Scotland’s fiscal position: an updated assessment

The Scottish Government’s Government Expenditure and Revenue Scotland (GERS) estimates the overall levels of government revenues and spending in Scotland and the implicit budget deficit or surplus in the previous year. With a new version of GERS reporting figures for 2014-15 and new UK-wide forecasts in the OBR’s March 2016 Economic and Fiscal Outlook (EFO), this observation provides updated projections of Scotland’s fiscal position for the next five years.

The public finance projections

Table 1 compares our latest projections for the UK and Scotland’s overall “net fiscal balance” – that is the difference between overall revenues and overall spending, including investment spending – with similar projections we made last year. For simplicity we refer to a negative net fiscal balance as a budget deficit and a positive net fiscal balance as a budget surplus.

Table 1: Net Fiscal Balance, UK and Scotland, 2013–14 and 2014–15 (outturns), 2015-16 to 2020-21 (projections)

Since our last projections were made the OBR has revised its forecasts, with the UK deficit now forecast to be a little higher in the period from 2016-17 to 2018-19. This reflects lower underlying revenue growth due to a weaker economic outlook, and a slower pace of spending cuts than planned back in Spring 2015. However, by the end of the forecast horizon, the budget position is expected to be a little better than previously expected: a surplus of 0.5% of national income (GDP) in 2019-20 and 2020-21. This reflects new net tax raising measures, and the extension of spending cuts into 2020-21 (as well as shuffling some revenues and spending between years as described in our Post Budget 2016 analysis).

However in the case of Scotland, our projections are for a larger budget deficit in each and every year. For instance, our latest projections imply a budget deficit of around 9.4% of national income in the coming financial year, 2016-17, compared to 6.8% in our previous projections.

There are a number of reasons for these downgraded projections, including that:

• The estimates of Scotland’s budget deficit in 2013-14 contained in GERS 2014-15 were higher than those in the previous edition of GERS, reflecting upwards revisions to estimates of government spending in Scotland. This higher level of government spending is estimated to have persisted in 2014-15, and then feeds into our projections for 2015-16 and future years.
• Oil and gas revenues are now forecast to be lower, following further falls in expected oil prices, and cuts to the tax rates levied on oil and gas producers. Indeed, over the next few years revenues are expected to be negative: -£0.8 billion a year, on average, between 2015-16 and 2019-20, compared to +£0.7 billion a year in last year’s forecasts. Given that the majority of these revenues would have come from operations in Scottish waters, the impact of these further declines on the Scottish deficit is proportionately much larger than that on the deficit of the UK as a whole.
• Declines in oil and gas prices, profits and investment also mean that Scotland’s economy has grown less quickly than previously projected. This means that a given cash deficit represents are larger share of the, now smaller, economy.

The Table also quantifies the differences between the projected Scottish budget deficits and the OBR’s forecasts for the UK as a whole. In 2016-17, for instance, the “fiscal gap” is projected to be 6.5% of national income (9.4% less 2.9%), which in cash terms is equivalent to about £10.6bn, or around £2,000 per person in Scotland. That is the size of the Scottish deficit on top of its share of the overall UK deficit (which is £850 per person in the UK in the same year). The projected gap then remains at a broadly similar percentage of national income over the following 4 years.

Interpreting the figures

So what are the implications of these higher budget deficit figures for Scotland?

Scotland is largely insulated from the consequences of the substantial gap between the government revenues it generates and the government expenditure undertaken in or on behalf of Scotland. This is because the Scottish Government gets most of its funding in the form of a block grant from the UK government, and the UK government uses revenues from across the UK to pay for non-devolved items like social security benefits and defence. The devolution of tax and welfare powers under the Scotland Bill 2015-16 will transfer some fiscal risk – and fiscal incentives – if its revenues or spending grows less or more quickly than those of the rest of the UK in the years ahead. But it does not transfer any responsibility for the existing larger gap between revenues and spending in Scotland. And while the Scottish Government can vary income tax, for instance, to increase or reduce the amounts it raises from these new powers, it cannot adopt a different fiscal stance to that of the UK government (changes in revenues must be balanced by changes in spending).

Figures on the Scottish deficit would be much more important if it became fully responsible for managing its own public finances. That is if it were to be fully fiscally autonomous or an independent state.

However, it is important to realise that our projections are calculated on the same basis as GERS, which allocates to Scotland a population-based share of spending on things like defence and interest payments on the UK’s national debt. The projections also assume Scotland’s onshore revenues and spending grow in line with those in the rest of the UK. Independence could have implications for the validity of these assumptions:

• An independent Scotland might have been able to negotiate a good deal on the share of the UK’s debt it took on. Lower debt would mean lower debt interest payments and would therefore reduce the budget deficit. However, it is worth noting that even if an independent Scotland had inherited none of the UK’s central government debt, its budget deficit would likely still be substantial: around 7.6% of national income (rather than 9.4%) in 2016-17 and 4.4% of national income (rather than 6.2%) in 2020-21 holding all other elements of our projections fixed.
• Independence could affect Scottish economic performance. A weaker performance – which perhaps may be expected in the short term – would tend to push up Scotland’s deficit. But if, as the Scottish Government have previously claimed, independence would allow policies to grow the Scottish economy more quickly, such faster growth would tend to push up revenues and reduce Scotland’s deficit.
• Independence would also, in principle, give the Scottish Government more freedom to tax and spend more or less, which could have implications for the Scottish budget deficit. In practice, however, if an independent Scotland faced a budget deficit anything like that in our projections, spending cuts or tax rises would be needed to put the public finances on a firmer footing.

But while the precise numbers would almost certainly differ if Scotland were independent, the recent weakening in Scotland’s public finances – driven to a significant extent by falls in oil revenues and associated economic activity – clearly would have made it more difficult for an independent Scotland to manage its public finances. The oil revenue and public finance forecasts produced by the Scottish Government in the run up to the referendum also look increasingly further away from what is now expected.

The volatility of oil revenues

Oil revenues are notoriously volatile though. For the UK as a whole, they were £6.0 billion in 2009–10, over £11.0 billion in 2011–12, and just £2.2 billion in 2014–15. This volatility also makes them difficult to forecast. The OBR, for instance, has had to revise down its forecasts in 12 out of the 13 times it has updated them.

Of course if oil prices and production had risen rather than fallen, rather than revising down earlier revenue forecasts, the OBR would be revising them up. This might mean we would be revising down projections of the Scottish budget deficit rather than revising them up as has been the case.

So it’s perhaps an unfair criticism of the Scottish Government to say it got its forecasts of oil revenues wrong – so did the OBR, and any revenue forecast for something as volatile as oil will be ‘wrong’. The right response to this is to take this uncertainty into account when setting policy. Therefore more problematic is the fact that in its analysis of the potential path of oil revenues, the Scottish Government considers scenarios where the revenues come in higher than the OBR forecasts but does not consider scenarios where revenues come in less than the OBR forecasts. In other words scenarios are skewed to the “upside” – and this can prove problematic if, as has happened, revenues keep coming in under forecast.

Having said this, it’s important to remember revenues can come in ahead of forecasts too. The OBR’s forecasts assume an oil price of $35.50 during 2016 but the recent modest rebound in prices means they have averaged around $41.00 in the last week. The additional revenues this may bring in if sustained would be far from enough to fill the “Fiscal Gap”. But it’s a timely reminder that what comes down can also go up.

Notes on methodology for projecting Scotland’s fiscal position beyond 2014–15

In order to project forward the GERS 2014–15 figures to the period covering 2015–16 to 2020–21 using figures from the OBR’s March 2016 EFO, the following method is used:

• Spending is projected on the basis that government spending in Scotland remains the same proportion (9.2%) of UK-wide government spending as in 2014–15.
• Onshore taxes are projected on the basis that the amount paid per person in Scotland grows in line with forecast growth in onshore revenues per person for the UK as a whole. This means onshore tax revenues per person in Scotland are projected to be 96.6% of the average for the UK as a whole, as in 2014–15.

• Offshore (oil and gas) taxes are projected under the assumption that Scotland’s share of overall UK offshore tax revenues remains the same as in 2014–15 at 82%.

The same basic set of assumptions was used in our last projections too, although these were, of course, based on GERS 2013-14 and the figures available in the OBR’s March 2015 EFO.

We have chosen the assumptions on the basis of their simplicity. As with any economic or fiscal forecast or projection, the projections outlined in this observation are subject to a number of sources of potential error that mean actual outturns will differ. This includes errors in the OBR forecasts for the UK as a whole; and trends in spending and government revenues in Scotland relative to the UK differing from the above assumptions. There are some reasons to suggest that, if anything, the assumptions are more likely to lead us to under-estimate rather than over-estimate Scotland’s fiscal deficit relative to that of the UK as a whole. First, Scottish Government plans to borrow additional money to fund capital investment mean Scottish Government spending may fall less between 2014–15 and 2020–21 than equivalent spending in the rest of the UK. This would tend to increase Scotland’s share of overall UK government spending; in contrast, we have assumed this share would remain constant. Second, the OBR forecasts revenue growth to be particularly strong for taxes like capital gains tax, inheritance taxand stamp duties, which make up a relatively smaller share of Scottish revenues. All else equal, this would tend to suggest growth in revenues per person in Scotland would be lower than for the UK as a whole. Third, while our revenue projections account for declines in oil revenues, our projections assume that GDP from the North Sea rises in line with onshore GDP. If North Sea GDP declined, as one might actually expect, then Scotland’s cash-terms deficit would represent a larger percentage of GDP. (Of course, as noted above, if oil prices rebound, oil revenues and North Sea GDP would likely grow more quickly than we have projected).

Figures for Scotland’s deficit if it inherited a 0% share of UK central government debt are calculated by subtracting estimates for Scotland’s population share of the UK’s central government net debt interest payments from our baseline projections for Scotland’s public spending.