Adjusting Scotland’s block grant – the options on the table

The UK and Scottish Governments have so far failed to agree the new 'fiscal framework' that must accompany the transfer of tax and welfare powers recommended by the Smith Commission and set out in the Scotland Bill. Perhaps the biggest bone of contention is how to adjust Scotland’s block grant to reflect the associated transfer of tax revenues and welfare spending to the Scottish Government. With another 'deadline' for an agreement looming, this observation aims to explain the proposals put forward by each government, set out their respective rationales, and analyse recent 'compromise' proposals put forward by the UK government. An accompanying briefing note provides additional information, and a detailed report to be in Edinburgh on 22nd March will give our full assessment on the proposals or agreements as they then stand.

We find that there are clear rationales behind the positions of both the UK and Scottish governments. As our report last November showed, it seems impossible to design a system that will satisfy all the Smith Commission’s principles. Both governments claim adherence to these principles, but prioritise them differently.

The Scottish Government emphasises the principle that there should be 'no detriment as a result of the decision to devolve further powers' – i.e. that Scotland should be no worse (or better) off simply as a result of devolution. The UK Government instead focuses on the principle of 'taxpayer fairness' which holds that changes in devolved taxes in the rest of the UK should not affect the level of public spending in Scotland after the transfer of tax powers has taken place.

We also find that the recent 'compromise' proposal from the UK government represents a significant move towards the Scottish Government's position - but that the two sides remain some way apart on how differences in population growth between Scotland and the rest of the UK (rUK) should be reflected in the block grant adjustment (BGA) indexation method. There are still hundreds of millions of pounds a year in spending power at stake.

In what follows we focus on taxes – and especially income tax – but the issue of BGA indexation is also relevant to welfare devolution too.

The Scottish Government’s position and initial proposals

There is broad agreement on how to adjust the block grant immediately after devolution: Scotland’s block grant should be reduced to reflect the amount of tax revenues transferred to Scotland. The problem lies in agreeing the BGA for subsequent years. This reflects differing interpretations of the principles included in the Smith Commission report.

The Scottish Government’s position is that 'no detriment' applies on an ongoing basis. It argues that if Scotland's revenues per capita grow at the same rate as in the rest of the UK, then the Scottish budget should be neither smaller nor larger than if income tax were not devolved and funding remained determined by the Barnett Formula alone.

This leads it to favour the indexation method known as Per Capita Indexed Deduction (PCID), where each year the BGA is increased or decreased by the rate of change of devolved revenues in rUK adjusted to account for the relative change in population between Scotland and rUK. This protects the Scottish budget both from Scotland’s lower per capita tax revenues and from Scotland’s slower population growth. The Scottish Government argues that the implicit insurance against differences in population growth provided by PCID is fair due to its lack of policy levers to influence the rate of population growth in Scotland relative to rUK.

One of the UK Government’s arguments against this approach is that a world without tax devolution is not in fact the relevant counterfactual against which Smith’s ‘no detriment’ principle should be assessed. Arrangements for the partial devolution of income tax under the Scotland Act 2012 (SA2012) are already agreed: Scotland’s block grant is to be adjusted by a different mechanism which takes no account of Scotland’s relatively slow population growth. PCID would therefore be relatively more generous than the already agreed mechanisms for the partial devolution of income tax, meaning the Scottish Government would gain relative to existing plans.

But the UK Government’s main objection is that it thinks the PCID mechanism infringes the ‘taxpayer fairness’ principle, because this approach would redistribute some of the future growth in rUK income tax revenues to Scotland.

The reason for this relates to the continued use of the Barnett Formula to determine Scotland’s block grant. The Barnett Formula increases Scotland’s block grant each year by a population share of increases in comparable spending in rUK. But the PCID mechanism for updating the BGA is based on percentage changes (not population shares).

This is important because when the BGA is initially set, it will take account of the fact that Scotland raises less income tax per capita than rUK. Thereafter any percentage increase in this BGA as a result of growth in income tax in rUK would be less than the corresponding population-share based increase in Scotland’s Barnett-determined block grant. In other words, when tax revenues increase in rUK, the increase in Scotland’s block grant would be bigger than the increase in the amount taken off its block grant to account for it’s ability to raise its own income tax revenues. This would happen both for revenue increases due to economic growth and tax policy changes. And each year more and more income tax from rUK would therefore implicitly be transferred to Scotland.

This redistribution already happens under the Barnett Formula, but the UK Government’s view is that devolution implies the end of this “pooling and sharing” for the taxes that are devolved.

The UK government’s position and initial proposals

The UK Government initially argued that the so-called ‘Levels deduction’ (LD) approach should be used to index the BGA. Under this approach the change in the BGA is given by the population share of the change in comparable aggregate revenues in rUK, not the percentage change.

One implication of the LD approach is that there would be no further redistribution of income tax revenues from rUK to Scotland. This is because, whilst the Barnett formula continues to give Scotland a population share of rUK spending increases, the LD approach removes a population share of rUK tax increases. Any increase to the Scottish budget coming through Barnett as a result of changes in income tax revenues in rUK is exactly offset by the same increase in the BGA. This therefore satisfies the UK government’s interpretation of the ‘taxpayer fairness’ principle.

However, another implication of this approach is that it sets a particularly high bar for Scottish revenue growth if the Scottish budget is to keep pace with what it would be without devolution of income tax. Because Scottish revenues per capita are lower than those in rUK, Scottish revenues per capita actually have to grow at a faster percentage rate than those in rUK to keep up with the population-shared based increase in the BGA. If Scottish revenues per capita instead grow at the same rate as those in rUK, Scotland’s budget falls relative to what it would have in the absence of devolution. The Scottish Government argues that this is inconsistent with Smith’s ‘no detriment from the decision to devolve’ principle.

A recent proposed ‘compromise’

In an earlier paper published last November we showed that the difference in the amount of money available to the Scottish government under the PCID and LD approaches could easily differ by over a billion a year after just a decade or so. It is therefore perhaps unsurprising that agreement has been difficult to reach.

In an attempt to reach a compromise, the UK Government has put forward a new proposal that moves significantly towards the Scottish Government's preferred approach. The new proposal is based on the LD approach, but takes into account Scotland’s lower initial tax revenues per capita. We term this tax-capacity adjusted levels deduction, or TCA-LD. TCA-LD removes one of the Scottish Government’s major objections to LD; it would no longer require Scottish per capita revenues to grow at a faster rate than those in rUK simply to match a world without tax devolution. But in proposing TCA-LD the UK Government has effectively conceded - in practice if not principle - its initial 'taxpayer fairness' argument for favouring the LD approach. By taking account of Scotland’s lower initial tax capacity, there would continue to be some redistribution of rUK income tax revenue increases to Scotland in future.

On the other hand this proposal would not address the Scottish Government’s other main concern: relative population growth. If revenues per capita grew at the same rate but Scotland’s population grew more slowly than rUK’s, the Scottish budget would still be worse off than it would without tax devolution. So the Scottish Government argues it still does not satisfy the ‘no detriment’ principle.

The UK Government’s response to this criticism is two-fold. First, as discussed above, that the correct counterfactual against which 'detriment' should be assessed should include the Scotland Act 2012 income tax provisions, which do not adjust for differential population growth. And second, that it would be unfair for the Scottish Government to be insulated from population-based risk on the revenue side when on the spending side it gains rather than loses from Scotland’s relatively slow population growth (because the Barnett formula does not take account of this slower population growth when allocating funds). Consistency instead requires a symmetric set of risks on the revenue side as on the spending side, which TCA-LD (but not PCID) would deliver.

Simulating the options

Can we say one side is right and the other wrong? No. Both governments make arguments that are consistent with (different parts of) the Smith Commission’s principles. However, we can attempt to quantify the effects of the different proposals on Scotland’s budget using ONS population projections for Scotland and rUK, and OBR estimates of long-term revenue growth (Table 1).

Looking at income tax only, if revenues grow at the same rate per capita in Scotland and rUK, then the Scottish Government would be no better or worse off under their proposals than without any devolution of income tax alone. The UK government’s initial proposals would have seen the amount Scotland gets from its block grant and income tax (given the specific assumptions we have made) fall by 4.5% after 15 years. Given a block grant of just under £29 billion in 2015–16, this 4.5% fall would be around £1.3 billion in today’s terms.

The UK government’s compromise proposals bring this gap down to around £0.5 billion in today’s terms. The important flipside of this is that an additional £0.8 billion of income tax revenues in today’s terms would be redistributed from rUK to Scotland on top of the amount redistributed today (albeit £0.5 billion less than under the Scottish Government’s proposals).

Compared to what would happen under the Scotland Act 2012 powers, the Scottish Government’s proposals would lead to an increase in Scotland’s annual budget of around 1% after 15 years, while the UK Government’s compromise approach would lead to a decrease of around 1% (in both cases equivalent to around £0.2 – 0.3 billion in today’s terms).

Table 1: Difference in Scottish Government’s budget from block grant and devolved income tax after 15 years, relative to two “no change” counterfactuals

Source: Authors’ calculations using ONS population projections, OBR’s Fiscal Sustainability Report, HMT’s Public Expenditure Statistical Analysis and Statement of Funding Policy, and HMRC’s Disaggregated Tax Revenue Statistics

Concluding thoughts

While the UK government has made significant concessions from its initial position, there are still hundreds of millions of pounds a year to play for. There are also continuing differences about the extent to which Scotland should bear risks associated with differential population change, and whether existing devolution arrangements under the Scotland Act 2012 should influence the choice of BGA indexation. There are no right or wrong answers here – just differences in opinion. Perhaps it’s not surprising that a deal is still elusive. Reaching one will take good will and further compromises by someone.

Notes:

David Bell and David Eiser are at the University of Stirling and the Centre on Constitutional Change.

David Phillips is a senior research economist at the Institute for Fiscal Studies (IFS)

An accompanying research paper, Adjusting Scotland's Block Grant - the options on the table, has been published on the Centre on Constitutional Change website. 

This analysis and accompanying paper was supported by funding from the Nuffield Foundation. The Nuffield Foundation is an endowed charitable trust that aims to improve social well-being in the widest sense. It funds research and innovation in education and social policy and also works to build capacity in education, science and social science research. The Nuffield Foundation has funded this project, but the views expressed are those of the authors and not necessarily those of the Foundation. More information is available at nuffieldfoundation.org.

The work was also supported by funding by the Economic and Social Research Council (ESRC) through the Centre for the Microeconomic Analysis of Public Policy at IFS (grant reference ES/H021221/1).