Fiscal Settlement: Flawed IFS Report Bad News for Scotland

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.

 

 

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  1. johnny rudkin says:

    my biggest worry ie john and nicola will sign up for something that is going to turn sour for scotland and we wont be able to reverse it look what happened on the smith report they were all nice and friendly and signed the smith report only to come out against it the following day why did they sign if they weren’t pleased with the outcome we need a guarantee if things dont work out scotland will be no worse off than the barnet formula

    1. Casper1066 says:

      They are not stupid, I have read that about 5 economists North and South, plus they have a few in their own ranks, plus Mr an Mrs Cuthbert have looked at it, they are all saying its a web which will spiral into debt if accepted in the way it is just now. I think that’s why Swinney /Nicola have said if its going to be a financial hole which they can’t dig us out off, they won’t sign it. But it sure tells you how much damage Cameron/Osborne is happy too inflict without a second thought. So much for the broad shoulders, what they meant was it was OUR shoulders they were going to stand on. Scotland needs to wake up..and quickly.

  2. bringiton says:

    The problem with all this is that the process is being driven by politics and not economics.
    The Tories have no interest in Scotland,other than what they can take out if it and having “won” the referendum have no desire to give us anything.
    Possibly all we will get out of this is the mechanism for the SG to start collecting some tax from Scots but not much else.
    People need to understand that having spent millions to ensure they held onto Scottish revenues,the Westminster treasury isn’t about to give that up now.

  3. Dorothy Bruce says:

    I think we need to show confidence in the Scottish Government. They are not idiots and have done well so far, so let’s treat them as intelligent people who want the best deal possible for Scotland. I’m sure John Swinney will be well advised and have read widely on the pros and cons, including articles and papers by the author and his wife. The Westminster government may be devious and strangers to the truth, but the Scottish Government are hardly naive and have been through nearly nine years in power during difficult times, and negotiated a referendum campaign where, despite what Westminster, opposition parties and the media threw at the Yes side, it was nearly successful. So have some faith.

  4. Raphie de Santos says:

    Surely the big problem is that under independence we must rely solely on our actual tax revenues. Currently that implies a massive deficit. We are 8.4% of the UK’S population but pay 7.5% of the total income tax and account for 9.2% of publuc spending. The Yes campaign using figures for 2011/12 because the oil tax revenues for that year were £11 billion implied fiscal autonomy would make us better off. The next financial year oil tax revenurs had fallen to £6.8 billion and Scotland’s deficit for. that year was £12 billion and over 10% of GDP. Now oil tax revenues have fallen to zero. The Greens were quite right to vote against fiscal autonomy without a plan to increase tax revenues through progressive taxation, closing down the tax avoidance and most importantly nationalising oil. To accept autonomy within the framework of the union means massive cuts to public spending on top of what we are already experiencing.

    1. Phil says:

      I always worry about being a bit thick about this but why have you only used the income tax figure for Scotland? Wales and Northern Ireland are in a slightly worse position than Scotland in terms of income tax per head; a decent amount of public spending in Scotland includes defence spending which isn’t actually spent here; and the skew that London places on both income taxes from the City and ancillary services as well as in terms of public spending means comparisons are really quite awkward. The tax take is also affected by a helluva lot of offshoring which may not always be the case (i.e the pitchforks may one day force a reckoning). If oil prices are low now they won’t always be and Scotland still has a lot going for it in terms of future energy prospects. I would tend to be more optimistic. If independence means anything it means looking to do the right thing for all future generations and not to be blinded by the very shortest of short-term projections.
      I suppose what I’m saying is that a better short-term view is available and a better long-term prospect can certainly be envisaged.
      But I am still prepared to be considered a thicko on these matters.

      1. Casper1066 says:

        This is a ex-Tory who worked in Westminster and had access to all the books, he is a Scot living in Glasgow and he has a blog – John Jappy Blog

        Very worth your while to get all your questions answered, I highly recommend it. Plus a lot more on the site.

        http://independencequestionsanswered.blogspot.co.uk/

    2. sheilavee says:

      Forget oil! We have already been told that oil would be a bonus. If we were independent, we wouldn’t have to pay for a lot of the things which we are currently paying for. Trident, illegal wars, HS2, new runway, all London infrastructure, UK debt (Scotland has been living within its means for years). We would also get the export taxes for whisky, foods etc which we send abroad, as that would no longer go to the UK treasury. We would also get our share of all the UK assets. So, when you add these things up, I am sure that you will find that we have NO black hole – and then there is any income from oil as a bonus.

        1. Interested says:

          The most likely reason for that, may well be, the tax is collected offshore or given to the recipient nation as a consideration,Contractual probably,
          Could be a write off.

      1. Ken Waldron says:

        There is no “export tax on whisky: what there is though is Corporation tax on profits. Yet the UK government currently collects no tax at all on Scotlands best selling most profitable whisky brand instead kindly allowing Diageo to offshore the profits by registering Johnnie Walker as a Dutchman… repeat after me: we are all Better Together…

        1. Casper1066 says:

          I would bet my house that they have some back handers going on here. OBR/IFS books are not the ones we need to get our hands on its the Pink Books, that’s what has the real figures. All the VAT paid in shops in Scotland who have their H.O South, that tax goes through their H/O and allocated as WM money, not Scotlands. Mr an Mrs Cuthberts had a look at the books and they couldn’t get things to add it, everytime they asked about something, civil service brushed them off or couldn’t answer. They said it was like guessing, but they found and proved some of the numbers were millions out, so they have to correct that, but they also finished with there is millions not accounted for. Makes you wonder just how much are WM hiding from Scotland.

    3. Me Bungo Pony says:

      Raphie;

      (1) Why compare %age of income tax with %age of public expenditure? Income tax is only one of many sources of revenue. Also, the 9.5% of public expenditure you quote is highly dubious. While GERS tells us exactly how much money the Scottish govt gets in its block grant and exactly where it spends it, it is extremely inexact on how much the UK govt spends in Scotland. The UK govt makes an assumption, adds it to the pot and then stands back in “amazement” at its own dubious largesse. There are easily identified £bns that are attributed to Scotland but never get within a hundred miles of it.

      (2) Even were the figures you quote accurate, it is not what you could call “an advert for the union”. When ALL our small, independent near neighbours have far better socio-economic stats than the UK, never mind Scotland, you have to wonder just what benefits Scotland gets out of the union. Surely Scotland should be thriving if the union is such a good thing? It appears, by your reckoning, that it’s alright because the rUK ” bails us out” with what are effectively charitable donations; that it’s fine to be a “beggar nation” as unionist commentators have branded us. However, what happens when that “charity” is withdrawn as many Westminster MPs and Metropolitan chatterati are adamant should be sooner rather than later? Scotland would be devastated and there would not even be the myth of “pooling and sharing” to fall back on for unionist die-hards.

      (3) I agree, fiscal autonomy within the UK would be disastrous for Scotland given the myth, prejudice and vagueness that informs the financial debate over Scotland’s funding. Only the powers and freedom to act that come with independence can change the bleak picture you paint.

    4. Proud Cybernat says:

      World’s wealthiest countries by GDP (PPP):

      1. Qatar.
      2. Macau
      3. Luxembourg
      4. Singapore
      5. Kuwait
      6. Brunei
      7. Norway
      8. United Arab Emirates
      9. Switzerland
      10. Hong Kong
      .
      .
      .
      24. United Kingdom

      (Source: Wiki.)

      What you will notice from the list above is that 5 of the top 10 wealthiest countries in the world (all small countries) do not export ANY oil.

      The political/economic Union of 1707 is holding Scotland back, preventing us from achieving our true potential. You only have to look to see how well these other small nations are doing WITHOUT OIL to see a much better future for Scotland.

    5. Casper1066 says:

      This is a ex-Tory who worked in Westminster and had access to all the books, he is a Scot living in Glasgow and he has a blog – John Jappy Blog Very worth your while to get all your questions answered, I highly recommend it..

      http://independencequestionsanswered.blogspot.co.uk/

  5. Walter Hamilton says:

    Hope for the best, plan for the worst, and if the worst comes to the worst reject the offer and it they cry foul there is always independence. You keep going on about oil revenue, forget oil, look at the saving, no Westminster, no new runways, cross rail, HS railways, flood deference, and many, many more saving I sure you can think of. Let us see what comes out of the negotiations, who know Cameron may even change his mind on full fiscal responsibility, if the alternative is a second referendum on Scottish independence, don’t laugh, he might.

  6. Alf Baird says:

    “we can have no confidence that our negotiators have not already conceded too much ground”

    I hope Mr Swinney is not relying on our mostly unionist ‘negotiators’ within the senior ranks of the supposedly ‘Scottish’ civil service, but of course he is. The civil service in Scotland remains part of the Home Civil Service, and it is obvious where their loyalty lies. Their jobs and salaries are safe even if public finances in Scotland were to go pear shaped. They might even get promotion to the UK Treasury!

    It would be far better for Mr. Swinney (and Scotland) to appoint Jim Cuthbert to head up his team, with the latter consisting of persons who do not have two masters to serve.

  7. Broadbield says:

    The usual high quality article and some good comments.

    I have long been worried about the IFS, its status amongst the Establishment and it’s much vaunted “independence”. To take just one aspect, “independent” it certainly is not: it is fully signed up to the neoliberal consensus, as Richard Murphy argued some years ago, and takes it as axiomatic that this WM government’s economic “plan” is the only option. I don’t recall any papers discussing radical, reforming, more progressive and more equitable taxation policies, including shutting down the more egregious aspects of the City of London’s laundering functions, tackling tax havens, corporate ploys such as transfer pricing rebalancing the taxation of Capital versus Labour and so on.

    So it has been with it’s papers on Scotland’s Independence where they assume things will continue much as they have under WM or, as above, assume the “best case” scenario is the one which will suit Westminster.

  8. Mike says:

    Which begs the question why is the Scottish Government going along with the process? Why aren’t they screaming blue murder to the rafters?
    I appreciate they cannot go to the mainstream media with these issues but they can go viral online and expose the entire farce for what it clearly is.
    All too often the Scottish Government and SNP party as a whole sit tight and keep stum while the opposition use the media to smear and attack with impunity.
    They allowed project Fear to dictate the terms of the Indy ref campaigning. They’ve allowed the broken vow to go unchallenged. They participated in the Smith commission in the full knowledge that it was a total farce and betrayal of the vows and pledges made.
    Now they will not only sit back and ignore the UK Governments witches brew concoction of their version of “new powers” they will give them credence by sitting in committees and negotiating trivial details of trivial measures of trivial powers and then they will try to spin any concession as a victory.
    They have the power of veto which they should have used on the Smith commission. They should have point blank refused to participate with the Smith commission from day 1.
    They absolutely knew they would get nothing from Smith. Now we can expect less than the nothing Smith proposed.
    Scotland voted No and this is what we get for doing so. What else did we really expect?

    1. Douglas says:

      It ought to be recognized by now that significant elements within the SNP are really quite happy with the status quo…of course, theoretically, they are for indie, but you can tell a mile away….just look at their culture policy…a national party which comes to power with no culture policy…nothing…just a blank sheet of paper….what does Fiona Hyslop do all day? I’ll tell ye: doodle!! She sits there DOODLING all friggin day… hee hee hee…and they call it the national party….ha ha ha

      1. Derick fae Yell says:

        Pish

        1. Alf Baird says:

          So, where is the Scots Language (Scotland) Act, Derick? Language is at the very heart of any national cultural policy, yet this SNP administration will not even give Scots language equal status to English and Gaelic languages, far less include it in the curriculum.

      2. C Rober says:

        Long agreed with you douglas on the teaching of the Gaelic in Schools , second languages from primary onward enables the brain to learn more languages if taught early instead of in adolescence and teens.

        I fear you too have realised that the SNP are a party of promises , of blame slinging , where the original policy of indy is now merely an aid to being elected…. not something wanted or indeed needed .

        After all , with indy , there wold be 50 or so unneeded SNP politicians on the dole , something is contradictory there , expecting a person to forge onward , where if they did their job right they will be unemployed at the end of it. No one in the media seems to be asking that very question.

        Perhaps I am wrong , in expecting the turkeys to vote for xmas.

        1. Me Bungo Pony says:

          C. Rober;

          What a lot of wishful nonsense. The only “mud slinging” going on is coming overwhelmingly from the Labour/Tory side of the debate. From the parties themselves as well as their willing buddies in the Tory press. Few are fooled by it; more are repelled by it. Hence the poll ratings. Still, its touching to see your blind faith in the union undaunted by reality 🙂

  9. arthur thomson says:

    A concerning post Jim. Obviously, I would not like to see the Scottish Government being deceived to the detriment of Scotland. I presume that they have good economic advisors and I trust that you have made them aware of your misgivings. I presume also that they will be prepared, politically, to reject any ‘deal’ that is detrimental. To date, the Scottish Government has shown a high degree of competence and I must say I would be surprised if I didn’t see this continue through these negotiations.

    But I never underestimate the scale of the task they face in negotiating constantly from a position of weakness. Nor do I imagine that they have not been infiltrated at the highest levels by elements of the British State. Even so, their past record suggests that they will not be suckered and that they will, if necessary, reject any proposed changes. Their excellent record in representing Scotland would enable them to do this, with the backing of the Scottish electorate.

    The considered attitude adopted by the SNP is often wrongly perceived as being insufficiently assertive. The Westminster regime is and always has been predatory. In dealing with them it is necessary to think laterally all the time and sometimes that inevitably means rolling with the punches. The success of the SNP, in providing Scotland with its best governance in 300 years and simultaneously continuing to grow in popularity, is impressive. But they are not miracle workers. Those who apparently imagine that they can absolutely transform Scotland in just a few years are either being naive or disingenuous.

    The SNP will win some and lose some but it is not about to change an over-all successful strategy and I don’t want it to.

    1. C Rober says:

      It would be better served if they rejected it completely , both as a political point and highlighting the reasoning , much like the Scottish income tax being an additional tax , a tax for being located north of Carlisle.

      The SNP failed during indy , partly because of project fear , partly because of the use of the pound being denied. However I have not seen one thought or argument by them in preventing crown dependencies from using the pound as a rebuttle in Westminster.

      I have not seen them take on Westminster with Smith additions for the ariwaves taxes , and of course for the licence fee.

      Example Scotland never got one McCent back from the 2g , 3g , 4g spectrum auctions.Something that they can do at Hollyrood , making the collection of the TV licence fee illegal as long as it is not applied in the same manner as income tax , ie a portion send to London of 9 percent , not the current system of barely 30 odd percent returned for programming. Hollyrood need to proactively use the legislation it has to get flys into the oitnment , legal civil disobedience if you will.

      The Snp are not a party of do , they are a party of blaming , nor are they a party of Socialism , but a party of the promise of Socialism.

      For one of the newest parties they seem to have the old poltiics covered , promise and blame.

      Something that worked well for SLAB during the Thatcher years was the poltics of blame and promise.

      But with 15 years of Blarism , the promise to reindustrialise Scotland was eventually found out , if not sold out , much like during indy , where Scotland was sold out not by England or Westminster tories , but by Scottish Labour politicians , thus they lost their jobs the next general election and where some got some shiny gongs for selling out their party comrades that were and still are red clyde labour men and women.

      The SNP would do well to learn from that lesson , the crest of a wave is exactly that.

      1. Me Bungo Pony says:

        C. Rober’s post above is incomprehensible. I suspect it is meant to be. I suspect more clarity would be detrimental to his case.

    2. Alf Baird says:

      “providing Scotland with its best governance in 300 years”

      Let’s face it, that wasn’t hard to do considering the ‘parcel of rogues’ that have mis-governed and asset stripped Scotland over the last 300 years, many of whom are still around today.

      “The success of the SNP” as you describe it, is debatable. As an organisation, they may be described as successful, with now c.1,000 party folk on the public and party payroll (replacing Labour’s troughers). But they have failed to secure their fundamental objective – independence. Until independence is achieved, the SNP are merely managing the shop on behalf of our nation’s real political masters. In that sense the SNP have achieved nothing.

  10. arthur thomson says:

    So the SNP is being roundly criticised on this page for not having either the bottle or the nouse of red clyde labour.

    Ah, yes, the glory days of red labour, that I apparently lived through and missed. No I didn’t miss it, it never happened, it was glorious failure mythologised. The myth is perpetuated to justify the continued exploitation of the poor and the vulnerable by an ideology that failed for everyone – except for the control freaks and the pseudo socialists on the make who have now made it big time in the world of easy money.

    I have no doubt that labour had a relevance at a point in time, before anyone reading Bella was alive, but for the last 50 years at least they were a nightmare, culminating in inflicting terrible violence on people in the middle east. Of course, that wasn’t the fault of red labour, they were against it so they take no responsibility for it.

    Truth be known, responsibility isn’t their strong point. The SNP on the other hand are pursuing a policy of deliberately behaving responsibly, which is why increasing numbers of people support them and why what’s left of labour are desperate to discredit them.

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