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Economist Jim Cuthbert warns that Scotland's new financial arrangements may be a dream come true for unionists and a disaster for the SNP

AS Commonspace readers cannot have failed to notice, the annual GERS publication came out last week. The headline figure showed Scotland’s gross fiscal deficit, following a decline in oil revenues, as £14.8bn in 2015/16, or 9.5 per cent of GDP (as compared with a UK deficit of four per cent of GDP.)

The publication was followed by a predictable bout of unionist crowing, along the lines that these figures marked the size of the 'union dividend' which Scotland receives from its membership of the UK.

What was conspicuously absent from the unionist hype, however, was any discussion of the risks for future levels of public expenditure in Scotland, implicit in the new funding system brought in following the Smith Commission report.

What will be demonstrated in this note is that the new post-Smith fiscal system puts public expenditure in Scotland at grave risk.

The current GERS figures are the product of the old Barnett Formula system, which has now been replaced. It is meaningless and hypocritical to flaunt the old system as validating the union without discussing the likely performance of the new system. (And incidentally, although not the subject of this note, it is also hypocritical to stress the funding of Scotland’s present deficit as somehow indicating an advantage of the union, without also balancing this by noting the £150bn or so by which, cumulatively, Scotland has subsidised the rest of the UK since the start of the Barnett Formula.)

What will be demonstrated in this note is that the new post-Smith fiscal system puts public expenditure in Scotland at grave risk: the vaunted union dividend, and perhaps the union itself, may not survive the operation of the post-Smith fiscal settlement.

First of all, some background is necessary on the fiscal settlement negotiations which culminated last February in the deal between the Westminster and Scottish governments.

Following the famous 'vow', the Barnett Formula was always going to play an important part in the new system: but, of course, Barnett had to be modified to allow for the new taxes which were either going to be devolved to Scotland, (like income tax), or hypothecated to Scotland (like half of VAT.)

Without going into the rather complicated algebra, the position reached in the final stages of the fiscal settlement negotiations was as follows: The Scottish Government was arguing that, in order for the fiscal settlement to be neutral, (i.e., in order for Scotland to receive the same funding as it would have done under Barnett), what Scotland would have to match the rest of the UK in its per capita growth rate in devolved and hypothecated tax receipts.

The UK Government position implied that, in order to achieve neutrality, Scotland would have to match rUK in the growth rate of per capita tax receipts, and match rUK in rate of population growth.

Since Scotland has historically had a lower rate of population growth than rUK, the UK Government condition is more challenging than the Scottish Government condition: i.e., it would be more difficult for Scotland to achieve the same funding as it would have received under the old Barnett Formula if it were operating under the rules the UK Government wanted to set, as compared with under the rules the Scottish Government was proposing.

Putting this another way: in the final stages of the negotiation, both parties were agreeing that Scotland should accept economic risk: i.e., that Scotland would do worse than Barnett if the Scottish economy did not generate devolved tax revenues which grew as fast per head as the corresponding revenues in rUK.

But the UK Government was also arguing that Scotland should accept relative population growth risk as well: i.e., it would also lose funding relative to Barnett if it did not grow its population as fast as rUK as well.

There is a real prospect that Scotland’s per capita tax receipts will not keep up with rUK’s. If this happens, the penalties will be severe.

At the end of the day, therefore, the difference between the two parties boiled down to whether Scotland should accept relative population growth risk or not: and the final agreement was an uneasy compromise.

What was agreed was that, on the one hand, the UK’s proposed method should be used: but, on the other hand, for the first five years the results would be adjusted in line with the Scottish Government’s proposed method. After five years there would be a review.

The status of this review is somewhat confusing. David Mundell, (secretary of state for Scotland- so he should know what was agreed), implied to the House of Commons that Scotland would be expected to take on relative population risk after the review: but a careful reading of the actual agreement suggests that there is no presumption that the UK option would be the default position after the review.

Because the final disagreement in the negotiations came down to the question of whether Scotland should accept the risk of its relative population growing more slowly, and because John Swinney won a (possibly temporary) victory on this point, he claimed a triumph for the SNP.

But this neglects the economic risk that Scotland is exposed to under both of the opposing approaches. At a time when Scotland’s oil industry appears to be going into secular decline, and also given that the Scottish Government has relatively limited economic powers, there is a real prospect that Scotland’s per capita tax receipts will not keep up with rUK’s.

It is worth noting that the fiscal settlement deal is out of line internationally in the extent to which it leaves Scotland exposed to economic risk.

If this happens, the penalties will be severe. If Scotland’s per capita tax receipts on devolved taxes chronically grow at a slower rate than rUK’s, then public expenditure per head on devolved services would converge to a limit of about 60 per cent of that in rUK – a fine union dividend indeed.

It is worth noting that the fiscal settlement deal is out of line internationally in the extent to which it leaves Scotland exposed to economic risk. As a report by the Institute for Fiscal Studies, published in March, said, Scotland’s new fiscal arrangements look "increasingly unusual" in international terms, with "virtually no insurance for future economic shocks or trends that affect Scotland’s devolved revenues and welfare more than they do equivalent spending in rUK".

The final position we have reached is unsatisfactory from nearly everyone’s point of view. From the unionist viewpoint, despite boasting about the 'union dividend', they have managed to put in place a deal which puts Scotland at major economic risk – a risk which quite possibly threatens the union itself.

From the SNP viewpoint, it has tamely accepted a deal where it has to manage economic risk – at the very moment when oil is declining, and without adequate economic powers.

Moreover, because John Swinney claimed as a triumph his partial negotiating success in countering population risk, this means the SNP will have to accept the blame for failure if, as is likely, the fiscal settlement does turn out badly for Scotland.

Because John Swinney claimed as a triumph his partial negotiating success in countering population risk, this means the SNP will have to accept the blame for failure if, as is likely, the fiscal settlement does turn out badly for Scotland.

Overall, an unsatisfactory position indeed. Probably the only people who can be happy are those on the unionist side who are interested in punishing Scotland for our presumption in holding the 2014 referendum in the first place.

Picture courtesy of Scottish Government