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The dash from full fiscal autonomy and the biteback of the ‘no detriment’ principle

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The SNP Scottish Government has spent the time since indyref 1 repeatedly calling for ‘full fiscal autonomy’. This has virtually been their stated price for staying in the United Kingdom – until they’ve got the hang of it.

The irony is that starting to get a grasp of the issues  – accelerated by some hard fiscal realities delivered in a series of papers by the Institute for Fiscal Studies – has changed the game already.

Now the last thing they want is full fiscal autonomy.

First Minister Nicola Sturgeon and Finance Secretary, John Swinney were in the middle of executing a disguised retreat from the demand for ‘full fiscal autonomy’, by individually finding moments to mention, casually, that this would, of course, take several years to implement.

This managed retirement was blown out of the water last Sunday, 31st May 2015, by someone habitually identified by journalists as ‘a senior SNP source’, anonymised because ‘he’ is under instructions, serially disregarded, to keep out of the limelight these days.

This source ‘indicated the nationalists are not ready to fight for their flagship manifesto pledge of full fiscal autonomy to be included in the Scotland Bill when it is debated in the Commons over the coming weeks’. [Ed: our emphasis above.]

Yet, only last week, Mr Swinney, still in slow reverse, declared that the SNP ‘could‘ still put down a full fiscal autonomy amendment in this debate.

So what’s the problem?

The dash from full fiscal economy

The problem is plural, with every element heavyweight:

There is the global glut in oil; the impact of that on the price of oil; the impact of that on North Sea tax revenues; the consequent shrinking of the North Sea oil industry, with its high production costs making it uncompetitive in the current market; job losses and the ongoing firesales to minnows of North Sea assets by the major players still in the UKCS; the loss of exploration activity, of current production and of future production in the ongoing permanent shutting down of ‘mature’ wells and some pipeline infrastructure in the  North Sea;

The OBR [Office of Budget Responsibility] forecast  in March 2015 a 73% drop in average annual North Sea revenues over each of the five years from this year, 2015-16 to 2019-20.

The IFS [Institute for Fiscal Studies] projected and defended a structural deficit in the Scottish Government’s budget plans resulting from these latest OBR forecasts – from £7.6Bn this year,  2015-16  – increasing to £9.7Bn in 2019-20.

There has been a less than successful first implementations of two existing fiscal powers by the Finance Secretary. There was his 2008 change to business rates, which first had to be capped in 2012; and then, this year, had to be listed for necessary revision in 2017, allowing time for him to consult with the business sector. This raises the question of why adequate consultation did not precede the initial change to this rate?

Then there was his LBTT [Land, Buildings and Transaction Tax] – a tax that was Mr Swinney’s replacement for Stamp Duty on property sales. Under LBTT, 50% of properties are removed from tax but those selling at over £333k [hardly 'mansions'] pay a higher tax than had previously been the case. Faisal Choudhry, Savills’ Associate Director, says that Savills had warned the Scottish Government that the new tax carried a risk of generating lower revenues because it relie3 on 8% of buyers to generate 75% of the tax revenue target.

Mr Choudhry points out that, while the fall in sales and LBTT revenue in April was inflated to a degree because of the rush to get sales of affected properties completed before the introduction of the new higher rate on 1st April 2015, this was not by any means the whole story. The Scottish Government insists that the new tax has been a roaring success and collected £18M in its first month.

Savills say that £6.9M was raised in April 2015 from LBTT, while £17.8M was raised in April 2014 from the former Stamp Duty. The fall of £11M in April 2015, from the 2014 figure, if these are correct, would tend to support Savills’ position.

It has taken an unexpected length of time to establish the administration of two small taxes devolved to Scotland – the aggregates tax and the landfill tax. This has brought a sharp reality check on what ‘full fiscal autonomy’ would actually demand, not only in systems but in expertise.

The economic reality

In the IFS paper by David Phillips, issued on 19th March,- Scotland’s fiscal position: an update in light of the OBR’s March Forecasts – David Phillips calculated that the factors active over five years,  listed immediately below, would lead to a deficit of 8.6%, [£7.6 billion] of GDP in the 2015-16 Scottish budget – 4.6% over that for the entire UK and currently absorbed within the Union:

  • ‘Falls in forecast oil and gas prices have reduced forecast revenues by £1bn a year;
  • ‘Falls in forecast production have reduced forecast revenues by £1bn a year;
  • ‘Other modelling changes have reduced forecast revenues by about £0.7 billion a year;
  • ‘Tax cuts have reduced forecast revenues by about £0.3 billion a year;
  • ‘And a fall in forecast [tax deductible] investment and operation expenditure offsets around £1.1 billion of these falls a year.’

This IFS paper explains that the impact of the fall in oil tax revenues this year will impact more sharply on Scotland than on the UK as a whole. This is because the greater negative impact from the loss in anticipated revenues and the lesser positive impact from economic growth as a result of lower energy prices are down to the same physical fact: the much smaller scale of the Scottish onshore economy, population and therefore tax base, in relation to the UK as a whole. Size matters.

The Phillips paper instances here: ‘the reduction in forecast revenues in 2015–16 is equivalent to around 0.8% of Scottish GDP but only around 0.1% of GDP for the UK as a whole’. An eight times greater hit is a punitive asymmetric hit.

Attempts at dismissal by claiming that the Phillips IFS projections are ‘only a snapshot’ have been shown by a follow-up observation paper to be unfounded, with the given assumptions underlying the projections clearly secure.

Phillips goes on to show that, while it is correct that Scotland’s deficit as a percentage of GDP would reduce over the years to 2019-20 [from -8.6% in 2015-16 to -4.6% in 2019-20]:

  • the gap between the Scottish deficit and that of the UK as a whole would  not decrease over that period and would indeed rise [from -4.6 this year to -4.8% in 2016-17, staying at that level until 2019-20 when it would rise again to -4.9%];
  • that. in cash terms, in the three years of 2016-17 to 2018-19, where the percentage of the projected gap between the two deficits remained stable at -4.8%, the cash translation of that gap would nevertheless rise annually;
  • and that in cash terms, the translation of the negative gap between the Scottish deficit and that of the UK as a whole would rise from -£7.6Bn in 2015-16 to -£9.7Bn in 2019-20;

As Phillips says, of course the Scottish Government could shrink that gap with the UK as a whole IF it were able to grow the Scottish economy faster than could the UK.

The rate of growth this would require is not impossible but, as Phillips succinctly puts it, ‘is much easier to promise than it is to deliver’.

The Phillips IFS projections offer the means to calculate the rate of growth that wojld be necessary to close the deficit gap within optional periods. They show that to close the deficit gap with the rest of the UK  in five years, Scottish revenues per capita would have to grow by 4.5% in real terms, year on year, to 2019-20; and that even trying to close the gap over 10 to 15 years ‘would require a step-change in Scottish economic performance, and revenue generation’.

As things stand, an uninterrupted widening of the gap between the Scottish and UK deficits shown in the projections  – on current spending and revenue forecasts – means that a later implementation of full fiscal autonomy [if granted], when the SNP Government felt ready to deal with it,  would not see them starting from a better deficit position but a worse one.

This position would mean that the introduction of full fiscal autonomy would inevitably require immediate and significant cuts in spending and raises in taxation in Scotland.

The fiscal contradiction of the Smith Commission

With the SNP strategy, perforce, to consign ‘full fiscal autonomy’ to the shadows, the ‘senior SNP source’ cited in the press last Sunday said that the party’s strategy is now to press for enhanced powers to be added to those to be devolved on the recommendations of the Smith Commission.

In our view, the agreed powers stretch to breaking point an already markedly asymmetric union. They also start to undermine the correct core argument advanced by the UK Government during indyref 1 against access to a shared Sterling currency zone by an independent Scotland.

This was that differing fiscal policies between Scotland and the continuing UK, within a common currency union, could only put the stability of that currency under pressure.

Adding to these ‘Smith’ powers the unconsidered and unsanctioned additional fiscal powers now demanded by the SNP crosses the threshold either to make that key argument look a patent fiction [which it was not] or to begin the weakening of Sterling it forecast from such fiscal circumstances.

Even if Scotland could handle them, there is no constitutional process to enable simply throwing in another barrowload of devolved powers to the Scotland Bill, since these would not have emerged from the Smith Commission process and agreement which, however ill-considered in its inception, at least underpins that Bill.

What the Scotland Bill gives Scotland already unbalances the impact on the Union of the original devolution settlement, itself a typical Blairite piece of inadequately interrogated ad hockery.

How will the lesser ambitions fare?

The risks, responsibilities and aggravated difficulties in having major fiscal controls at or not far short of ‘full fiscal autonomy’ are the reality of the challenge for Scotland, independent or not.

Whatever Scotland’s constitutional position, devolved or loosely devolved, that deficit will have to come down before there is any chance of making a fiscally sound case for independence. That is not to suggest that a case as unsound as the last one would not now carry the day regardless in indyref 2.

Closing the gap between the Scottish and UK deficits can be done in four ways: reducing spending; increasing tax revenues; growing the economy; and borrowing.

Of these, the bond markets would not take a supportive stance on the irresponsibility of borrowing largely for deficit reduction. What could therefore be borrowed for this purpose would be very expensive. Moreover this tactic  could only reduce the deficit temporarily. It could not impact on the endemic structural deficit.

Given the success of the vote-catching promises of increased spending on enhanced welfare, the SNP government risks a great deal politically if it has to cut back on spending as part of the address to closing the deficit gap.

That leaves raising taxes and growing the economy as the remaining tools to deploy in meeting this challenge – and there is a dangerous relationship between the two.

With a large mainland landmass and inhabited island archipelagos, all underpopulated and with that population markedly skewed to the far end of the age scale, there is a fundamental imperative for Scotland to increase its working-age population base as a major stimulus in growing its economy. This is the most energetic and constructive approach to reducing the structural deficit.

However, what the Finance Secretary seems minded to do can only impede the success of a strategy to encourage inward migration of those who can be net contributors to the Scottish economy.

In the Scottish Parliament this week, Mr Swinney refused to answer a direct challenge from the Scottish Conservaive Leader, Ruth Davidson on whether or not he would raise income tax with the powers to be devolved in the Scotland Bill.

This is where, whatever the constitutional position of Scotland, tbe Finance Secretary is heavily restricted to the point of paralysis.

With increased spending promised on elements of welfare, Mr Swinney cannot change the bands and rates of income tax to produce lower revenues. He needs to generate higher tax revenues. That need is driven by the structural deficit alone, never mind the extra spending to come.

He cannot raise income tax on lower earners, so he would have to look at whether to raise it on the middle earning bands or on higher earners or both.

If he were to raise income tax substantially on higher earners, many would migrate outwards and have the economic mobility to do so, with high level skills, expertise and experience to sell.

They would not be replaced at the same level of proven ability or experience. With its small population, Scotland has a shallow talent pool; and why would highly able and experienced people choose come to Scotland to take home less in a more demanding tax regime?

The high end emigrants would be replaced by the ambitious, less experienced and perhaps less able in search of promotion – who might still take home a little more, if the balance of a higher salary and a higher tax take played out acceptably in their individual cases. Some might be prepared to take promotion at little or no enhanced take home income, to gain experience to allow them to migrate outwards to a lower tax regime as soon as possible, on the back of an enhanced CV.

Proportionately, there are fewer high earners anyway, so the impact of raising their rate of income tax would not alone achieve the necessary rise in revenues; and Scotland could experience a drop in performance standards in those in the higher earning bands. This would encumber and not assist economic growth.

Alternatively, as is likely to be the intended main plank of his strategy, if Mr Swinney went  for the more numerous middle earning bands, proportionately fewer might migrate outwards but the higher rate of tax for such earning bands would act as a positive deterrent to the vital inward migration of the working-age earning bands that is the engine of economic development.

And where does all of this leave the deficit gap?

Paralysis

There is little that Mr Swinney can do with the Scotland Bill powers other than fiddle minimally on the fringes.

The close proximity of England and Wales with a bigger employment market leaves the Finance Secretary effectively shackled to a common income tax regime.

If this is the rock, the hard place that limits his movements in other forms of taxation is the ‘no detriment’ principle in the Smith Commission report [addressed below]. This means that any change to fiscal measures either by Scotland or by England and Wales that can be shown to disadvantage the other, requires due compensation for that loss to be paid by the active to the affected member/s of the Union.

Since the compensation to the larger economy would be likely to equate to or exceed the value gained by the smaller economy of Scotland from the measure in question, there is little point in the Finance Secretary devising competitive variations of fiscal policy.

Were he to have ‘full fiscal autonomy’ and in theory be free to put together specific inducement packages by playing the variations on the relationships between welfare support, income tax, rates, corporation tax, covert income taxes like NICs and other forms of tax like VAT, Mr Swinney might have more apparent flexibility to vary fiscal policy within the United Kingdom; or even as an independent country within the island of Britain.

But the greater flexibility and power of the far larger economy of England and Wales would generally make it very difficult for him to engineer any serious change that did not carry an equally serious cost.

However, the First Minister and the Finance Secretary appear to be attaching the mooring lines of their strategy to cry for greater devolution of serious fiscal powers to two particular stanchions. Neither of these is secure and each has been perceived with a degree of wishfulness:

  • one is the continuation of the Barnett formula, effectively to cover the costs of failures as Scotland feels its way into managing these new powers. But why would the rest of the UK pay an even greater per capita subsidy to Scotland than it already does – if Scotland cannot effectively deploy in its own interests the far greater powers devolved to it than to any other member of the Union?
  • the second is a notion called the ‘no detriment’ principle contained in the Smith Commission recommendations – but which the SNP government appears to understand imperfectly.

 The added powers now sought by the SNP government

These additional powers are the devolution:

  • of corporation tax;
  • of National Insurance Contributions (NICs);
  • of the welfare system.

Phillips notes that the powers agreed for devolution by the Smith Commission, taken together, ‘would see devolved or assigned revenues making up more than half the Scottish Government’s budget, substantially higher than the 7% or so, at present.’

On the one hand this will see devolved to Scotland very substantial powers over its own revenues.

On the other hand, should the use of these powers fail to raise the revenues coming in under the current fiscal policy measures, control of 50% of revenue raising in untried hands could be a pretty hefty punt.

The SNP government appears though, to be counting on making stick as protection against failure the ‘no detriment’ principle contained in the Smith Commissions report. Chancellor George Osborne has also committed to this ‘no detriment’ principle.

That principle is already more of a control device than an escape hatch – as shown below – but in any case it can only be applied to powers already agreed for further devolution. It cannot be assumed that it would be applied to the outcomes of the use of additional devolved powers beyond the Smith recommendations; or that its ‘controlling’ effects would  not be strengthened in any revision.

So what is this principple and who does it protect from what?

Double edged ‘no-detriment’ principle

The no detriment principle is described as applying to policy decisions following the devolution of tax raising powers in the Scotland Bill born from the Smith Commission recommendations.

Accountancy Live says that: ‘in cases where either the UK or Scottish government makes a policy change which affects the tax receipts or expenditure of the other, then the decision-making government will either reimburse any costs the other government incurs, or receive a transfer of funds if the other government benefits.’

This protects each of the Scottish Government and the UK Government from fiscal policy changes made by one of them which negatively affect the other.

There are two issues here which the SNP government – and Scots – need to grasp securely before seeing the ‘no detriment’ principle as a unilateral protection against fiscal failure.

If the Scottish government makes fiscal policy changes in Scotland which negatively affect England and Wales, they will have to make restitution for that loss. Since the economy and tax base of England and Wales is very substantially larger than that of Scotland, the impact on the smaller budget of recompensing the larger one for any detrimental effect of competitive changes to fiscal policy could be a pretty mighty hit.

‘No detriment’ is a level of protective action against unintentional or intentional competitive predation by one of these governments upon the other; but, more immediately, it is a powerful ‘cooling-off’ device to arrest premature and potentially highly expensive action. The cost of a precipitate and unthought change of fiscal policy could wipe out any competitive gains and would continue to be paid until that policy was revised.

The second issue is that the ‘no detriment’ principle protects each government only against detrimental impacts arising from fiscal decision taken by the other government. It does not protect Scotland against detrimental impacts on its own budget from failed fiscal policy decisions taken by itself. So Scotland will now bear the cost of its own mistakes – on the basis of an inexperienced team taking responsibility for raising 50% of our annual spending revenues.

As we have shown above, the use of new powers already devolved are exposing the nature and extent of Finance Secretary John Swinney’s previously untested fragilities in fiscal management.This means that the possibility of failure in raising all of the 50% of tax  revenues necessary to cover committed spending is a greater actual worry than anyone, possibly including Mr Swinney, had anticipated it would be.

As Mr Swinney ventured into the uses of the financial instruments becoming available to him, he has been responsible for a series of expensive misjudgments that were all too clearly born of an ability to play drafts but not chess.

The ‘no detriment’ principle’ in action

If, with the devolved powers to come in variations of Air Passenger Duty [APD], were Scotland to lower the rate of APD resulting in a negative impact on airports in the northeast or northwest, such as Newcastle, Manchester and Liverpool, the detrimental impact on those local economies of the Scottish action would require to be fully compensated by Scotland.

Where Scotland, though, raised income tax in changes which delivered higher revenues, those would accrue to Scotland with no negative impact on England and Wales.

Using that same example, but this time where Scotland raised income tax in changes which failed to deliver the anticipated rise in revenues, that loss would be Scotland’s problem.

Neither the Barnett formula nor the ‘no detriment’ principle may be used to cushion the result of mistaken policies or miscalculations.

The devolution of new powers cannot, in fairness to Scotland’s partners in the United Kingdom, be a ‘no risk’ arrangement where Scotland is compensated for the cost of any application of those powers which does not produce anticipated positive outcomes; and may even have delivered below the former UK-wide fiscal policy measures.

There is a serious issue to be addressed by England and Wales – as to whether the ‘no detriment’ principle would prevent the introduction of fiscal policy changes that would be of benefit to England and Wales.

There is a possible scenario where such changes would be of benefit to Scotland had there still been a common fiscal policy but no longer apply there because of divergence of fiscal policies under enhanced devolution.

Asymmetrical introduction of beneficial new measures in England and Wales, following the transfer of the Smith recommended powers in the Scotland Bill would then see Scotland disadvantaged, requiring the payment of compensation to Scotland.

The cost of such a cushion might be unacceptable and would then see England and Wales disadvantaged by decision not to introduce fiscal measures which would previously have been helpful.

It is possible that the outcome of Smith will be to see taxes in both Scotland and in England and Wales lower than they would otherwise have been – and while the underinformed might celebrate that, the result is lower spending since there will be less revenue available to pay for it. What’s that about there being no such thing as a free lunch?

The correct argument was forcibly made during the indyref 1 campaign – that divergent fiscal policies within a union are essentially destabilising of that union – and of its currency.

It therefore remains a matter of surprise that Gordon Brown’s panicking back-of-an-envelope promises at the tail end of that campaign were immediately accepted without any interrogation of consequences by all pro-union parties and are now to be implemented.

We suggest that any thoughts about even greater asymmetric devolution of fiscal powers should be put on ice until the UK confronts the already necessary fundamental constitutional changes to a form of federalism.

Note: The series of influential papers by David Phillips for the independent Institute for Fiscal Studies [IFS] are linked below:


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