The UK and Scottish governments have finally published the long-awaited update to the Fiscal Framework, following the review that has been going on for the last couple of years.
Since this was due to happen in 2021, we have been waiting for the outcome of this review. For more background, see our blog from late 2021.
For those new to it, the Fiscal Framework sets out the rules for how devolution of tax and social security powers following the Scotland Act 2016 is supposed to work in terms of finances. It sets out the mechanisms by which the Scottish block grant is adjusted to reflect the fact that large amounts of tax and social security powers are now the responsibility of the Scottish Parliament.
It also sets out fiscal flexibilities that the Scottish Government can choose to use in managing these powers, as new tax and social security powers also come with risks that require to be managed.
In this blog, we set out the main headlines and our initial reaction to the updates.
The mechanism for adjusting the Block Grant will remain permanently as the Index Per Capita (IPC) method.
This is one of the most complex areas of the fiscal framework but definitely one of the most significant.
For tax, it sets out the mechanism for working out how much the UK Government has “given up” by devolving a tax to Scotland, given that it is a significant loss in revenue. As, following devolution, there are different policies pursued in rest of UK and Scotland, this is not straightforward. Essentially though, the mechanism agreed in 2016 was to grow the tax at the point of devolution at the rate, per person, that it grows in the rest of the UK. This is known as the Index Per Capita (IPC) method.
So, the idea is that if taxes per head grow quicker in Scotland, the Scottish Budget will be better off – conversely, if taxes per head grow more slowly, the Scottish Budget will be worse off.
In 2016, when the fiscal framework was first agreed, the IPC method was the SG’s preference, whereas the UKG preferred the “Comparable Method” (which would generally be worse than the IPC method for the Scottish Budget). So they agreed to use IPC for the first 5 years and review it in this review published today.
They have now agreed that the IPC method will remain on a permanent basis.
Interestingly, this means that, on a permanent basis, the mechanisms for adjusting the block grants for Wales and Scotland will be different, given Wales’s Fiscal Framework uses the Comparable Method, albeit with additional provisions to keep a funding floor in place.
Borrowing Powers for managing forecast error have been increased significantly
Resource borrowing powers to manage forecast error associated with tax and social security powers have been increased from £300m to £600m. This is required because when budgets are set, the tax, social security and block grant adjustment estimates are set on the basis of forecasts from both the Scottish Fiscal Commission and the Office for Budget Responsibility. When the outturn data is available, if there is a discrepancy (which is very likely), then the Scottish Budget has to reconcile these differences.
This will be good news for the Deputy First Minister looking ahead to delivering her first budget in December, given that it was confirmed recently that there will be a large negative reconciliation to reflect income tax receipts in 2021-22 of £390m. As these changes are coming into effect for the 2024-25 budget year, this means she will have more flexibility to borrow to cover this.
All limits, such as resource and capital borrowing powers, will be uprated in line with inflation
When the Fiscal Framework was first agreed, the limits on borrowing for both resource and capital, and the limits for what could be put into the Scotland reserve, were set in cash terms and have been fixed ever since.
This agreement sets out that the ones that remain will be uprated by inflation (although the exact inflation measure and timing is still to be confirmed), and that the limits on the additions and drawdowns on the Scotland Reserve will also be abolished.
The VAT Assignment can gets kicked down the road again
One thing that is a little disappointing is that there was no final decision on VAT Assignment. See our blog from 2019 to get the background in this.
VAT Assignment was included as part of the Smith Commission powers. The idea was that half of VAT raised in Scotland would be assigned to the Scottish budget, which would mean, if the Scottish Economy was performing better than the UK as a whole, the budget would be better off, and conversely, if VAT was growing less quickly in Scotland, the budget would be worse off.
However, after almost 10 years, it has become clear that there is no way to estimate VAT in Scotland that is precise enough for this to have budgetary implications. It is a large amount of money (more than £5 billion) so even small fluctuations in how it is estimated can mean changes of hundreds of millions of pounds.
Today, the Governments have agreed to just keep discussing it. We think it is time that everyone admitted it is just not a sensible idea.
First published by the Fraser of Allander Institute