This article started as a personal festschrift celebrating Scotland’s latest Economics Nobel Prize winner. It aimed to outline his work and then apply some of his methods to data that is used to monitor the Scottish economy. However the data turns out to hide a hornets’ nest. The hornets have to be dealt with if Scottish Ministers and Parliament are not to be stung when they start to use their new powers under the Scotland Act to manage the economy

Muscatelli, Anton

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Muscatelli, Anton (2016) The fiscal framework and the Scotland Bill : right on the money. Fraser of Allander Economic Commentary, 39 (3). pp. 101-104. ISSN 2046-5378 , This version is available at https://strathprints.strath.ac.uk/62071/Strathprints is  designed  to  allow  users  to  access  the  research  output  of  the  University  of Strathclyde. Unless otherwise explicitly stated on the manuscript, Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Please check the manuscript for details of any other licences that may have been applied. You may  not  engage  in  further  distribution  of  the  material  for  any  profitmaking  activities  or  any commercial gain. You may freely distribute both the url (https://strathprints.strath.ac.uk/) and the content of this paper for research or private study, educational, or not-for-profit purposes without prior permission or charge. Any correspondence concerning this service should be sent to the Strathprints administrator: strathprints@strath.ac.ukThe Strathprints institutional repository (https://strathprints.strath.ac.uk) is a digital archive of University of Strathclyde research outputs. It has been developed to disseminate open access research outputs, expose data about those outputs, and enable the management and persistent access to Strathclyde's intellectual output.University of Strathclyde | Fraser of Allander Institute Economic Commentary: 39(3) Policy perspectives   March 2016            1  The Fiscal Framework and the Scotland Bill: Right on the money  Anton Muscatelli, University of Glasgow    On the 25th February 2016, the UK and Scottish Governments agreed the Fiscal Framework associated with the Scotland Bill1. The Fiscal Framework set out a number of the aspects governing the devolution of additional taxation and welfare spending powers as a result of the Smith Commission Agreement2. This is a good deal for both Scotland and the UK.  It should be noted that the Fiscal Framework is a complex agreement covering a number of aspects of the additional powers. Elsewhere I have set out various aspects of the Fiscal Framework in detail and I have provided some analysis on the most controversial aspect of the agreement, which deals with the GHWHUPLQDWLRQRI6FRWODQG¶VUHPDLQLQJEORFNJUDQWDQGKRZLWLVDGMXVWHGLQGH[HGRYHUWLPH3.  The block grant adjustment (BGA) mechanism for the devolution of additional income tax powers was at the centre of much of the debate. An excellent analysis of the different types of indexation is offered in a number of sources4.  The bargaining position between the two governments, as far as one could discern from public sources, was the following: the Scottish Government had argued that the basis for the BGA should be the per-capita indexed deduction method (PCID)5. This method would give Scotland the incentive to grow its tax base relative to the rest of the U.K., but would protect Scotland against demographic risks in addition to those present through the Barnett formula. The argument is that anything other than PCID fails to meet the Smith Commission's first no-detriment principle, and would have undermined the Smith commitment to maintain the Barnett formula as the cornerstone of the agreement.  The U.K. Government seemed to initially focus on a levels deduction (LD) approach, which in a sense is a 'Barnett formula for tax'. The UK government's position was that PCID does not meet one part of the Smith Commission's Agreement's second no-detriment principle, around 'tax-payer fairness'. This would imply, for instance, that an increase in UK government spend on devolved areas such as the English NHS, financed using devolved income taxation would unduly benefit Scotland through the Barnett                                                         1 See https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/503481/fiscal_framework_agreement_25_feb_16_2.pdf  2 https://www.smith-commission.scot/smith-commission-report/  3 See my evidence to the Devolution (Further Powers) Committee at Holyrood http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/Inquiries/devolution_committee_-_AM_-_Final.pdf and my recent Stevenson lecture at the University of Glasgow - http://www.gla.ac.uk/schools/socialpolitical/research/politics/stevensontrust/newsandevents/headline_445809_en.html   4 David Bell, David Eiser and David Phillips offer a survey of the three main approaches to the BGA ± see http://www.ifs.org.uk/publications/8060 and the update in http://www.centreonconstitutionalchange.ac.uk/blog/adjusting-VFRWODQG¶V-block-grant-options-table.  5 A rationale for PCID was originally published in the Fraser Economic Commentary (Vol. 39, No. 1, June 2015) by Jim Cuthbert ± see http://strathprints.strath.ac.uk/53549/1/FEC_39_1_2015_CuthbertJ.pdf  University of Strathclyde | Fraser of Allander Institute Economic Commentary: 39(3) Policy perspectives   March 2016            2  formula as Scottish taxpayers would gain additional funding net of the BGA. This is because the Scottish population share as a proportion of the UK LVODUJHUWKDQ6FRWODQG¶VVKDUHRI8.LQFRPHWD[DWLRQ6.  In my evidence to the Devolution Committee7  I set out these two BGA methods and the Indexed Deduction (ID) method, a third method similar to PCID but which does not adjust for population changes.  I argued in a number of interventions during the debate and in my evidence to this Committee and to the House of Commons Scottish Affairs Committee that PCID is the only method which satisfies the major aspects of the Smith Commission Agreement. The Smith Commission agreement placed Barnett at the centre of the fiscal framework. The LD (and ID) methods erode Barnett over time and violate the first no-detriment principle. They expose Scotland to additional demographic risk when Scotland does not have the policy levers to offset these trends. The current differential demographic trends between Scotland and the rest of UK as projected by the Office for National Statistics (ONS) are starkly different. Based on ONS population projections, the costs to Scotland of adopting LD instead of PCID would have amounted to a cumulative £7bn loss in real terms over the first 10 years of the Scotland Bill being enacted. Even with ID the losses would be very marked8. Hence anything but PCID erodes Barnett and does not deliver Smith.  In the end, in the Agreement the governments reached, the following compromise position.  There was a decision to use Barnett as the formula for the indexation mechanism for welfare with a 100% comparability factor, which seems appropriate given the nature of the welfare devolution envisaged in the bill.  The BGA adjustment indexation mechanism for tax (see Paragraphs 17-19 of the Agreement) is a FRPSURPLVH $ µ&RPSDUDEOH 0RGHO¶ ZLOO EH XVHG µWR HIIHFW WKH %*$¶. In essence this is a modified version RI WKH OHYHOV GHGXFWLRQ /' PHWKRG ,W LV PRGLILHG E\ D IDFWRU ZKLFK UHIOHFWV 6FRWODQG¶Vdifferential share of the UK tax pool for each of the devolved taxes. This is described in detail by Bell, Eiser and Phillips9. Indeed Bell et al call this modified /'µWD[-FDSDFLW\DGMXVWHGOHYHOVGHGXFWLRQ¶7&$-/' ,QHVVHQFHWKLV%*$PHFKDQLVPPRYHVVRPHZD\WRWDNHDFFRXQWRI WKH6FRWWLVK*RYHUQPHQW¶Vconcern that LD exposes Scotland to additional risk by reducing the adjustment in the block grant in those taxes (like income tax) where Scotland has a lower share of the UK tax pool than its population share.  Unlike Level Deduction (LD) the TCA-LD mechanism addresses the problem of Scotland initially having a lower share of UK tax revenues, but it still does not pURWHFW6FRWODQGµVEORFNJUDQWIURPWKHDGGLWLRQDOGHPRJUDSKLFULVNGXHWR6FRWODQG¶VSRSXODWLRQJURZWKEHLQJVORZHUWKDQWKDWLQWKHUHVWRIWKH8.7KHGHWULPHQW UHODWLYH WR WKH µQR-GHYROXWLRQ FDVH¶ RI DGRSWLQJ 7&$-LD is shown in Table 1 in Bell et al.                                                         6 The problem is neatly set out in an example in Bell, Eiser and Phillips http://www.centreonconstitutionalchange.ac.uk/blog/adjusting-scotland¶V-block-grant-options-table.  7 See Slide 4 in my presentation (http://www.scottish.parliament.uk/S4_ScotlandBillCommittee/Inquiries/devolution_committee_-_AM_-_Final.pdf)  8 Indeed ID has other undesirable features which are explored in detail in the literature. 9 see http://www.centreonconstitutionalchange.ac.uk/blog/adjusting-VFRWODQG¶V-block-grant-options-table. University of Strathclyde | Fraser of Allander Institute Economic Commentary: 39(3) Policy perspectives   March 2016            3  Curiously, in offering this compromise with the hybrid TCA-LD method the UK government in effect DEDQGRQHGLWVGHPDQGVIRUWKHµWD[-SD\HUIDLUQHVV¶SDUWRIWKHVHFRQGQR-detriment principle.  However, whilst this TCA-LD mechanism is notionally calculating the BGA, in para. 20 in the agreement it is clear that this BGA mechanism is de facto overridden. Paragraph 20 of the agreement states that the outcome until 2021-22 will be that the BGA will shadow the per-capita indexed deduction method (PCID), which as nRWHGDERYHLVWKH6FRWWLVKJRYHUQPHQW¶VSUHIHUUHGPHWKRGDQGWKHDSSURDFK,KDGsupported.  In essence, the TCA-LD method will be a shadow formula which is not operational during the initial duration of this Fiscal Framework Agreement (i.e. until 2021-22), during which de facto PCID will determine the BGA.  The key question is what happens after 2021-22. This is set out in para. 20-23 of the Agreement and which was clearly one of main sticking points in the negotiation.  The Agreement makes it clear that there will be an independent review which will inform the two JRYHUQPHQWV¶YLHZV7KHJRYHUQPHQWVZLOOGHFLGHWKURXJKDQHZQHJRWLDWLRQSRVW-2021, what the future LQGH[DWLRQPHFKDQLVPVKRXOGEH ,QHIIHFW WKLV LVD µVXQVHWFODXVH¶ IRU WKH%*$LQGH[DWLRQPHchanism post 2021-22. The important point is that there is no presumption that a particular method will be used after that date. The agreement does not specify what might happen if a methodology is not agreed in time for 2021-22.  I have suggested that this agreement by the two governments is good for Scotland and for the UK. The reasons for this are the following:  1. For Scotland, it ensures that PCID is de facto used to determine the BGA, thus avoiding additional demographic risk.  2. For Scotland, it is important that the first no-detriment principle as embedded in the PCID method is still operative and does not automatically lapse after 2021.  3. For the UK, although PCID does not, during the period until 2021-GHDOZLWKWKHLVVXHRIµWD[-payer fairnHVV¶WKHVHFRQGSDUWRIWKHVHFRQG6PLWKQR-detriment principle) it ensures that this principle is not forgotten, and will be part of the 2021 review. It is important to stress that TCA-LD would not have GHDOWZLWKWKHµWD[-SD\HUIDLUQHVV¶SULQFLSOHHLWKHr, whilst LD would have. As I set out in my evidence to the House of Commons Scottish Affairs Committee, and in a recent Stevenson Trust lecture at the 8QLYHUVLW\ RI *ODVJRZ D PRGLILHG YHUVLRQ RI 3&,' PLJKW KDYH DGGUHVVHG WKH µWD[-payer fairness principle¶PRUHGLUHFWO\E\DGMXVWLQJWKHEORFNJUDQWIXUWKHUZKHQHYHUDGGLWLRQDOLQFRPH-tax changes are made by the UK government to reflect changes in devolved spending.  4. For the UK, the use of PCID in the next few years will not impact greatly on the µWD[-payer IDLUQHVV¶LVVXHDVWKHSHULRGXQWLO-22 is likely to be a period of continued fiscal consolidation, which University of Strathclyde | Fraser of Allander Institute Economic Commentary: 39(3) Policy perspectives   March 2016            4  means that the issue of the UK government raising additional income taxation to fund additional UK spend in devolved areas such as NHS and education is unlikely to be substantive issue. Indeed the )LQDQFH$FWLQFOXGHGWKH8.*RYHUQPHQW¶VµWD[ORFNFRPPLWPHQW¶ZKLFKQRWLRQDOO\SURKLELWVWKH8.government increasing income tax rates during the current parliament. This further limits aQ\ µXQIDLU¶benefit from UK taxes to Scotland.  5. For both Scotland and the UK, the period until 2021-22 provides a period in which we will learn more about the actual economic and demographic risks that emerge from the framework without having to rely on modelling assumptions and forecasts.  6. For both Scotland and the UK as I stressed before it is important that the Agreement provides a stable framework. It is important that the different spending and taxation policy proposals for the 2016 Scottish Parliamentary election by the political parties can be evaluated, and that this debate happens against the background of a Fiscal Framework which will not trade off changes in taxation and welfare spending decisions that would be swamped by an unstable block grant due to demographic effects. This Agreement provides that stability by taking away the issue of demographic risk, violating the first no-detriment principle.  My conclusion is that this agreement comes to the right decision on the BGA method. It is a pragmatic solution by the two governments which produces the right result, whilst conceding that a final decision on the BGA will not be considered until 2021, and it will need to be arrived at, following an independent review, by mutual agreement. It goes without saying that this review will be important as it will be difficult for either government to deviate from the conclusions of a genuinely independent review.   Author Details  Professor Anton Muscatelli Principal, University of Glasgow principal@glasgow.ac.uk     

The fiscal framework and the Scotland Bill : right on the money

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