The Scottish Government’s second Medium-Term Financial Strategy states that the Scottish Government’s decision to set a different income tax policy from the rest of the UK means that the Scottish Government has over £500 million more in its 2019‑20 budget than it would otherwise have had.
However, the same document also shows that, on latest forecasts, the amount expected to be raised in income tax in 2019-20 is £5 million lower than the block grant adjustment (BGA) – the amount that the UK Government removes from the Scottish budget to account for the fact that the Scottish Government now sets its own income tax policy.
But if the BGA is meant to represent what the Scottish Government would raise in income tax if it followed the same policy as the rest of the UK (rUK), how can these two facts be true?
The fiscal framework can explain…
The answer lies in the ‘fiscal framework’ agreed in 2016 between the UK and Scottish Governments in advance of the devolution of further powers that followed from the Smith Commission. The fiscal framework sets out the rules for calculating the BGA for income tax (and other devolved taxes and benefits).
Broadly speaking, in the first year of devolution, the BGA for income tax should represent the amount that Scotland would have raised if it had kept the same income tax policy as the rest of the UK. In subsequent years, as set out in the fiscal framework, this initial amount is then indexed in line with per capita growth in income tax revenues in the rest of the UK. This indexation mechanism is intended to ensure that Scotland’s budget does not lose out if the Scottish population grows more slowly than in the rest of the UK (as has been the case in recent years).
However, importantly, the fiscal framework formula only protects Scotland from slower population growth. It does not protect Scotland from other fiscal risks – such as changes in the composition of taxpayers, or slower economic growth. In addition, at the time when the BGA is first calculated, it is based on estimated tax revenues, not actual tax revenues (which are not confirmed until much further down the line). And just to further complicate matters, the BGA is based on forecasts made by the Office for Budget Responsibility (OBR), while the forecasts of income tax receipts that the Scottish budget is based on are made by the Scottish Fiscal Commission (SFC). All of these factors mean that the relationship between the BGA and Scotland’s income tax receipts is not straightforward.
The income tax BGA in a given year is calculated by taking the previous year’s BGA and multiplying by the percentage growth in income tax receipts per head in the rest of the UK multiplied by Scottish population growth. So, for example, if the BGA in year 1 was £11 billion, then rUK tax receipts per head grew by 3% and the Scottish population grew by 1%, then the BGA in year 2 would be £11.4 billion.
This calculation determines the income tax element of the first part of the equation – how much is deducted from the Scottish budget. It is determined by rUK tax policy decisions and rUK economic performance (and, in turn, the growth in rUK taxes). When the Scottish budget is initially being set, this is informed by OBR forecasts of rUK income tax receipts.
The second part of the equation is determined by the Scottish Government’s decisions on income tax policy and the performance of the Scottish economy (and, in turn, the growth in Scottish taxes). When the budget is initially being set, this is informed by SFC forecasts of Scottish income tax receipts.
Over time, economic performance comes into play…
Over time, it is entirely possible that – even if Scottish income tax policy had stayed the same as rUK tax policy – these two parts of the equation might not cancel each other out. This is because the Scottish economy might grow faster or slower which will affect the growth in tax receipts, even if tax policy is unchanged. This is part of the risk of fiscal devolution.
…and forecasts matter
Also, the different forecasting bodies – the OBR and SFC – might take different views about growth in income tax which means that, until actual income tax receipt data are available, these differences in views will influence the two parts of the equation – potentially in opposite directions.
Running to stand still?
Since April 2017, the Scottish Government has adopted a different income tax policy from rUK, aiming both to increase revenues and create a more progressive income tax system. The latest Medium Term Financial Strategy suggests that this has allowed Scottish income tax revenues to just offset the BGA, but not to add any additional resources beyond this. Table 2 of the Medium Term Financial Strategy shows that, in 2019-20, the BGA for income tax is expected to be £11,709 million, while Scottish income tax receipts are forecast to be £11,703 million. That is, the two elements of the equation almost exactly cancel each other out, even though the Scottish Government has not passed on the income tax reductions introduced by the UK Government.
However, as Derek Mackay, Cabinet Secretary for Finance, Economy and Fair Work, has pointed out, if Scotland had adopted the same income tax policy as rUK, then Scottish income tax receipts would be some £500 million lower and the Scottish budget would be £500 million lower than currently forecast. So, if Scotland had the same income tax policy as rUK, Scottish income tax revenues would be expected to be £500 million less than the BGA, with a correspondingly smaller Scottish budget. Higher taxes in Scotland have not resulted in a net increase in the overall budget, but have prevented it from shrinking.
As explained above (and more fully explored in this IPPR Scotland report), this may reflect slower growth in income tax per head in Scotland than in rUK. But, as the 2019-20 figures are still based on forecasts, it could also reflect different approaches to forecasting income taxes between the OBR and SFC. If, for example, the SFC has been more pessimistic than the OBR and the final Scottish income tax figures are higher than currently forecast, then the balance moves in Scotland’s favour. And if the OBR’s estimates turn out to be too optimistic, then the final BGA will be lower, again tipping the balance in Scotland’s favour. Only time will tell how much of the explanation lies in forecasting inaccuracies.
Fiscal devolution brings risks and uncertainties
The risks of fiscal devolution are also explored in this blog from the Fraser of Allander Institute. As both blogs highlight, fiscal devolution requires Scotland to bear the risk of different economic performance and its impact on the tax base. In the short term, there is also the uncertainty of having to base budget decisions on forecasts made by two different organisations who in turn produce forecasts for two different economies.
Nicola Hudson, Senior Analyst, Financial Scrutiny Unit