What is the right budget constraint for Scotland?


An analysis by Professor Paul Hallwood (University of Connecticut) and Professor Ronald MacDonald (University of Glasgow)

 

Highlighted recommendations include:

• Block grants from Westminster should not be elastic in the sense that if the Scottish Parliament cannot finance its chosen spending level out of the existing block grant and own-sourced taxes, the block grant is not automatically or quickly increased.
• Any extra taxes raised by Scotland are not shared with Westminster.
• If the Scottish Parliament’s tax policy led to a smaller tax base (a shrinking economy), it should have to live with that during the extended period of non-adjustment.
• Borrowing by the Scottish Government should be regulated.

Executive Summary

Our position paper submitted to the Smith Commission considers the devolution of further fiscal powers to the Scottish Parliament in the context of the objectives and remit of that Commission. Our argument builds on our extensive discussion of fiscal decentralization to Scotland made in our previous published work.

We ask what sort of budget constraint the Scottish Parliament should operate with. A soft budget constraint (SBC) allows the Scottish Parliament to spend without having to consider all of the tax and, therefore, political consequences, of that spending, which is effectively the position at the moment. The incentives to promote economic growth through fiscal policy – on both the tax and spending sides are weak to non-existent. This is what the Scotland Act, 1998, and the continuing use of the Barnett block grant, gave Scotland.

Now other budget constraints are being discussed – those of the Calman Commission (2009) and the Scotland Act (2012), as well as the ones offered in 2014 by the various political parties – Scottish Conservatives, Scottish Greens, Scottish Labour, the Scottish Liberal Democrats and the Scottish Government. There is also the budget constraint designed by the Holtham Commission (2010) for Wales that could just as well be used in Scotland.

We examine to what extent these offer the hard budget constraint (HBC) that would bring tax policy firmly into the realm of Scottish politics, asking the Scottish electorate and Parliament to consider the costs to them of increasing spending in terms of higher taxes; or the benefits to them of using public spending to grow the tax base and own-sourced taxes?

The hardest budget constraint of all is offered by independence but, as is now known, a clear majority of those who voted in the referendum did not vote for this form of budget constraint. Rather they voted for a significant further devolution of fiscal powers while remaining within a political and monetary union with the rest of the UK, with the risk pooling and revenue sharing that this implies.

It is not surprising therefore that none of the budget constraints on offer, apart from the SNP’s, come close to the HBC of independence. However, the almost 25% fall in the price of oil since the referendum, a resource stream so central to the SNP’s economic policy making, perhaps underscores why there is a need for a trade off between a HBC and risk pooling and revenue sharing.

Ranked according to the desirable characteristic of offering something approaching a HBC the least desirable are those of the Calman Commission, the Scotland Act, 2012, and Scottish Labour. In all of these the ‘elasticity’ of the block grant in the face of failure to grow the Scottish tax base is either not defined or is very elastic – meaning that the risk of failure is shuffled off to taxpayers outside of Scotland.

The degree of HBC in the Scottish Conservative and Scottish Liberal Democrats proposals are much more desirable from an economic growth point of view, the latter even embracing the HBC proposed by the Holtham Commission that combines serious tax policy with welfare support in the long-run. We judge that the budget constraint in the SNP’s proposals is too hard as it does not allow for continuation of the ‘welfare union’ in the UK.

We also consider that in the case of a generalized UK economic slow requiring a fiscal stimulus that the Scottish Parliament be allowed increased borrowing to be repaid in the next economic upturn.

Full recommendations

In the Scottish context we recommend a HBC and this requires:

i)  Block grants from Westminster should not be elastic in the sense that if the Scottish Parliament cannot finance its chosen spending level out of the existing block grant and own-sourced taxes, the block grant is not automatically or quickly increased. The Holtham Commission recommended a 12 to 15 year ‘waiting period’ with respect to the Welsh Assembly and Government, and the Scottish Parliament should abide by rules such as these. A non-elastic block grant amounts to a ‘no bailout clause’ (it is time consistent). The advantages of this are:

a) SCG spending decisions have to look to whether they are financeable during this extended period of time.

b) As there is a risk in adverse circumstances that taxes at the SCG level will have to go up to maintain chosen expenditure levels, the Scottish Parliament is forced to balance the benefits of its spending choices with the cost to Scottish taxpayers. This principle is consistent with risk sharing in a ‘welfare’ union. But a ‘sharing union’ is not the same thing as an ‘unlimited pocket money system’ that would impose no costs at the sub-central level, simply transferring them to the rUK.

ii)  Any extra taxes raised in Scotland are not shared with Westminster, or, they are not so during the extended period of non-adjustment during the ‘Holtham interlude’ of 12 to 15 years. If it were otherwise the incentive to use tax policy to increase the Scottish tax base (size of the economy) is diluted. For example, if Scottish taxes were set to finance 40-percent of the Scottish Parliament’s spending, for every extra £1 of Scottish tax revenue 60-pence would be sent to Westminster.

iii) Likewise, if the Scottish Parliament’s tax policy led to a smaller tax base (a shrinking economy), it should have to live with that during the extended period of non-adjustment. If it were otherwise, a moral hazard would be imposed on the rUK, namely, that Scottish tax policy is a riskless exercise for MSPs and voters.

iv) Borrowing by the Scottish government should be:

a) Limited in amount – as several proposals suggested, with the proviso that borrowing could be increased during a generalized UK economic downturn.

b) Allowed only for capital projects (except in a generalized UK economic downturn) so that repayment is sustainable.

c) Subject to a no-bail out clause so that borrowing can be disciplined by financial markets.

Only the budget constraints suggested by the Scottish Liberal Democrats, the Scottish Conservatives and Scottish Greens are hard enough to be given serious consideration. They imply much less immediate transfer of policy risk away from the Scottish Parliament to the rUK. As such they will concentrate minds in Scotland – of government and voters – on what can work at the fiscal level to promote prosperity in Scotland. The fiscal proposals of the SNP are the hardest of all, but they do not allow for continuation of the UK’s welfare union.

To view the paper in full please click HERE