How accurate were the SFC’s forecasts and what does this mean for the Budget?

The Scottish Fiscal Commission (SFC) published three documents on Wednesday – a Forecast Evaluation Report 2017-18; a Value Added Tax (VAT) Approach to Forecasting and a Statement of Data Needs.

This blog focuses on the Forecast Evaluation Report.

Forecast Evaluation Report

The Forecast Evaluation Report (FER) fulfils the SFC’s statutory responsibility to evaluate their forecasts once per annum. It assesses forecasts made against outturn on economic growth, income tax, non-domestic rates, land and buildings transaction tax (LBTT) and Scottish Landfill Tax (SLfT).

The largest forecast errors relate to economic growth and income tax, and occur according to the SFC as a result of “new or revised data becoming available”.

So, what has changed?

Economic growth

In May 2018, the SFC forecast GDP growth for 2017-18 in Scotland of 0.7 per cent. This compares with the most recent data release showing growth of 1.3 per cent. The SFC note that this forecast error of 0.55 percentage points is “slightly greater than the OBR’s average GDP forecast error of 0.42 points, but close to the OBR average when considering the typical variation of the OBR’s forecast error.”

The main reason for the change relates to revisions made in the August Quarterly National Accounts Scotland (QNAS) data to historic GDP growth. The main change arises from revisions to the construction industry data since 2015. Previous data showed the construction sector shrinking by 12 per cent from its 2015 peak. However the latest revised data now shows the construction industry growing by 4 per cent since 2015.

The impact of this revision on the overall Scottish growth rate for 2017-18 was to revise it upwards from 0.8 per cent to 1.3 per cent. The SFC note that the “impact of this revision was a large contributing factor in our in-year GDP growth forecasting error of 0.55 percentage points for 2017-18”.

In discussing this forecast error, and how it may have been avoided, the SFC state that they would have needed to create their own different estimates of economic activity in 2017-18.

“While we were conscious that revisions to the construction series could lead to revisions in GDP, we took the decision to not make explicit adjustments to our short run modelling. This decision was based on the view that the then official estimates produced by the Scottish Government statisticians were the best current estimates of activity.”

The SFC continues to take the view that economic growth will remain subdued, and that their view of the underlying picture is unchanged.

“overall, we do not anticipate that the revised GDP data will significantly alter our medium- to long-run view of the Scottish economy when it comes to our next forecasts. We had already controlled for the volatility in construction industry data in our longer-term modelling of the economy.”

Revisions to GDP data are not unusual, but the scale of the revisions for 2017-18 was exceptional. It will be interesting to watch whether the SFC alter their approach to forecasting GDP in light of the risk of revisions to outturn data.

Income tax

In July, HMRC published its first outturn data on Scottish income tax receipts in Scotland for 2016-17 (based on full administrative data using Scottish taxpayer codes).

This showed outturn income tax revenues of £10.7bn in 2016-17, £550m lower than the SFC estimate of May 2018 of £11.3bn. This difference of 5.1 per cent was, like the GDP forecast, higher than the OBR average UK income tax forecasting error.

The SFC state that they consider most of the error to be a result of data issues, specifically that the number of higher and additional rate taxpayers was lower than previously thought. Previous HMRC forecasts for income tax receipts assumed there to be 18,000 additional rate taxpayers and 337,000 higher rate taxpayers. The latest data shows that there were in fact 13,000 additional rate and 294,000 higher rate taxpayers. The reduced number of higher and additional rate taxpayers is estimated by the SFC to account for £500m of the £550m forecast error.

The SFC argue that they do not believe it would have been possible to predict the differences between previous and new data sources in advance of publication of their most recent forecasts. They conclude:

“Now that we have outturn data for the first time, we will explore options for how best to adjust our forecasts to this new information and present a new approach in the next forecasts. By calibrating our forecasts to this new information, our future forecasts are less likely to be subject to such large errors caused by underlying data differences.”

What does this mean for the budget?

These changes do not result in any immediate impact on the Scottish budget.

Despite Scottish outturn revenues in 2016-17 being lower than forecast, this in itself is unlikely to affect the resources available to the Scottish budget in 2017-18 or any future year.

This is because 2016-17 is used as the baseline year for the purpose of adjusting the Scottish block grant for the new income tax powers. The lower the revenues, the smaller is the ‘initial deduction’. What matters for the Scottish budget in 2017-18 is how quickly income tax revenues grow after 2016-17 in Scotland compared to the rest of the UK.

A lower than forecast outturn figure does not tell us anything about the relative growth rate of Scottish revenues in future. It will mean that the SFC revises down its forecast of Scottish revenues for 2017-18 and beyond. But the block grant adjustment for income tax will be revised down too, as the starting point is lower.

However, one implication of the outturn data is that Scotland appears to have relatively fewer higher and additional rate taxpayers compared to rUK than was previously thought. This could mean that it is less likely that the growth of Scottish income tax revenues per capita will match the growth of rUK tax revenues per capita.

Revenue and budgetary impacts from lower than expected numbers of higher and additional rate taxpayers will need to be carefully considered as new data comes to light.

Ross Burnside, Senior Researcher, Financial Scrutiny Unit, SPICe