill should be delayed until the fiscal settlement details were known; but, apart from that, the report did not advance us materially towards a solution. The other development was the publication in late November of a report by the Institute for Fiscal Studies, (IFS), dealing with adjustment mechanisms for the Scottish government’s block grant after Smith. Unfortunately, as will be explained here, there are serious flaws in the IFS report, which make a satisfactory outcome of the fiscal settlement negotiations much less likely.

For a fuller critique of the IFS report, see my Jimmy Reid Foundation, (JRF), working paper, “IFS Report Provides Inadequate Basis for Fiscal Settlement Negotiations”, published on 11 December, which can be accessed on the JRF website here. I will not attempt to repeat here the full detail of the working paper, but will summarise the main points, and bring out some of the implications.

The Smith Report had laid down various principles which the final fiscal settlement should meet. The IFS report, correctly, points out that these principles are inconsistent. The implication is that, in arriving at the final fiscal settlement, there will need to be a process of agreeing which principles are vital: and what others can be relaxed, and by how much. The problem with the IFS report is that it did not embark on this process in a judicious and even-handed fashion. Instead it plunged in, giving certain principles primacy on arbitrary or ill-considered grounds, while entirely neglecting other important issues.

The IFS make one key decision in particular on the basis of a cursory, and indeed flawed, argument. This is their decision to concentrate on methods of indexing the income tax abatement to the Barnett formula block grant in line with the growth in tax revenues in the rest of the UK, (rUK), rather than in line with the growth in the rUK tax base. (Tax revenues are the total of tax collected: tax base is the aggregate of taxable incomes.) All three of the indexation methods which the IFS analyse in detail involve tax revenue indexation. But using tax revenues, rather than tax base, exposes Scotland to a whole new class of potential risk. Indexation on tax base means we face the risk of our tax base not growing as fast as rUK’s.  Tax revenues depend not just on the size of the tax base, but also on the proportion of incomes falling into the different tax bands: so the IFS decision to concentrate on indexing on tax revenues exposes Scotland to the additional risk of being penalised if incomes in the higher tax bands grow at a faster rate in rUK.

The three indexation methods which the IFS report analyses in detail are the tax revenue versions of the three approaches I described in my earlier Bella note, which I called the Holtham, adjusted Holtham, and ID methods. As I argued in that earlier note, the milder tax base versions of these methods pose unacceptable risks for Scotland, given Scotland’s lack of economic powers. The position is even worse given that the IFS report is now concentrating on the harsher tax revenue based versions of the three methods. In particular, the LD approach implies that Scotland has to grow its income tax revenues 14% faster than rUK if it wants to maintain the same funding it would have had under the Barnett formula.

If one were to take the IFS report as the starting point in determining the fiscal settlement, one would find oneself working in one narrow part of the overall space of possible decisions – a part of the space with some very specific properties. The eventual fiscal settlement which would result would be one which involved indexing the block grant adjustments using some form of indexation based upon tax revenues. It would therefore expose Scotland to the whole risk of differential economic performance, (including the risk of differential changes in the tax richness of the tax base, as well as in the size of the base) – a position which is totally unacceptable in the light of the limited economic powers the Scottish government possesses. There are other implications, (as explained in detail in my JRF Working Paper). One is that it would involve a particular mechanism for delivering the principle of taxpayer fairness – which has the inevitable drawback of meaning the Scottish government loses control of its own tax rates whenever Westminster changes income tax to fund reserved services. It would involve an unjustifiably narrow interpretation of the Smith principle on dealing with UK economic shocks. And it would be a rigid, rule based system, quite unable to deliver the flexibility required in running a successful monetary union.

Unfortunately, it is now clear, from what participants on both sides of the negotiation have let slip, that the options set out in the IFS paper have come to dominate the current negotiations. Even worse, the existence of the report allows the Treasury to push the iniquitous LD variant as a negotiating ploy.

Overall, this puts us in a very worrying situation. The immediate priority must be for the veil of secrecy to be stripped away from the current negotiations. Otherwise, we can have no confidence that our negotiators have not already conceded too much ground: the danger is that they may be allowing themselves to become trapped within the unacceptable range of options outlined in the IFS report.