London and Edinburgh governments would not be able to keep promise that no country’s taxpayers will end up worse off

The Institute for Fiscal Studies has warned that it will be impossible for the Treasury and Scottish government to design a fair, flawless system for funding Scotland after it gets new tax-raising powers.

The IFS said the London and Edinburgh governments would be unable to meet the promises they made to voters when they signed up to the Smith agreement on new powers for Holyrood, to ensure no country’s taxpayers suffered after Holyrood gets nearly complete control over Scottish income tax in 2017.

It said the entire basis for funding the devolved governments in Edinburgh and Cardiff – the widely disliked Barnett formula – may need to be scrapped and replaced to address these conflicts – backing up similar calls on Friday by peers in the House of Lords.

David Phillips, a senior research economist at the IFS and co-author of the paper, said: “It may now be time for a more fundamental reassessment of how the devolved governments are financed: including whether the Barnett formula should be reformed.

“[The] Smith commission parked these issues to one side by committing to the current Barnett formula. Making the UK’s fiscal framework sustainable for the long term may require reopening the debate.”

In a detailed study of the possible mechanisms for implementing the deal, written jointly with the Centre on Constitutional Change at Edinburgh University, the IFS said its main principle that neither taxpayers nor governments on either side of the border should lose out were contradictory. They were incapable of being simultaneously honoured.

There was no clear way that balancing tax incomes and spending between the two governments could stop either Scotland eventually ending up £1bn a year worse off, or instead lead to the Treasury continuing to heavily subside Holyrood by another £1bn or more a year, the paper stated.

Echoing strong and very similar criticisms by the Lords economic affairs committee overnight, the IFS also criticised the secrecy surrounding the intergovernmental talks between Edinburgh and London on the so-called fiscal framework.

Adding weight to the growing political pressure on both governments to disclose far more detail about their post-Scotland bill funding plans, Prof David Bell, a co-author of the IFS report, said the debate on how to fairly fund Holyrood under the Smith agreement had to take place in public.

UK and Scottish ministers are resisting that pressure. Lord Dunlop, the junior Scotland Office minister, rejected the Lords’ demand for the Scotland bill to be delayed until the fiscal framework was published, which is not expected until January.

There was no need for that, Dunlop told BBC Radio Scotland on Friday. “All the issues that the House of Lords committee are raising in its reports are exactly the issues that the two governments are discussing and negotiating at the present time,” he said.

There would be ample time for both parliaments to study its proposals. “I don’t think you can scrutinise something which has not yet been agreed and negotiated,” Dunlop said.

The IFS agreed with the Lords economic affairs committee that a central problem arose from keeping the Barnett block grant formula, the complex Treasury system for allocating spending to Scotland and Wales based on government spending in England.

In findings endorsed by all the major political parties and both governments, the Smith commission, set up after last year’s independence referendum to propose extra tax and policy powers for Holyrood, said the Barnett formula should remain the bedrock for Scottish funding.

But on top of that, Holyrood should have greater financial independence from the Treasury: it will control about £11bn-worth of income tax, plus other minor taxes, spend half the VAT raised in Scotland and oversee £2.7bn-worth of welfare spending. Those would involve “block grant adjustments” to account for Scotland’s new domestic tax-raising.

However, to avoid Scotland suffering from slower population increases, a weaker tax base and economy or being damaged by global or UK level downturns or economic decisions that it could not control, the UK government has promised to ensure its finances are not unfairly affected. And similarly, the Scottish government would not be able to profit from the rest of the UK’s problems, either.

The IFS said: “It therefore turns out that it is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett formula remains in place. Some methods better satisfy the first and others the second principle.”