SELECT COMMITTEE on ECONOMIC AFFAIRS the Devolution of Public Finances in the United Kingdom Oral and Written Evidence Contents

SELECT COMMITTEE ON ECONOMIC AFFAIRS

The devolution of public finances in the United Kingdom

Oral and written evidence

Contents

Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) ...... 4 Dr Angus Armstrong, NIESR; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow – Oral evidence (QQ 1 – 13) (DPFOE0001) ...... 19 Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007) ...... 20 Bevan Foundation – Written evidence (DPF0007) ...... 21 Constitution Reform Group – Written evidence (DPF0018) ...... 25 Dan Corry (Chief Executive, New Philanthropy Capital) and Dr Peter Kenway (Director, New Policy Institute) – Written evidence (DPF0013) ...... 29 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) ...... 30 Tom Crotty, INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) ...... 45 Dr James Cuthbert – Written evidence (DPF0004) ...... 46 Dr James Cuthbert – Supplementary written evidence (DPF0021) ...... 52 Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014) ...... 61 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) ...... 64 Mrs Margaret Cuthbert and Dr James Cuthbert – Written evidence (DPF0014) ...... 78 Mrs Margaret Cuthbert and Dr James Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) ...... 79 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) ...... 80 Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001) ...... 95 Professor Jim Gallagher, University of Glasgow; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) ...... 99 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) ...... 100 Her Majesty’s Revenue and Customs (HMRC) – Written evidence (DPF0024) ...... 128

Her Majesty’s Treasury (HMT) – Written evidence (DPF0015) ...... 131 Professor Gerald Holtham – Written evidence (DPF0003) ...... 141 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) ...... 147 INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77- 88) (DFPOE0007)...... 172 Institute of Chartered Accountants of Scotland (ICAS) – Written evidence (DPF0010) 173 Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007) ...... 200 Institute of Economic Affairs – Written evidence (DPF0006) ...... 201 Peter Jones – Written evidence (DPF0020) ...... 239 Peter Jones and Lesley Riddoch– Oral evidence (QQ 47-55) (DPF0005) ...... 259 Professor John Kay, London School of Economics (LSE); The Weir Group PLC; Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)...... 260 Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013) ...... 261 Professor Noel Lloyd CBE, Silk Commission; The Weir Group PLC; Professor John Kay, London School of Economics (LSE) – Oral evidence (QQ 98-107) (DPFOE0008) ...... 265 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022) 266 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) ...... 273 Professor John McLaren – Written evidence (DPF0019) ...... 292 Professor John McLaren, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow – Oral evidence (14-27) (DPFOE0002) ...... 295 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) ...... 296 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) ...... 310 Plaid Cymru – The Party of Wales – Written evidence (DPF0008) ...... 326 PricewaterhouseCoopers LLP – Written evidence (DPF0023) ...... 331 Nicholas Ramsay – Written evidence (DPF0005) ...... 360 Scottish Government – Written evidence (DPF0016) ...... 363 Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005) ...... 371 Socialist Health Association Cymru Wales – Written evidence (DPF0017) ...... 380 Professor Adam Tomkins, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) ...... 383

Professor Alan Trench (University of Ulster) – Written evidence (DPF002) ...... 384 Professor Alan Trench, University of Ulster; Professor David Heald, University of Aberdeen Business School; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) ...... 390 The Weir Group PLC – Written evidence (DPF0012) ...... 391 The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)...... 394 Welsh Government – Written evidence (DPF0011) ...... 409 Welsh Liberal Democrats – Written evidence (DPF0009) ...... 416

Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008)

Evidence Session No. 8 Heard in Public Questions 89 - 97

TUESDAY 20 OCTOBER 2015

Members present

Lord Hollick (Chairman) Baroness Blackstone Lord Forsyth of Drumlean Lord Griffiths of Fforestfach Lord Kerr of Kinlochard Lord Layard Lord May of Oxford Lord Monks Lord Sharkey Lord Teverson Lord Turnbull Baroness Wheatcroft ______

Examination of Witness

Sir Danny Alexander

Q89 The Chairman: Sir Danny, thank you very much for joining us this afternoon. Thank you also for accommodating the slight change in the timing. We have a visitor this afternoon in the shape of the President of China.

Sir Danny Alexander: Let me apologise for my voice. I was at Twickenham on Sunday and have not recovered from the vast amounts of shouting that I was doing, sadly in a losing cause.

The Chairman: Have you spoken to the referee?

Sir Danny Alexander: I have not. I think he is best served by avoiding Scottish people for some time to come. Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008)

The Chairman: Perhaps I might start. You said to the Scottish Finance Committee in January this year that it was “essential that the fiscal framework is agreed by the Governments so that the House of Commons and the Scottish Parliament can hear about it when they consider the Bill to implement the Smith plan”. Alistair Darling, now Lord Darling, made a similar point when we saw him—that it was really impossible to come to any reasoned conclusion without that—yet we have not seen a fiscal framework. How on earth is it possible, therefore, for Parliament and the Scottish Parliament to come to any sensible conclusion on this Bill?

Sir Danny Alexander: I hold to the view that I expressed before. I agree with Alistair Darling that it is important that before the Bill has completed its passage—I have not been following the Bill as closely as perhaps I would have been if I were still a Member of Parliament—Parliament has a chance to see and consider the fiscal framework. In a way, the fiscal framework that lies behind the Bill is at least as important as the things on the face of the Bill—the taxes that are being devolved, the welfare spending elements that are being devolved and so on—because ultimately the fiscal framework is the element that determines whether or not, for example, the principles of “no detriment” have been satisfied, that the economic incentives on both sides are properly set out and that there is a degree of simplicity and consistency to the way in which the new system will operate that means you will not have rows every year about how much money is changing hands. I would hope and expect that that work would be completed and Parliament could see it. Whether it needs to be available to Parliament at every stage of consideration is a different question, but I certainly think that that information needs to be available before Parliament as a whole has finished its consideration of the Bill.

Q90 The Chairman: The Government have been somewhat shy about appearing in front of us, because they clearly feel that it would be inappropriate to comment on negotiations as they are going through. One can understand that a little, but if that is going to deprive MPs, Peers and MSPs of vital information, how on earth can they come to any reasoned conclusion?

Sir Danny Alexander: MSPs, MPs and Peers are people who will have to make their own judgment on that subject. My perspective from when I was in Parliament and in government was that you have these core building blocks for the new system. You have the Barnett formula, which continues to exist but is much less important, you have the devolution of taxes and welfare payments, and you have a new fiscal framework behind it that ensures that the whole thing adds up. I would hope that both the UK Government and the Scottish Government were taking their responsibility seriously in terms of putting such a framework in place. I know that there are elections to the Scottish Parliament next year. It may be that the Scottish Government are worried about the political consequences of coming up with a new fiscal framework. It may be that there are delays in Whitehall. Who knows what the reasons are? However, this is a pretty centrally important part of the new system. You and your colleagues in the House of Commons ought to have some knowledge of that, I would argue, but I cannot give you any insight into what the negotiations are. I no longer have any such window on that.

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Lord Forsyth of Drumlean: The Bill has gone through and has been discussed by the House of Commons without that fiscal framework being known to it. Do you think that it needs to go back to the House of Commons for consideration?

Sir Danny Alexander: I have not followed the parliamentary process enough really to have a view on that question. If your Lordships had access to that information, you could make any amendments that you felt were necessary, which would then go back to the House of Commons. That is the way that such things are normally accommodated in parliamentary procedure.

Q91 Lord Forsyth of Drumlean: Going back to your experience in the Treasury, a number of the witnesses have complained that in deciding on the funding, particularly of Barnett, the Treasury is judge and jury in its own court, and that there is a need for some kind of independent process. What is your view on that, now you are released from collective responsibility?

Sir Danny Alexander: First, I think that the Treasury has a core responsibility for the financial stability of the United Kingdom. It is right that it takes that seriously and does not contract it out. In respect of the Barnett formula, I do not accept the criticism. The way in which the Barnett formula operates is simple and transparent, for those who really care about the detail of how it operates. During my time in office, I do not recall once there being any great row or debate about whether or not the calculation of the Barnett formula had resulted in the right numerical outcome; I think that it is proposed that an independent body should oversee those sorts of calculations. I do recall that on one occasion there was an error on a spreadsheet, which was picked up pretty quickly by a civil servant and corrected.

One of the strengths of the Barnett formula is precisely that people might disagree about the politics that lie behind different policies—they might, for example, criticise the deficit reduction and the fiscal consolidation that has led to reduced spending over the years, which I support; I think that you do, too—but the rows tend to be at that level. In my experience, there has not really been a row, an argument or a question mark over whether or not the Barnett formula itself has been applied correctly. Incidentally, I think that that is one thing that needs to be replicated in the new fiscal framework. You need to have a new fiscal framework that is understood and predictable, so that you do not have rows every year about whether the right number has been generated as a result of it. Of course, that is one of the difficulties that will exist between the two Governments in terms of sorting this out, although I happen to think that there is a fairly straightforward way to do it, which we may come to. However, I do not particularly see the need for an independent body to oversee these things, because I do not think that there is any evidence whatsoever of Barnett calculations having been subject to any sort of trickery or difficulty, certainly not in my time and, I suspect, not in yours either.

Lord Forsyth of Drumlean: Actually, in my time we did all the time. We were constantly trying to fiddle it in order to get Scotland more money. That is one of the reasons why convergence has not happened.

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Sir Danny Alexander: That is one of the differences between a coalition and a Conservative Government, I suspect.

Lord Forsyth of Drumlean: On the point that you made about not having an independent body, this is my concern, which reflects the evidence that we have had. You have just made the point that Scottish funding will be less dependent on Barnett because more of it will be dependent on raising tax from within Scotland’s tax base. However, as Scotland’s tax base is somewhat narrower than that of the rest of the UK, the likely outcome is that there will be less money available and, therefore, more argument about the extent to which the block grant is calculated. Would you accept that? If you accept that, is there not a case for getting the Treasury out of that argument, so that you avoid conflict between the two Governments?

Sir Danny Alexander: People cannot have it both ways. One of the consequences of devolution of tax power is that you are taking a greater degree of responsibility for funding yourself. That ought to create an incentive for the Scottish Government to adopt policies that expand the Scottish economy, improve the Scottish tax base and so on. The fiscal framework ought to be established in a way that gives fair reward for policies that achieve that but which also ensures that the Scottish Government take the consequences if their policies have the opposite effect. That is the nature of the responsibility. If you do not want to have that responsibility, you should not favour devolution, still less independence.

Lord Forsyth of Drumlean: I absolutely agree, but do you think that most of the people who say that they want this devolution realise that it will mean less money?

Sir Danny Alexander: I do not think it is axiomatic that it means less money.

Lord Forsyth of Drumlean: If your tax base is narrower and you are more dependent on the tax base, surely it does.

Sir Danny Alexander: Over time, that depends on the policies that are pursued by the Scottish Government and the policies that are pursued by the UK Government. People should realise that devolving taxes heightens responsibility in that way and means that if Scotland systematically pursues policies that scare away business, deter investment and stop people wanting to locate in Scotland it will suffer a fiscal consequence of those sorts of policies. It is a fairly modest fiscal consequence compared with that to which Scotland would have been exposed had we voted “yes” in the independence referendum.

Lord Kerr of Kinlochard: So you do not accept that it was a pity that the continuation of the Barnett formula was written into the vow, which is presumably immutable. It seems to me that the problem with the Barnett formula is, first, that I do not believe the outside world understands it, secondly, that it creates a genuine grievance for the Welsh—

Sir Danny Alexander: I am sorry, but could you repeat that? I missed the second point.

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Lord Kerr of Kinlochard: It creates a genuine grievance for the Welsh as a result of its operation. Thirdly, it creates an ersatz grievance for the Scots. Scots are very good at grievances. The strange thing about the rugby match is that, for once, we really was robbed. [Laughter.] You defend the Barnett formula. You think that our predecessors in 2009 were wrong to recommend a needs-based system.

Sir Danny Alexander: In fairness, I fought the 2010 election on a Liberal Democrat manifesto that proposed a needs-based assessment. I changed my view on that during my time in office. I think that the process of moving from the Barnett formula to some sort of needs-based assessment would be lengthy and rancorous and would result in an outcome that had broadly the same results in terms of financial allocations as the system that exists at the moment, because that would be the nature of that sort of row. That would be a waste of everyone’s time, effort and emotional energy.

What I want to see is a system that improves the degree of financial and economic responsibility that is taken by the Scottish Government and the Scottish Parliament. What we achieved through the vow and, particularly, through the Smith commission is a set of proposals that reduces the reliance, in the Scottish context, of the Scottish Government on the block grant from about 90% of its funding at the moment to about 35% of its funding once the Bill has come into force and all aspects of it have been implemented. That is a very big change. That is a much better way to handle this situation. I would defend the retention of the Barnett formula. My party changed its view on that. I do not think that any other party has argued for changing the Barnett formula. Rather than wasting our time with a massive row about something that will become progressively less important, I would focus on getting the fiscal framework behind the tax and welfare devolution right.

Lord Kerr of Kinlochard: I agree, of course, that working out and getting agreement to a new system would be a lengthy process. I wonder whether underlying your arguments there is not the Scottish heresy that any change would be further to the detriment of the Scots, which I think is completely invalid. It would entirely depend on the weight that you attached to the particular factors that you were addressing when you considered needs. If you gave great weight to sparsity of population, the Scots might end up better off. It seems to me that the Scots have always been wrong to resist the idea of having a look again at Barnett. It would be better to have a system that was based on clear principles that people understood. I accept that we are where we are and that this is—

Sir Danny Alexander: I am afraid that I disagree with you. Your point is right that, in developing a needs-based system, you have to decide which needs are important and what weight they have in an allocations formula and to work through what the financial results of that would be. That could lead to a myriad of different outcomes. Politics being what it is, it would probably lead to broadly the same outcomes that we have at the moment, just through different means. That would not be a productive use of time and energy, which could be better spent on getting the nature of fiscal devolution right.

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Q92 Lord Sharkey: I would like to talk about how we make adjustments to the block grant. We have heard evidence on three main methods: the fixed percentage adjustment, just repeating the first year’s percentage; indexing the whole thing to the percentage change in the rest of the UK’s revenues; and indexing to growth in per capita change in the rest of the UK, in terms of revenue. All are very different, and all have different consequences. How do you think in general we should go about making these adjustments? Do any of the three that have been discussed appeal to you?

Sir Danny Alexander: Some form of tax receipts indexation to the tax receipts in the rest of the UK is the most logical and appropriate way of making the adjustment. You can have either indexation towards the total tax receipts or indexation to the tax receipts per capita, which was your third option. The first is probably a bit neater and easier to organise. Indexation to the tax receipts means that decisions to increase or reduce taxation in the rest of the UK are reflected in the allocations to Scotland, but also that Scotland is able to take the benefit or pay the cost of its own policy successes or failures, while recognising that, if there is a recession that causes a dramatic fall in tax receipts, Scotland or, indeed, other devolved parts of the UK would be protected against that. The ability of a system to maintain the collective economic risk pooling in the UK financial system is a feature that needs to be retained.

Q93 Lord Teverson: Sir Danny, perhaps we could move on to the “no detriment” part of the proposal on fiscal devolution, which we have generally found quite contentious—particularly the second part of it. A number of our witnesses have questioned whether it is even really possible to apply and whether it should perhaps be seen as just a very high-level principle, rather than one that is looked at in the micro. What worries me about it in many ways is that the philosophy of “no detriment” leads to exactly the sort of rows we are talking about, if it is looked upon at all in a micro way. Does it mean that there needs to be a compensation to Scotland for whatever happens elsewhere in the UK and the Treasury, which leads to a ratcheting- up of the financial settlement as time goes on?

Sir Danny Alexander: The principle is a sensible one, as something that ought to be in our minds as the fiscal framework is constructed. There should be no detriment at the starting point and the means of adjustment should be devised to be as automatic as possible, so you do not have those rows, but to ensure that fiscal responsibility is taken in the appropriate spheres by the UK Government and the Scottish Government. The tax receipts indexation methodology Lord Sharkey referred to achieves that. It means, for example, that if the rest of the UK chose to increase taxes the block grant deduction would also be increased, but Scotland would gain the benefit of increased spending through the Barnett formula. The effect would be that increases in taxes in the rest of the UK would fund increased services in the rest of the UK, but the position in Scotland would be unaffected; likewise in respect of tax reductions. Your question has force only when you get into very small, micro-level decisions. I do not think that the “no detriment” principle should be read as meaning that every micro-level decision needs to be adjudicated by some sort of committee. Of course there will be areas where, at the margins, there are issues. Air passenger duty devolution is one such. Arguments have been made that airports in the north-east or, indeed, Bristol airport,

Page 9 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) in the case of devolution of air passenger duty to Wales, would lose out substantially. However, when you look at the numbers, the effect is quite small in macro terms. That level of things can be absorbed by the relevant Government.

Lord Teverson: On a related issue, particularly looking at those minor taxes and things, one of our witnesses made the point that any taxation change in the UK will effectively affect Scotland in some way, because of adjustment mechanisms like “no detriment”. Does that make the whole question of English votes for English laws very difficult to define in the House of Commons? Does it make it all impossible?

Sir Danny Alexander: I fear, Lord Teverson, that you are drawing me on a subject that is beyond the scope of my evidence. I always thought that English votes for English laws was pretty hard to define in the first place. In the end, the only way really to have that organised in a sensible way is through some sort of wider constitutional change in the United Kingdom. You and I might agree about that, but we would probably also agree about how far away it is.

Lord Teverson: I suppose that I am asking whether in a practical sense, given your knowledge of the financial system, this makes it a lot more difficult than perhaps people think.

Sir Danny Alexander: It means that there are decisions made in England that may apply in England only but that have an economic effect in Scotland and Wales, and therefore that Scottish and Welsh devolution should be taken into account within the parliamentary debate. Incidentally, you might make the same argument that decisions made in the Scottish Parliament have an effect on the north of England, for example, yet those voices are not weighed. If the Scottish Parliament is debating things like whether to reduce or increase its top rate of income tax, that might have an effect on people moving backwards and forwards across the border and on where businesses choose to locate either side of the border. The argument cuts both ways, but one has to be pretty careful to say that Scottish voices should be excluded in a parliamentary sense on decisions that have a knock-on effect in Scotland.

Structures also need to be put in place around the fiscal framework. A body called the Joint Exchequer Committee was established. I am not sure that it was all that effective in my time, to be honest with you, but it had Finance Ministers from the Scottish and UK Governments, which allowed some of these issues to be debated and discussed and allowed consequences to be weighed and so on. That sort of co-ordinating mechanism will be much more important, given the scale of fiscal devolution that is now being talked about. It might allow some of those issues to be weighed up in a practical way.

Lord May of Oxford: I have a possibly silly question. I confess that I do not understand all of this as fully as I would like, but it seems to me that it is all really rather complicated. I do not think that it can be defended as a system that will make it simpler to run, and complexity carries a cost. This interplay, so much of which is generated by ambitious and idealistic commitments of certain people, seems to me to

Page 10 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) have a fair potential for working less well than what we have now. Would you explain to me what is wrong with that argument?

Sir Danny Alexander: First, I do not think that it is particularly complicated.

Lord May of Oxford: You are right in the middle of it, but I must say that it does not read or sound simple.

Sir Danny Alexander: The amount of money available to be spent in the Scottish Parliament will be the block grant, as calculated by the Barnett formula, with a deduction for the devolved taxes, adding the amount of revenue raised in Scotland directly by the taxes that have been devolved to it and some further grant for the welfare areas that are being devolved. It is the sum of four things. Of course, there is complexity in how you calculate those four things and so on, but ultimately it is about having a system that operates UK wide—the Barnett formula—and trying to enhance the financial responsibility and accountability of the Scottish Parliament by giving it control over money raising and deducting money from the formula for the money raised. Then you have welfare. We have not talked about welfare, but obviously there will need to be an adjustment mechanism for how the welfare supplement is uprated year by year.

Each of those is complicated when you go into them. When you go into the Barnett formula, it is complicated. You have to look at the comparability factor in population weighting for each and every area of public expenditure, and there are thousands of them in the spreadsheet. I expect that very few people have studied that spreadsheet. I have had the misfortune—or the good fortune, perhaps—to be in that position, but the operation of it is fairly smooth. The point that I am trying to make is that in devising the new fiscal framework trying to replicate the smoothness and automaticity of the Barnett formula is really important. You should not be having rows every year about whether or not the adjustment process is fair. People can have rows politically about whether or not they think that there should be fiscal consolidation, or they can have rows in the Scottish Parliament about whether they should have higher or lower taxes in Scotland. That is what the rows should be about. It is not straightforward to work out precisely how you do that, but the model itself is fairly straightforward.

Lord May of Oxford: However well intentioned and however good an idea this is, it sounds to me like it will create quite a large number of new jobs, so one of its benefits will be reducing employment. I am not altogether being sarcastic.

Sir Danny Alexander: Who knows? There may be a technological solution. Maybe there can be an app that works it all out and you can have fewer people working on it. I do not know.

Lord Forsyth of Drumlean: Going back to the “no detriment” principle, I am sure that I must have got this wrong—like Lord May, I think that it is a bit complicated—but under the Major Government, for example, in England they decided to privatise water and in Scotland we decided not to privatise water. The result of that was that all of the

Page 11 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) money that was spent in the public sector on water was no longer part of the Barnett consequences.

Sir Danny Alexander: That is right.

Lord Forsyth of Drumlean: We therefore lost 10% of what was being spent on water through taxpayers’ resources in England; instead people paid for their water through charging. Does the “no detriment” principle really mean that if, for example, that were to happen now—if something like water were no longer part of the public sector—the English taxpayer would have to send a cheque north of the border to compensate the Scots for the fact that they were not doing the same thing? Is that really practical politics?

Sir Danny Alexander: No, I do not think that it means that. I do not remember all of the details of that. You were involved in it, obviously. I think that I was at university at the time—

Lord Forsyth of Drumlean: Let us not talk about that example. Let us take any example where—

Sir Danny Alexander: Let me just work it through. The consequence of that would be a reduction in public expenditure in England. In that case, an item is simply taken out of the Barnett formula. However, let us suppose that expenditure in the Department of Health is reduced in England; that might be an equivalent example. If spending were reduced, the Barnett consequential would be that the Scottish Government would get less money. Under the new system, unlike at that time, the Scottish Government would then have a choice. Do they want to increase taxes to raise more money to cover the cost? That was not an option available when water was privatised.

Lord Forsyth of Drumlean: I am talking about “no detriment”. What I understand “no detriment” to mean is that each side compensates the other for changes in policy. To take your own example, if in the health sector it is decided to have more charging for prescriptions or something of that kind—no, that does not work. Take my example. You decide not to do something, which results in less public expenditure and a reduction in the Barnett consequences. My reading of the legislation says that they have to send a cheque to the Scottish Parliament to compensate it for the change in policy in England. Is that wrong?

Sir Danny Alexander: Yes, I think that is wrong.

Lord Forsyth of Drumlean: So what does it mean?

Sir Danny Alexander: What it means is two things. First, when you set up the system at the start—

Lord Forsyth of Drumlean: No, this is after that.

Sir Danny Alexander: The initial adjustment should be—

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Lord Forsyth of Drumlean: No, this is the second—

Sir Danny Alexander: I understand. The initial adjustment is one that should not have any effect. Then the fiscal framework that you establish should not in itself cause gain or loss to either side systematically as a result of the way that it operates. In this case, just as at the moment, that change would be captured within the fiscal framework, so I do not think that it would require some other decision-making to go on top of that.

Q94 Lord Griffiths of Fforestfach: Sir Danny, do you think that the choice of taxes that are being devolved was based on principles, or do you think that it was just horse- trading?

Sir Danny Alexander: It could be both. Of course, within the Smith commission it was based on trying to get a consensus among five political parties with quite different views around the table. However, there is a quite sensible principle that would support devolving personal taxes, meaning income taxes, while retaining control of business taxes—taxes in the UK single market, if you like—at UK level. You could rationalise it in that way. Certainly, that is how I would defend not devolving corporation tax or North Sea tax duties but devolving income tax. Sharing VAT revenues would be another example. Part of what is behind it is, how do you retain the financial integrity of the UK single market in a situation where there is greater devolution and not just allow harmful tax competition, which results in a race to the bottom? That would be a risk with some of those business taxes.

Lord Griffiths of Fforestfach: Gerry Holtham suggested that the tax base should be as immobile as possible. If you look at income tax, I wonder whether with tax competition and so on, possibly with people moving, you are not using something that potentially could become more mobile.

Sir Danny Alexander: The answer, of course, is that, in the extremes, people might choose to move because of the tax regime. I often think that that argument is somewhat overstated. If Scotland chose to increase its top rate of tax to 60%, say, I suspect that you would see some movement going on, but it is much less mobile than some other taxes. Of course, that is part of the responsibility that you have to take as a Government with responsibility for income tax. That is the same responsibility that the UK Government take for the tax rates that we set and the effect that those have on whether people choose to locate in London, in New York, in Paris or wherever. Again, there is a risk, but it is the sort of risk that a financially responsible Government ought to be weighing up in their decisions.

Q95 Baroness Wheatcroft: Could we explore income tax a little more—in particular, whether you agree with the decision to devolve 100% of income tax? Is there not a risk that, emotionally at least, that takes a step closer to independence, rather than devolution? Alistair Darling raised the issue of what involvement one feels in defence, for instance, if 100% of your income tax is going to the Scottish Government.

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Sir Danny Alexander: I see the argument. My response would be that I am not so worried about that, because in the UK we have two forms of income tax. One is called income tax and the other is called national insurance, but they are both income taxes.

Baroness Wheatcroft: But they should be one, really.

Sir Danny Alexander: Maybe they should, although doing so is rather complicated and difficult. We could dwell on that on another occasion. Your national insurance goes entirely to the UK Government. That is a contribution to what the UK Government do and is paid by everybody. Your income tax goes to the Scottish Government. Given that we have two income taxes, one that will effectively be fully devolved and one that is fully reserved, to my mind that maintains the sense that everybody is making a contribution both to services in Scotland and to services at UK level.

Baroness Wheatcroft: Is the fact that tax on savings and dividends will not move a purely pragmatic solution with which you are quite comfortable?

Sir Danny Alexander: It is purely pragmatic. Devolving those things is very complicated. Probably the complexity would cause more trouble than it was worth.

Q96 Baroness Blackstone: What limits would you place on additional borrowing powers for Scotland?

Sir Danny Alexander: There is quite an interesting choice here. First, in a sense we are talking about two kinds of borrowing. One is borrowing to manage income fluctuations. The current arrangements, as you know, mean that there are current borrowing powers of, I think, from memory, up to £500 million. There are then capital borrowing powers. The current borrowing powers need to increase. A greater amount of tax is being devolved, so there is a greater amount of year-by-year volatility the Scottish Government would need to be able to borrow for. That should be within limits, but those limits might be two, three or four times greater than those that exist at the moment, depending on the total size of the taxes being devolved.

With the capital borrowing, we currently have borrowing within a limit of about £2.2 billion, I think—it may be a bit more these days—but uprated.

There is an option to say, “Let us get rid of the capital grant that goes through the Barnett formula and replace it with a prudential borrowing power of the sort that local authorities have for devolved Governments”. That might be preferable, because it would give full control over capital spending amounts year by year to the Scottish Government—provided that there is a form of the prudential code that the Treasury can trust, so it will not result in excessive borrowing that cannot then be repaid. That would be consistent with the direction of policy. I never formed a view on that when I was in government, because there are pros and cons on both sides, but the idea of a prudential borrowing arrangement for devolved institutions should be given really serious consideration. It might well enhance responsibility, enable better planning of infrastructure and capital projects and avoid the sorts of oddities that you have when

Page 14 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) you have quite a strict capital budget but very big and lumpy projects to pay for within it.

Baroness Blackstone: Some people have argued that the UK Government should legislate against any bail-out of the Scottish Government. What is your view on that, if there is irresponsible overspending and so on?

Sir Danny Alexander: The Scottish Government should not operate on the basis that if they make mistakes with their borrowing they will be bailed out. In a unitary state, the markets will always believe that in the end there will be a bail-out, exactly as they believe that with local authorities in the UK, with their current borrowing arrangements. I am not entirely sure how you manage that. In practice, local authorities have a very clear understanding from the central government that they will not be bailed out, while at the same time having the benefits, through the Public Works Loan Board or the national loans fund, as it is now organised, of the low interest rates that the UK sovereign can command. However, the markets would probably assume that, in extremis, there would be a bail-out.

Baroness Blackstone: In other words, legislation would be too inflexible and you would not be in favour of having a really tough regime that said, “Legally, there is no bailout”.

Sir Danny Alexander: You absolutely need to avoid the moral hazard, but that needs to be codified in the borrowing arrangements that exist within the UK. Of course, the Scottish Government would have the ability, if they wished, to raise bonds of their own on the market. That is a power that has already been devolved. In value-for-money terms, they would be very unwise to do so, because they would pay a premium, even within the UK, for issuing their own bonds. There would be relatively small numbers, there would be very little market for it and there would not be much liquidity in the market, so there would be an interest rate premium to be paid. If they are borrowing through the UK Debt Management Office and taking advantage of the strength and credibility of the UK sovereign, they ought to be subject to constraints, to avoid the kind of moral hazard that you describe, but I am not sure that legislation is really the right place to do that.

Baroness Blackstone: You would instead have limits on borrowing powers.

Sir Danny Alexander: You should look at the way the prudential borrowing arrangements for local authorities in the UK work. There are not any formal limits within the prudential code, in terms of cash amounts. Instead, the code requires that any bit of borrowing is against an income stream that is demonstrably able to repay it. Putting in place a code of that sort might well be appropriate in the context of a devolved situation as well. I am sure that you will ask others, but the widely held view is that the prudential code works pretty well. The Treasury is able to predict pretty accurately borrowing that takes place and there are very few examples of irresponsible borrowing taking place, because local authorities simply do not expect that that will then be bailed out in a way that is cost free to them.

Page 15 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008)

Q97 Lord Turnbull: I was somewhat surprised at your robust defence of the Barnett formula. I think that there is a manifest unfairness in it that has persisted unchallenged for 40 years. It is supposed to produce convergence of public expenditure per head, but it has manifestly not done that. It has allowed these divergences not only to persist but actually to increase. The evidence of that is that it has become so unfair that the UK Government have had to introduce a compensatory mechanism, the funding floor for Wales. Why are you so complacent in allowing this failure to produce any convergence to exist? If you were Welsh, would you be saying something different?

Sir Danny Alexander: I cannot imagine myself into the last part of your question. I am not sure that I have much to add to what I said before. In any system for allocating funding, you need to have a number of things. It needs to operate on a practical basis that is smooth and predictable and in which people feel confidence, so that from a practical point of view it works well. You are right that in Wales there is a particular grievance about convergence. That has led to discussions about a Barnett floor, although it is worth noting that in a period of contracting public expenditure there is divergence going on again. When the state’s budget is shrinking, you do not see that convergence happening. That is something that will take some time to reassert itself. My argument is based on whether, as a former Member of Parliament and a former Minister and politician, I think that the process of putting together a needs-based arrangement would result in something that had materially different outcomes overall. I do not think that it would.

Lord Turnbull: Can I ask you about that? If you had a needs-based arrangement, you would probably have five variables: how many people—

Sir Danny Alexander: You say that you would have five variables. I suspect that people might—

Lord Turnbull: Holtham argued that you would catch most of the data with a small number: the number of people, the number of old people, the number of young people, some measure of income and sparsity. Incidentally, I do not agree with John Kerr that sparsity would be particularly relevant, because the number of people who live in the sparse areas is so small. They are all in Glasgow and Edinburgh.

Sir Danny Alexander: I would argue that sparsity is extremely important.

Lord Turnbull: For a small number of people.

Sir Danny Alexander: That is because I come from the highlands—exactly. Everybody would argue the importance of the different elements, depending on where they came from and what interests they were representing. The ability to have an objective discussion on this is very limited.

Lord Turnbull: But precisely these variables are already in use in various parts of the UK public finances, and people are not arguing that it is impossible to use them. You say that you do not think that it would produce much difference. Why do you not find out? Why do we not do an exercise and see how difficult it is and what the result is?

Page 16 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008)

Sir Danny Alexander: I am not doing it, but I am sure that your Committee is welcome to try. [Laughter.] I look forward to seeing the results.

Lord Turnbull: Do you think that it would produce expenditure per head in Scotland 20% higher than that in England?

Sir Danny Alexander: It might; it could well do. You mentioned five variables. You might look at life expectancy. You might look at some of the indices of health inequality. You might look at educational attainment. There is now a whole range of variables that people who are constructing policy seek to target. You think about the attainment gap in education. That is a very important variable that, certainly under the coalition, the UK Government were seeking to target.

Lord Turnbull: But that is an indicator of how successful the outcomes of spending the money are, not of what the need is.

Sir Danny Alexander: Is that really correct? If 30% of young people are failing to achieve a basic standard in education, you might argue that that means there is a need for improved education.

Lord Turnbull: But they have had a lot more money spent on them.

Sir Danny Alexander: Maybe, maybe not. The point that I am making is that one could have an endless debate about which variables you would choose. There would be voices from all sides of the United Kingdom who would choose the variable that best suited them and argue for it to be weighted in a particular way. I think that the way in which our public finances in the UK should develop is through greater fiscal responsibility being held closer to people, through devolving tax-raising powers and through the sort of borrowing for capital that we were talking about earlier. It is much more fruitful to concentrate on getting that right, rather than having—

Lord Turnbull: Are you arguing that the present structure—the Smith structure—does not have enough tax in it and has too much grant?

Sir Danny Alexander: No, not necessarily. I think that the balance is pretty good. Over time, depending on the fiscal framework that is put in place and the way in which the welfare side of the equation develops, you will see the importance of the Barnett formula being considerably less than it is at the moment. Last year, 90% of the money spent by the Scottish Government was derived from the block grant. When all of this system is in place, it will be a third or so. The financial responsibility to raise money and the accountability that that generates are the consequence of devolution.

The Chairman: In the one minute that remains, I turn to Lord Kerr.

Lord Kerr of Kinlochard: Are you sure that you are not coloured by your experience as an extremely distinguished Chief Secretary to the Treasury when you say that over time the “no detriment” principle will work perfectly well, people will accept the rough with the smooth, there will be give and take and there is no need to open the black

Page 17 of 420 Sir Danny Alexander – Oral evidence (QQ 89-97) (DFPOE0008) box at all—no need to have the principles laid out, no need to have any independent monitoring body and no need to have any transparency?

Sir Danny Alexander: No. I think that the principles and the way in which this works should be laid out. There needs to be some mechanism periodically for that to be discussed between the Governments and for the outcome of that to be something that is public and scrutinised by both Parliaments. We currently have a thing called the statement of funding policy—I am sure that you have all read it—which sets out how the financial arrangements are supposed to work. That is reviewed periodically. The thing that needs to be conducted absolutely independently is the economic forecasting that lies behind a lot of the tax and spending decisions that are taken, but I am not convinced at all by the argument that you need an independent body to oversee all of this. In a way, that might just lead to the independent body being in receipt of all sorts of bogus grievances that are generated simply for the purposes of publicity.

The Chairman: Heaven forbid.

Sir Danny Alexander: Heaven forbid, my Lord Hollick. [Laughter.]

The Chairman: Sir Danny, thank you very much for your helpful and informative answers.

Sir Danny Alexander: Thank you.

Page 18 of 420 Dr Angus Armstrong, NIESR; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow – Oral evidence (QQ 1 – 13) (DPFOE0001) Dr Angus Armstrong, NIESR; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow – Oral evidence (QQ 1 – 13) (DPFOE0001)

Submission to be found under Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001).

Page 19 of 420 Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007) Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007)

Submission to be found under Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007).

Page 20 of 420 Bevan Foundation – Written evidence (DPF0007)

Bevan Foundation – Written evidence (DPF0007)

The devolution of public finances in the United Kingdom

Response by the Bevan Foundation

1. The Bevan Foundation develops ideas to make Wales fair, prosperous and sustainable. It is a registered charity and social enterprise. We welcome the opportunity to submit our views to the House of Lords Economic Affairs Committee’s inquiry into the possible models for devolution of the public finances in the United Kingdom.

2. The Bevan Foundation has recently begun to explore the potential for new taxes to be introduced in Wales, under s.116C of the Wales Act 2014. This project is already highlighting some of the issues being considered by the Committee.

Tax powers What is the rationale behind the choice of taxes proposed to be devolved in the Wales Act 2014? 3. The choice of taxes devolved in the Wales Act 2014 is mostly based on the first report of the Silk Commission established by the UK Government,1 which drew heavily on the report of the Holtham Commission, established by the Welsh Government.2 The exception is Air Passenger Duty, which is not devolved despite the Silk Commission’s recommendations.

4. The Silk and Holtham Commissions’ reports were written in a different constitutional climate and could not take into account the subsequent devolution of taxes to Northern Ireland or those proposed for Scotland, nor the pressure for devolution of some taxes to English cities. Because the UK context is changing rapidly, the Silk Commission’s report and the Wales Act 2014 cannot be regarded as final positions.

With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers?

1 Silk Commission (2012) Empowerment and Responsibility: Financial Powers to Strengthen Wales http://webarchive.nationalarchives.gov.uk/20140605075122/http://commissionondevolutioninwales.independent. gov.uk/files/2013/01/English-WEB-main-report1.pdf 2 Holtham Commission (2012) Fairness and Accountability: a new funding settlement for Wales. http://gov.wales/docs/icffw/report/100705fundingsettlementfullen.pdf

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5. No. The Scotland Bill will devolve Air Passenger Duty which has not been devolved to Wales, despite the recommendation of the Silk Commission. As devolution within the UK continues, views about whether it is appropriate to devolve certain taxes have changed – corporation tax being a notable example. Other taxes could emerge for potential devolution in the future. Because of this, further tax devolution may become desirable. There is also the question of whether any new taxes introduced by the UK government should be devolved to Wales (as well as Scotland and Northern Ireland), as considered by the Silk Commission. For these reasons, the rapidly changing devolution settlement also means that the position in Wales cannot be regarded as settled.

Should other taxes be devolved (for example corporation tax to Scotland and Wales)? 6. The devolution of other taxes to Wales, including corporation tax, needs further consideration. These have not been actively considered in Wales since the Silk Commission reported in 2012. In our view it is likely that there are other taxes, including some business taxes (or tax reliefs) that it would be appropriate to devolve, that were previously rejected. Other taxes suitable for devolution may emerge in future.

7. A robust mechanism is required to manage the process and avoid ad hoc decisions in respect of one devolved nation that have implications for the others.

Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome? 8. Competition is not the inevitable result of tax devolution. Whether there is competition depends on whether devolved governments choose to vary a tax, the sensitivity of the market to variations in tax, and the mobility of the goods, services or transactions being taxed. Similarly, competition may sometimes be desirable and sometimes not. For example, in our view it is unlikely that variations in taxation on land transactions will result in significant competition between Wales and England, but that variations in tax on waste sent to landfill could create undesirable competition (as waste is mobile and the market is price sensitive).

Fiscal framework What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

Page 22 of 420 Bevan Foundation – Written evidence (DPF0007)

9. The Barnett formula has long been regarded as not fit for purpose because it does not take account of the additional need in Wales, is not transparent, and has numerous unintended consequences. The devolution of tax powers puts further strain on the Barnett formula, which was designed for very different circumstances.

10. We are strongly of the view that funding for devolved nations should be based on social, economic and environmental needs not just per capita allocations. A new assessment would need to take into account:  Population  Age structure  Socio-economic disadvantage  Rurality  Environment and infrastructure.

11. A new funding arrangement would also need to take into account the tax base of each devolved nation.

How should block grant funding reflect devolved tax and welfare powers? How should future changes to the block grant be decided? How should the Smith Commission proposal of “no detriment” apply over time? 13. The relationship between block grant funding and devolved tax and welfare powers is complex. The ‘no detriment’ principle emerged from discussions in respect of Scotland and we are not aware that it has been discussed let alone agreed by either the Welsh Government or wider civil society in Wales.

Page 23 of 420 Bevan Foundation – Written evidence (DPF0007)

14. We are in favour of devolved governments having additional borrowing powers. There needs to be further discussions about the provisions required if devolved governments exceed their borrowing limits.

What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap? What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland? 15. The implications for Wales of either full fiscal autonomy or a renegotiation of the fiscal framework have not even begun to be considered.

16. Given the constitutional changes which have taken place since the Silk and Holtham Commissions, the prospect of additional tax and borrowing powers being devolved to Wales and other UK nations and regions, and the various other issues raised in this response regarding the devolution of public finances, we recommend that an independent commission should be established to consider the impact of this on Wales.

20 August 2015

Page 24 of 420 Constitution Reform Group – Written evidence (DPF0018)

Constitution Reform Group – Written evidence (DPF0018)

CONSTITUTION REFORM GROUP

SUBMISSION TO THE LORDS COMMITTEE ON ECONOMIC AFFAIRS INQUIRY INTO THE DEVOLUTION OF PUBLIC FINANCES IN THE UNITED KINGDOM

1. The Constitution Reform Group is a cross-party body that has come together to address threats to the constitutional stability of the United Kingdom.

2. The first objective of the group is to inspire a widely-based discussion which will aim to articulate the core values of the United Kingdom. Arising out of that discussion, the second aim will be to identify principles which could form the basis of a revised constitutional settlement, which would command a general consensus of support from citizens, and thereby secure constitutional stability for the foreseeable future.

3. The issues to be addressed by the Committee in its inquiry into the devolution of public finances in the United Kingdom are within the remit of the Constitution Reform Group’s concerns. We are aiming to publish a discussion paper that will deal with this and other matters in September of this year. We hope that the Committee will be prepared to receive a copy of our report once published, by way of supplementary evidence; and we would greatly welcome the opportunity to expand on the nature of our concerns and proposed lines of exploration by way of oral evidence if the Committee thought that might be helpful.

4. The fundamental premise of the discussion paper that we propose to issue later this year is that the United Kingdom as an effective Union is under threat, is worth saving and can be saved by prompt action. We believe that the four constituent nations of the United Kingdom have been inextricably intertwined for decades, and that this has been greatly to the benefit of each of them. The nations and their peoples are connected by ties of family, business, education and research and by a history of which every citizen can be proud; and they share a culture of rights, the rule of law and openness to the world which are conducive to human happiness and the prosperity of all citizens. We believe that if the United Kingdom were to be broken up, we would all become dramatically weaker in the short term and more so with time.

5. We see an immediate threat to the constitutional future of the United Kingdom in the likelihood of a second referendum on Scottish independence in the near

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future. There are, however, other and longer-term discontents and concerns which we believe are placing increasing pressure on the existing constitutional settlement.

6. The proposed methodology for the discussion which we hope to inspire focuses on identifying which functions are truly central in the sense of being best performed for the United Kingdom as a whole by central state mechanisms. We propose to invite stakeholders to identify what functions are most efficiently and effectively performed at a central level; and how those functions enhance the nature of a strong central Union. We will also invite citizens of each part of the Union to consider whether there are aspects of an overarching state that are not necessarily about the performance of particular governmental functions, but may be more about establishing a partnership for greater fairness and justice for each constituent part, as well as preserving a shared national culture and identity. Our preliminary discussion paper will identify an initial list of central functions, including foreign affairs, defence, national security, macro-economic and monetary policy, immigration, nationality and certain other matters. We are open-minded as to what should be added to our list, and what mechanism should be provided to ensure flexibility to alter it in the light of experience.

7. Following the identification of central functions, there are a number of options possible for dealing with what remains. A fully federal system of one kind or another provides one set of options; a system based much more closely on the existing arrangements using devolution to national, local and regional institutions provides another set of options. At this stage we have, as a group, no settled view as to which set of options is likely to be most efficient to deliver a satisfactory and stable revised constitutional settlement.

8. We are clear, however, that there are dissatisfactions and inefficiencies in relation to the governance arrangements for England that require to be addressed. Again, there is a range of options for dealing with the issue of the largest component part of the United Kingdom having no system for localisation or devolution of power, and the contrast with the degree of self- determination enjoyed by the other nations as a result of devolution. We do not believe that the amendment of Standing Orders of the House of Commons in the way that has been proposed for English Votes for English Laws provides a complete or sustainable solution in itself. We are therefore proposing to explore a number of options, some of which may include consideration of the restructuring of the second Chamber of Parliament in the process.

9. On matters of public finance, we are clear that the Barnett formula requires to be replaced, but we have not yet formed a view as to what is the most appropriate redistributive mechanism to replace it. We have taken as a

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working assumption that central taxes raised at State or federal level require to be distributed on a per capita basis, with mechanisms for adjusting distribution patterns to reflect areas of poverty or other features of particular local or regional need. We have also assumed that greater fiscal autonomy for nations and regions within the United Kingdom needs to be matched by effective rules for borrowing by constituent parts of the Union so as to preserve the economic wellbeing of the State as a whole, while allowing each country and region the flexibility to secure investment for growth and to satisfy its own economic development aspirations.

10. We are clear that the benefits of a strong United Kingdom are not confined to economic and political matters, and much of our discussion paper will be directed towards attempting to identify some of the intangible benefits of the Union, with a view to considering how best to preserve and enhance them. In the same way, since for many people one of the most important features of the United Kingdom politically, socially and culturally focuses on respect for diversity, equality of opportunity and the protection of the rights of the individual, we will be looking at ways to ensure that human rights, equality and respect for diversity remain at the heart of any new constitutional settlement.

11. We will also be looking at the law and order implications for the Union, both of recent constitutional changes and of the kinds of change that we believe may arise from our discussion.

12. We have also begun to think about the importance of ensuring efficient and effective relationships within the United Kingdom, and how to deal with emerging issues in foreign affairs and defence, including internal defence, within the constitutional settlement.

13. If we can helpfully expand on any of these issues by way of supplementary written evidence or by way of oral evidence, we will be very happy to do so.

Members of the Constitution Reform Group Steering Group

The Marquess of Salisbury - Chairman Lord Lizvane The Rt. Hon. Peter Hain David Burnside Daniel Greenberg Tony Lodge Shana Fleming Caroline Roberts

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28 August 2015

Page 28 of 420 Dan Corry (Chief Executive, New Philanthropy Capital) and Dr Peter Kenway (Director, New Policy Institute) – Written evidence (DPF0013) Dan Corry (Chief Executive, New Philanthropy Capital) and Dr Peter Kenway (Director, New Policy Institute) – Written evidence (DPF0013)

Submission to be found under Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013).

Page 29 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009)

Evidence Session No. 9 Heard in Public Questions 108 - 116

TUESDAY 27 OCTOBER 2015

Members present

Lord Hollick (Chairman) Baroness Blackstone Lord Forsyth of Drumlean Lord Griffiths of Fforestfach Lord Kerr of Kinlochard Lord May of Oxford Lord Monks Lord Sharkey Lord Turnbull ______

Examination of Witness

Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund

Q108 The Chairman: Carlo Cottarelli, good morning and welcome to the House of Lords Economic Affairs Committee. As you know, I am sure, we are currently conducting an inquiry into the devolved finances of Scotland. In looking at that topic, one for which the arrangements are currently under negotiation between London and Edinburgh, we have taken some evidence about what happens abroad and in other countries that have already experienced this and have arrangements in place for devolved financing. You have written on the topic and have spoken widely on it, so we are very grateful that you have joined us today.

I wonder if I might start by asking you to perhaps paint the picture of the arrangements that have been put in place. Is there common ground between those arrangements? Which arrangements clearly have worked? What is the purpose behind the arrangements? Is there a set of principles that tend to guide these arrangements? If you could just give us an overview, then other Members will want to come in with more detailed questions.

Page 30 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) Carlo Cottarelli: First of all, thank you very much for inviting me. It is an honour to be here. You ask about the general issue of fiscal decentralisation, and no doubt there has been a trend in the last few decades towards increased decentralisation. There are good reasons to decentralise or devolve fiscal autonomy. It is normally thought that the closer the delivery of services is to the population, the better they are, because proximity implies that there is more accountability, first of all. There is a better alignment of incentives: if it wants to get better services, the local population has to pay more. So there are good reasons to decentralise.

At the same time, it is acknowledged everywhere, even in the most decentralised fiscal federations, that there is a need for a sizeable central Government to do things that it would be inappropriate to decentralise. There are things that are the essence of a state, a nation. Here, I am talking about defence and foreign affairs, for example. There are things you want to maintain centralised because of economies of scale. There are things you want to maintain centralised because you want to avoid competition, particularly tax competition and a drag to a lower level of the tax rate because of this competition. In general, there are spillover effects if you decentralise. There is an important risk-sharing motivation as to why you want to maintain certain things at the central level and, of course, there are distributional reasons why you want to maintain things centrally, because, in this way, you will be able to redistribute income across regions, if that is a policy priority.

Finally, there is a very important and sometimes underestimated reasons why you want to maintain things at the central level, namely that centralising policies makes various parts of the nation more similar to one another. For example, when you centralise corporate income tax, you create a level playing field for investment.

There are good reasons why you want to centralise; there are good reasons too why you want to decentralise. If you look at the experience of fiscal federations in general —I am talking about fiscal federations because they are relatively more decentralised than central unitary states—you find that, when it comes to decentralisation, you have anything between 10% and 60% of revenues and anything between 30% and 60% of spending at the local level. In any case, the central Government never gets below 40% to 50% of spending and revenues. That is a broad picture. I will stop here at this point.

The Chairman: Have you, in the work that you have done, seen any link between devolved fiscal powers and economic growth? We have heard evidence on both sides of that argument, and I wonder where the evidence that you have seen points.

Carlo Cottarelli: Let me first briefly summarise the theory. The theory will tell you that, precisely because there are good reasons to decentralise, some degree of decentralisation you would think would increase economic growth because you would have more efficient government. By the same token, there are reasons not to decentralise, so even in theory there would be a U-shaped curve in terms of fiscal decentralisation being associated with faster growth. Nobody really knows, honestly, where the right point is. I have seen all kinds of result in the empirical literature. Some suggest that more decentralisation is preferable; others are of different views.

Page 31 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) It is clear that certain things are necessary for decentralisation to work. If you decentralise, you need to make sure that the local or subnational governments behave properly from a fiscal point of view—they do not misbehave and they do not create a spillover effect with imprudent fiscal policies. That is essential. That is something I am pretty sure about. We have pretty sound results. On average, we have seen, in cases where there was decentralisation without fiscal discipline, things did not go well for the nation as a whole in terms of growth, because you end up in fiscal crisis, basically.

There is an interesting paper that was recently presented at the IMF, based on the experience of Italy, which makes essentially one point. Fiscal decentralisation helps growth not only at the local level but at the national level if what the authors call the social capital is well distributed across the nation. Social capital, in the definition of the authors, is a behaviour that does not incentivise free-riding. If you have some Governments that are free-riders, then you had better not decentralise. It stands to reason that that is the case. This comes from Italy and it is related to the debate in Italy on fiscal decentralisation to the south. Some authors, in the north particularly, believe they are not fiscally responsible, especially as there is not much social capital in some regions of Italy. If there is no social capital, in that case, you do not want to decentralise because it would affect the growth rate not only of those regions but of the nation as a whole.

The Chairman: Having strong social capital is a very important prerequisite of making any decentralised structure work.

Carlo Cottarelli: Yes. You want to have social capital, and strong and fiscally responsible institutions. That, I am pretty sure, is a condition for effective fiscal decentralisation. Other than this, as you mentioned, you can find any kind of results in the literature when it comes to growth rates.

Q109 Lord Kerr of Kinlochard: Which are the best taxes to devolve to subnational governments and why?

Carlo Cottarelli: Let us start again from the theory and then go to the practice. The theory is pretty clear. You want to maintain at the central level taxes where the base is very mobile, because you do not want to get distortions in the allocation of resources and you want to avoid tax avoidance. You want to maintain at the central level taxes that are unequally distributed across the national territories, as long as you care about income distribution across regions. You want to maintain at the central level—it is another argument—progressive taxes, again, if you care about distributional goals. You want to maintain at the central level taxes that are very cyclical and are very much affected by the economic cycle, assuming that the centre is in a better position than the periphery to finance deficits in a downturn, which is a reasonable assumption, certainly in Italy and in Europe in general. That is one of the reasons why it has been argued that, in the euro area, you want to centralise some very cyclically sensitive taxes, because, in a downturn, the euro area treasury, let us say, which does not exist but potentially could exist, would be able to finance itself more easily than at least the weakest part of the euro area. This is the theory of what you want to maintain at the

Page 32 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) central level. Everything else you decentralise. Based on this, typically you want to keep at the central level corporate income and financial transaction taxes, because the base is very mobile and because at least corporate income tax is very cyclical. In practice, you will find that corporate income tax is centralised very often.

VAT is a bit different because, in principle, VAT is a consumption tax. One could argue that consumption is less volatile than income, for example. In practice, the most common form of indirect taxation is VAT. VAT is difficult to decentralise, because you break the debit-credit chain, which is basically the definition of VAT. You would have to have borders if goods go to another region. That is why, in most cases, VAT remains centralised. There are some cases of decentralised VAT. The one that works relatively well is the one in Canada. India and Brazil also have decentralised VAT, but they are a bit of a mess. In India, if I remember correctly, services are taxed at the central level and goods at the local level. It does not work very well.

There is also this so-called VIVAT, which is a proposal that has been made to make possible a decentralised VAT. Basically, it says that all transactions among businesses are taxed—for example, at 20%. The final taxation is taxed at 22%, for example. That has not been tried. It is something that has been described in the literature, but you do not find it in practice. In principle it could work, but, again, it has not been tried. You find instead, at the local level, other retail taxes. In the United States, those are fairly common. While, in general, indirect taxation could be taxed locally, in practice, because it is VAT, it is kept central in most countries.

Personal income taxes are a mix. You typically have a strong central personal income tax, and in some cases you also have local taxation, as in the United States, in Canada and in Switzerland. In some cases, as in Italy, regions that are running deficits are allowed to have a small surcharge on personal income tax. When I was living in Rome last year, because healthcare in Italy is decentralised and the healthcare in the region of Rome, Lazio, was not very well managed—it was running a deficit—I had to pay a small surcharge on my income tax. In general, even in the most decentralised federation, you still have a large personal income tax.

What you definitely find completely decentralised in most cases—I would say in all cases I know—is real estate taxation. It is a perfect case. It is not very mobile—it is not mobile, if you want to say so—and it is not very cyclical, so that is kept at the decentralised level.

There is one last thing I want to say. Even when taxes are decentralised, it may be useful to maintain at the central level some components of the tax—for example, the definition of the tax base—because that helps tax administration. You can still maintain a single tax administration with economies of scale.

Lord Kerr of Kinlochard: In a country such as the United Kingdom, where large parts of the corporate sector operate in all regions of the country, would it make sense to devolve corporation tax? Can you think of examples where corporation tax devolution has worked well?

Page 33 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) Carlo Cottarelli: No, not really, in the sense that I am not aware of any complete corporate income tax devolution. There are some countries that have subnational corporate income taxes: Switzerland, Canada, the United States. They have local corporate income taxes, but together with a central corporate income tax. When you have a decentralised corporate income tax, one issue is how you distribute taxes, because firms operate in various parts of the country. If a firm that is established in Delaware operates throughout the nation, how do you distribute the tax revenues? There are typically formulas that are used in these cases; the approach is called formula apportionment. In principle, you should have the same formula across the states of the United States, for example. This is not the case. There are differences, unfortunately, which create some complication, but that is basically the approach.

I do not know whether you have followed the debate at the international level on base erosion and profit shifting, and what the OECD has done. The critics who say that the OECD has not done enough argue that they should have pushed towards a worldwide formula apportionment approach. That was not the case. It is a complicated thing to do. That is another reason why corporate income tax is not very often decentralised. As I said, the US, Switzerland and Canada are, in general, a group of countries that we would say in our book are the most decentralised federations.

Lord Kerr of Kinlochard: It is sometimes said in this country that Northern Ireland is a special case, because of very low corporation tax and strange regimes in the Republic of Ireland. Do you think there is a case for devolution of corporation tax to Northern Ireland?

Carlo Cottarelli: I do not know. I know the argument that has been put forward for Northern Ireland with respect to the Republic of Ireland. I do not know enough to see whether that is necessary or not. Without knowing much, one could say there is some degree of stronger competition there coming from Ireland. On the other hand, one could say, in the modern world, firms compete worldwide, so why pay particular attention to what the tax rate is in the Republic of Ireland?

Q110 Baroness Blackstone: What are the merits of sharing tax revenues, as against giving complete control to a subnational government? For example, it is proposed that the Scottish Parliament should retain all the revenues from tax on earnings but none of them from tax on dividends and savings.

Carlo Cottarelli: When one says “assign the revenues”, there are different approaches. One can say that the central tax is shared with various regions, meaning that a certain percentage of the total revenue goes to a certain region and another percentage goes to another region. In this case, this is just like a transfer. I guess what you are referring to is something that essentially implies that I do not assign 30% of the nationwide taxes to, for example, Scotland; I say whatever tax originates from Scotland stays there. In that case, that is something that has some features of a transfer, but also has some features of a full devolution of taxation. Clearly, you still have a single tax in the nation, which implies, for example in that case, that Scotland will not be able to

Page 34 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) change tax rate. You do not have that advantage, if that is regarded to be an advantage, but you have the advantage of maintaining a central tax.

Like the devolution of taxes, if you do this kind of assignment of revenues, however, you have some cyclicality. If the region that receives the tax is willing to take that cyclicality, then fine. It is something in between. Being in between a transfer and a full devolution of taxation is something that has advantages of one thing and disadvantages of others.

We can look at, in practice, what happens for some taxes. For example, you mentioned personal income tax. There are some cases of maintaining personal income tax at the local level. They are not very frequent and it is not very frequent to find very high proportions that are left at the local level. There are, however, exceptions. My own country, Italy, is an exception in this respect. In Italy, there are two types of regions: there are ordinary regions and special statute regions. The special statute regions are allowed to keep up to 100% of the personal income tax. It is normally 90%, but the Valle d’Aosta, which is the region close to France, keeps 100% of the personal income tax. The other special statute regions—Trentino-Alto Adige, the one close to Austria, Friuli-Venezia Giulia, the one close to the Former Republic of Yugoslavia, and the two islands—keep 90%. But that is not normally what you find in federations. This is a special arrangement that was made for very strong political reasons at the end of the Second World War.

Baroness Blackstone: What you are saying is that it is very rare for subnational governments to retain all taxes on income.

Carlo Cottarelli: Yes, all taxes on income is very rare.

Baroness Blackstone: There are no examples that you can think of.

Carlo Cottarelli: Well, there are some cases in which you have two personal income taxes. The small country of St Kitts and Nevis has two personal income taxes. Other than this, I do not think it is very common to have 100%. It is very rare to have 100% of the personal income tax left at the local level. Valle d’Aosta is one example. Some other regions of Italy get close to 100%.

Lord Griffiths of Fforestfach: How much fiscal autonomy would a state like Quebec have, in Canada, over something like income tax?

Carlo Cottarelli: I do not know exactly what the arrangements are for Quebec. Quebec, again, is a particular case because, within Canada, not all provinces are the same, but I do not know the arrangements in Quebec well enough.

Q111 Lord Monks: I will turn the conversation away from tax for a moment to the grants that come from the central authority to the regions. At the moment, in the UK the deal between London and Edinburgh is that there is only one variable in that grant. It is more or less fixed. The variable is population. We are aware that, in other countries, needs and the situation in the region get taken into account. It can get quite

Page 35 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) complicated, as we have learned from the situation in Australia. Do you have any good examples to give us about how the block grants are distributed across different countries, how they fund subnational governments and what criteria they take into account?

Carlo Cottarelli: First of all, again, there is range of approaches: there are transfers, but then there is revenue sharing; there is devolution of taxation. In principle, there are better ways to transfer resources than just looking at the population. The most appropriate way in principle, which is used in Canada, for example, but also in Italy—in Italy in a very sophisticated way, although it is still at the beginning—is to look both at the spending needs and the ability to raise taxes. In principle, you want to do so, because you want to take into account not only the needs of a certain area but also whether that area is able to take care of those needs by itself.

I mentioned Italy because it is an interesting case. Canada has basically the same approach, but it is more simplified. In Italy, for local governments, as of this year, 20% of the transfers are based on a very complicated system that takes into account the population, the kind of territory that you have—whether you are a mountain local government or a seaside local government—the structure of the population and the demographics. It is based on a huge questionnaire that includes thousands of questions, to tailor the transfer to the spending needs and to the taxation ability of a certain area. It is 20% this year. In 2016, the percentage will go to 30%, then 40% and then 55% in three years. The idea is that, in four or five years, all the transfers to local government will be based on this formula. In principle, it is a good approach. How sophisticated you want to be in tailoring the calculation of needs and the taxation ability depends on your preference and how much you dislike complicated things.

Lord Monks: I have just one follow-up. Take the Italian example that you have spoken of. It sounds horrendously complicated and a recipe for disputes of a very serious kind between the different regions and Rome on these things. Is that how it works or is it relatively equable?

Carlo Cottarelli: First of all, I have one clarification. The system I described applies to municipalities, not to regions. Essentially, most of the transfers to regions in Italy are for healthcare spending, and that is based just on population and the demographic structure of the population. For municipalities, there is a complicated system. Whether it will give rise to legal problems, I do not know. It was introduced this year; it is too soon to say. But the formulas and the approach were agreed with the National Association of Municipalities, so they have ownership of the process. It is a cumbersome and complicated process but, after three years of discussions, it has been fully accepted by municipalities in Italy, so, in principle, they should not have problems with that.

Lord Forsyth of Drumlean: I wonder, without getting into the detail, whether you have a view on the stability of a system where the grant was distributed from the centre without any account of the basis of need, but solely on the basis of population and what had historically gone before. I am thinking specifically of the way the Barnett

Page 36 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) formula works in this country between Scotland, Wales and the centre, where the amount of grant—the baseline, relates to what the money was in the 1970s, and, since then, a proportion based on population has been added. If you move towards a system where you have more tax powers and you retain a grant-based system that is solely related to population, do you have a view, based on your experience, of the likely stability of that?

Carlo Cottarelli: When you say “stability”, what do you mean there?

Lord Forsyth of Drumlean: I mean the scope for argument between the various constituent parts that they have not been fairly treated, which then leads to further problems.

Carlo Cottarelli: First of all, I am not too familiar with the Barnett formula and its history.

Lord Forsyth of Drumlean: You are very lucky.

Carlo Cottarelli: Having said that, I would presume that these things have to be discussed and, in a way, agreed jointly. If there is an initial decision to shift to a new system, a new approach, a new formula, and if that is accepted, then parties should be willing to accept the consequences of whatever decision has been taken. I am probably not well informed. My understanding was that, in the case of Scotland, the initial decision was to have a neutral shift. That relates more to the devolution of taxation power, that it would be a sort of compensation for the grant. As to changes in the way the grant is calculated—this is just common sense—if you accept a move to a different system, you have to accept the consequences. It is difficult to find good examples, because this process of fiscal devolution has been quite slow over time, in Spain, for example, and in Italy, so you do not really have these huge swings or huge breaks in a single year from the use of a certain formula to another formula. My impression is that, everywhere, things have been changing but slowly, precisely to avoid this kind of controversy that would arise if you had a big change all of a sudden.

Q112 Lord May of Oxford: I would like to take us a little wider than the focus we have had up to this point on essentially Europe and things near us, partly because I have spent something more than a third of my adult life in the United States and I think it is a very interesting example of where the various states feel that their tax should stay there. They have, right across the country, local taxes, very local taxes, state taxes and then the national taxes. It is a system that has things wrong with it, but a lot of things right with it. Some of the things are the inequities that arise in a system like that. If you contrast the finance available to the southern states in general with what is available in the north-east, which is where I was living, around Boston and so on, there is a big difference in the tax revenues for running things. There is also quite a difference, not so much in the money itself as in the attitudes. You go to the north-east and you go to the western parts around Caltech and so on, and you have people very focused in interesting ways on things like science, which is something that is a vexed issue in this country at the moment in many ways, and yet other parts are quite different. I wonder

Page 37 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) what your view of that is, because that is much less homogeneous and has lots of interesting examples of the compromises that are made between keeping the tax where it arose and distributing it in an equitable way.

Carlo Cottarelli: This is a preference that has been expressed for historical reasons by the United States. What you are saying is exactly true. The United States is one of the most decentralised federations. I would mention one more thing. The United States, in our sample, is the only country that does not have equalisation transfers across regions—money that is given from the centre to the states to equalise income. This does not exist in the United States.

Lord May of Oxford: That is because the states are raising it themselves, largely.

Carlo Cottarelli: Yes, not only that, but also because nobody wants to have the kind of redistribution of the income that you would have through these horizontal transfers or through the transfers that come to the centre to equalise income. There is still quite a lot of cyclicality in transfers. If a state of the United States, say California, is hit by a recession, its net transfers to the Government decline, but that is simply the by-product of still having a large portion of revenues centralised because they are cyclical revenues, so you still have transfers to states that go up and down with the cycle. If a state has economic troubles, it gets relatively more money from the centre, but it is because of the operation of the so-called automatic stabiliser, because of the centralisation of highly cyclical revenues. Whether this is good or bad, again, it is a political choice whether states want not to have redistributional grants, but it is the exception in our sample.

Lord May of Oxford: It is a nasty system in a way, in that it perpetuates inequalities.

Carlo Cottarelli: Yes, by definition. There are no equalisation transfers.

Lord May of Oxford: All the best universities are in the wealthier states, and so on. It is not coincidental.

Carlo Cottarelli: As I said, even in the United States, there is still some redistribution. Because personal income tax is progressive, the richer states contribute more to the federal budget than the poorer states, but it is a by-product of the centralisation of personal income tax. Again, it also has cyclical features that are nice from that point of view, but it is not the same kind of equalisation transfers that you get in other federations, not to mention, of course, the unitary nations.

Q113 Lord Griffiths of Fforestfach: I wonder if I could make a statement and then ask Carlo Cottarelli a question. I was fascinated by what you said earlier about the paper given at the IMF on social capital. I just wonder if our secretariat could have a reference to it to read it. It reminded me of something I have quoted in many talks over the years: a study by Edward Banfield of a small town in southern Italy done at Harvard in the 1950s called The Moral Basis of a Backward Society, showing that, with the culture and institutions of so many small towns in southern Italy, it would have been impossible to have tax devolution; they just did not exist. I would be very

Page 38 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) interested to see if there was any relevance of that—I suspect not, but there may be, in a way—to Scotland.

My question is that, for better or for worse, we are in the process of devolution in the United Kingdom, not just to Scotland but to Wales and to Northern Ireland. I just wondered, from your vast knowledge of the literature and practical experience, whether you think there are any lessons that you have observed and we could usefully learn from either the research or the experience.

Carlo Cottarelli: First of all, let me clarify. The paper I mentioned was presented in a seminar at the IMF. It was written by three Italian professors. One of them now happens to be teaching at Duke University in North Carolina, so that is why he came to the IMF. I can provide the reference. It is a nice paper.

On the general lessons about devolution and the conditions to make it work, I would just repeat what I said earlier. A critical condition is that constraints—fiscal rules or any other form of constraint—are put in place to avoid the deficit bias that would otherwise arise at the local level. Because you share the common currency, in principle this may create expectations of bailout from the centre in case of problems, so it is essential to have good fiscal rules at the local level and maintain certain things at the central level. I mentioned earlier certain taxes that should remain at the central level. It is also essential to have institutions that allow dialogue between the central Government and subnational governments so that there is co-operation and exchange of information.

Then, also—it may look trivial, but it is not at all trivial—there is the accounting system. In Germany, the Länder do not have the same accounting system. It is very messy. In Italy, until this year, the regions did not have the same accounting system, which meant that, if you wanted to compare how many subsidies to the industrial sector Lombardy was given with respect to Piedmont—I tried to do it myself—it was very difficult, because the balance sheets and accounting systems were different. I do not think this issue will arise in the case of Scotland and Wales, because presumably you will maintain the same single accounting system in principle, but it is something that needs to be maintained in the future. This is my first reaction to the preconditions for good devolution. I would certainly mention the use of fiscal rules or some other form of constraint, the accounting, the dialogue and maintaining at the central level stuff that should be maintained at the central level.

Q114 Lord Sharkey: Carlo Cottarelli, the Smith commission recommended a principle where there should be no detriment to either nation as a result of UK Government or Scottish policy decisions post-devolution. We heard from one of our witnesses, a Mr David Phillips of the Institute for Fiscal Studies, who said, “There was an event held recently in Edinburgh by a guy from the IMF who looked at 13 federal tax systems and devolution systems. He commented, when asked about these issues, ‘Wow, I have never seen any other country try to have a “no detriment” principle’”. That may not of course have been you, but I wonder whether you would agree with that statement and whether in particular you think that the no detriment principle could work.

Page 39 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) Carlo Cottarelli: My understanding is that there are two no detriment principles. One is, first, for the initial grant, and that is pretty straightforward. The other one is definitely more complicated, to the point of being in practice almost impossible. There are so many kinds of spillovers that, if you want to offset anything, in a way it is self-defeating to the goal of fiscal decentralisation. I always thought that this second part of the no detriment principle was to be interpreted more as a general guideline, to make sure that the two parties talk and discuss things that affect each other. In a way, it is similar to what I was saying earlier, that one important condition for successful devolution is that there are fora for discussion of common issues. I would interpret the no detriment principle as something that does not need to be interpreted in a legal way and to the last penny, but as something that is a guideline and strongly encourages co-ordination and discussion.

Lord Sharkey: Does it not seem to you, on the face of it, almost a logical impossibility?

Carlo Cottarelli: I would say more than logical—a practical impossibility, yes.

Lord Turnbull: In 1977, I was working in the IMF and I was sent on a mission to the Netherlands Antilles. The purpose of this mission was that the two islands, Aruba and Curaçao, would not talk to each other. They were in a fiscal federation. They would not talk to the Netherlands Government. The only person they would talk to was the IMF. All I can say is relations with Scotland are not great, but they are not that bad.

Lord Forsyth of Drumlean: Yet.

Lord Turnbull: We come back to this question of borrowing, which Lord Griffiths touched on. There seem to be two philosophies. One is that the federal Government sets a borrowing strategy—in our case, it is reaching a balance by a certain period— and the separate devolved authorities should broadly follow that and make a proper contribution to it; then you add in a bit of borrowing, to add a degree of flexibility to deal with cash-flow difficulties or whatever. There is a second philosophy that says these entities should stand on their own two feet; they can borrow on their own credit rating; the debt they issue is not guaranteed by the central Government; there is no bailout, and that should be sufficient. In the case of a state in the US, which model do they fit into? Does a state have free borrowing but run the peril that it could go bankrupt?

Carlo Cottarelli: In none of the federations that we looked at did we find the full implementation of your second approach. The second approach is that argues, “Let the market take care of the problem. If a subnational government borrows too much, the market will penalise it; it will pay larger interest rates and this will put pressure on fiscal finances. Everything will be fine.” None of the federations we looked at uses this approach, essentially because it is too risky. There is always the possibility that the market does not provide enough discipline and you end up, at the end, exposed, with the need to bail out a certain part of the nation.

Page 40 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) The United States uses a mixed system. On the one hand, as you know, there are fiscal rules in almost all the 50 states. Most of them, I would say, are self-imposed. The point is, as I have always argued, they are self-imposed historically, but, had the states not had self-imposed rules, they would have been imposed from the centre. I said “most”, but, no, all states have self-imposed rules in the United States. In general, in federations, you find rules that are imposed from the centre. In the United States, you do not have rules imposed from the centre, but you have self-imposed rules that are exactly equivalent. At the same time, you have the no bailout approach, which, in the United States, has worked pretty well. Since 1840, there has been no bailout from the federal Government of states. One could argue that the exception was the District of Columbia in the 1990s, but the District of Columbia is not a state. There have been bailouts of municipalities by states in the United States, but, in general, the approach has worked well.

Personally, I would not go for a system that just relies on market discipline. It is too risky, and it is not what we found in federations. At the other end of the spectrum, you have the approach, which is not very common but is found somewhere—I cannot remember where, but it is found—of having almost no discretion at all: every year, the budget of the subnational government is approved by the central Government. That is rare, except for cases in which the subnational government got into trouble and they essentially had to request support from the centre. From then on, for a few years, you have this vetting by the central Government.

Otherwise, the most common approach by far is fiscal rules, mostly with a ceiling on the deficit and a ceiling on the debt-to-GDP ratio. There are difficulties also with this approach, mostly related to cyclicality. It is a well-known problem, because it is difficult to have cyclically adjusted targets for subnational governments. It is very difficult even for the national Government, and even more for subnational governments. There are various solutions: rainy-day funds, for example. One could have cyclical transfers from the centre.

Lord Turnbull: What if it happens, though, that a devolved authority has a rule, but it is a rule that the central authorities strongly disagree with?

Carlo Cottarelli: As part of the devolution agreement, there should be rules for the local government that are accepted by the central government. The euro area is a somewhat different case, but, from the beginning of the introduction of the euro, the members of the euro area agreed to accept rules that were agreed by everybody, so it is not enough to have any rule at the local level. The rule, at the central level, must be approved by the nation as a whole.

Lord Turnbull: That is interesting. The euro zone is not really a very good example. First, they cheated in order to get in, and then they ignored the rules, and even some of the bigger countries like France were the leading offenders in saying, “We are not going to follow these rules”.

Page 41 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) Carlo Cottarelli: You can say that the European Union is not even a state; it is not even a nation. Even in nations, of course, there are difficulties in practice. Brazil relied on fiscal rules that were not working for a while. Then, in the last 15 years, the rules existing for the Brazilian states’ subnational governments were working very well. There is always tension, but it is necessary to have rules. Very often, if a set of rules does not work, then you end up bailing out the local government, but the counterpart of this is the acceptance by the local government of tighter rules and things like this.

Q115 Lord Forsyth of Drumlean: Following on from that, what kind of institutional arrangements do you think would be necessary where you have devolution of fiscal powers?

Carlo Cottarelli: It is interesting. It is linked to what I said earlier. Again, fiscal rules are part of institutional arrangements. You need to have common accounting and bodies or institutions where you can discuss fiscal policy issues or spillover issues. You may also want to discuss in those fora the nationwide fiscal stance, although, ultimately, the responsibility of the nationwide fiscal stance rests with the central Government.

Lord Forsyth of Drumlean: How does that work? I am thinking, obviously, of the situation with Scotland in particular, where, clearly, you need to have these institutions to work. In fact, in your Edinburgh presentation, you pointed this out as being a factor of a federal system. Of course, in this context, we do not have a federal system, but we have a Government that is dominant and actually wants to leave the state, and we have those tensions. Is it practical to establish institutions where one party wants to leave the state and that particular party may have a completely different view of macroeconomic policy?

Carlo Cottarelli: It is clear that the UK situation is a bit different from the others. Typically, one has the federal Government and then regional governments, whereas here, in my understanding, you would have a Scottish and a Welsh Government, and you would not have an English Government, I guess, so it is a bit awkward. It is an ad hoc situation. I do not think, however, that this would prevent the setting-up of institutions or commissions, whatever you want to call them, to discuss common problems. In any case, as discussions of this sort, perhaps at the quarterly level, with exchange of information, become more frequent, it would be necessary.

Lord Forsyth of Drumlean: You do not think it is necessary to have a common belief in the state to achieve that—you can set up the mechanisms, but to make them work.

Carlo Cottarelli: No. Clearly, you must share the goal. If you set up a commission because you believe common discussion is useful, there must be a common belief in the usefulness of the institution. I wanted to add one thing. Among the institutions that may be helpful are fiscal councils. You have a good tradition—it is relatively short, but still important—with the UK fiscal council, the Office for Budget Responsibility. A similar office would be useful also for Scotland. Perhaps that reflects my bias towards fiscal councils. They are not a panacea, clearly. They can help. I have seen experiences

Page 42 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) of fiscal councils that are not very effective, but I do not think they can cause any harm, and they can be helpful.

The Chairman: Following on from that, how would a fiscal council work?

Carlo Cottarelli: Do you mean how it would work in terms of mandate, for example?

The Chairman: It is established and agreed upon by all parties, I presume.

Carlo Cottarelli: I would assume that, for a fiscal council for Scotland, first of all, there would be an agreement with the UK Government to the establishment of a fiscal council. Then there would have to be some, presumably Scottish, legislation to establish it. That legislation would also clarify that the fiscal council is independent, because that is basically the precondition for its work as a fiscal council. There would have to be a mandate for the fiscal council—to do what? Normally, a fiscal council looks at, first and foremost, the application of fiscal rules, whether the rules are applied properly. The more general mandate is to follow fiscal developments in a certain area. The Scottish fiscal council would look at fiscal developments in Scotland. Presumably, the Scottish fiscal council would also have a dialogue with the Office for Budget Responsibility. That is the way I think it would work.

Q116 The Chairman: Can we come now to the transparency of the settlement? There is a certain amount of high-level understanding of the Barnett formula, but actually the working parts of it are fairly opaque. Reference has been made in previous questions to the potential here for discord and disagreement, particularly if the objectives and goals of the various parts of the United Kingdom are slightly different. If the information around the funding arrangements is not transparent, then is it the case that you are creating the potential for a great row, for discord? Is that what happens in other countries? How do other countries approach this problem?

Carlo Cottarelli: Transparency is critical. You mentioned some aspects that are not entirely clear. I think there should be transparency about the arrangements. When it comes particularly to funding arrangements, there should be full transparency, because otherwise you get into controversies. Again, looking at the experience of Italy, this has not to do with the funding; it has to do with who is responsible for what. In 2001, the Italian constitution was amended to give more responsibility to the regions. It was not very clear, unfortunately. There were some areas of shared responsibility and, because of this, it was not very clear whether the central Government was allowed to do certain things. The result of this is that now 80% of the cases at the constitutional courts are controversies between regions and the central Government of Italy. Now, this part of the constitution is being changed once again, as part of the reform the Renzi Government is putting forward, to make the system more manageable. When it comes to the relationship between the centre and subnational governments, the most transparent you are, the better.

Page 43 of 420 Carlo Cottarelli, former Director, Fiscal Affairs Department, International Monetary Fund (IMF) – Oral evidence (QQ 108-116) (DPFOE0009) The Chairman: Can you give us an example of a set of arrangements, with transparency and the publications of guidelines and things like that, that in your view works very well? Which countries have managed to achieve the gold standard?

Carlo Cottarelli: I do not know whether it is the gold standard. Canada works pretty well. Of the federations that we looked at, it works relatively well. We looked at many arrangements in developing countries, but, again, I do not think those are good examples. Italy is not a federation, anyway. It is not even included in our sample, but, again, it certainly is not a good example. I would say, in Canada, the system is working relatively well.

Lord Griffiths of Fforestfach: Canada is a country of enormous size. If you think of a country like Switzerland, would you say it works quite well in Switzerland too?

Carlo Cottarelli: Yes.

Lord Griffiths of Fforestfach: It is not a function of size, in other words.

Carlo Cottarelli: Switzerland also works relatively well, yes. I do not know what extent of fiscal devolution you want to have. Along with Canada and Switzerland, the United States also works relatively well. This system of having essentially a clear no bailout approach, coupled with fiscal rules that are in principle self-imposed but would be there anyway, works relatively well, and certainly better than cases like Argentina and Brazil. In my view, this probably has to do not just with the institutions that link the centre with subnational governments, but with a host of other factors. We know that, in almost all federations, with few exceptions, most debt is at the central level. You end up in a situation in which, in any case, the central Government represents a large amount of fiscal policy. In the sample that we looked at, on average, 25% of public debt was local and 75% was central. In a case like Switzerland, public debt is a bit larger than central debt, so it is very decentralised, but it works well.

The Chairman: In those countries that you have mentioned, are the detailed guidelines of how the settlement is made published and is the settlement itself published reasonably early after it has been agreed?

Carlo Cottarelli: When you say “the settlement”, do you mean the agreement?

The Chairman: Yes.

Carlo Cottarelli: In cases like Switzerland, this comes from history, so I do not think there was even an intention to have a final settlement for ever. These are things that have been built incrementally.

The Chairman: Thank you very much indeed, Mr Cottarelli, for joining us today, for giving us such insightful answers and for sharing your extensive knowledge of how this works around the world. Our challenge is to make it work here, from scratch. Thank you very much indeed.

Page 44 of 420 Tom Crotty, INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Tom Crotty, INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007)

Page 45 of 420 Dr James Cuthbert – Written evidence (DPF0004)

Dr James Cuthbert – Written evidence (DPF0004)

Written Evidence to the House of Lords Select Committee on Economic Affairs: The devolution of public finances in the United Kingdom.

Dr. J. R. Cuthbert

1. Before giving answers to the individual questions posed by the Committee in their call for evidence, it is appropriate to bring to the Committee’s attention the following two papers, copies of which have been sent to the clerk of the committee. These papers are:- a) Cuthbert, J. R.: “The Barnett formula under the Smith reforms”: Fraser of Allander Institute Economic Commentary, Vol (39)1, June 2015. b) Cuthbert, J. R., Cuthbert, M.: “Smith Commission – Why the economic and fiscal arrangements need to be changed”: published by the Jimmy Reid Foundation, 26 May 2015.

2. Without attempting to summarise the full content of these papers, it is useful at this stage to summarise the conclusions reached on two specific, but very important, issues which are covered in depth there.

3. Modelling the operation of the Barnett formula post-Smith. The first such issue is the subject of the Fraser of Allander paper referenced above. It appears that the arrangements for the new, post-Smith fiscal framework for Scotland have been set out before any detailed modelling has been undertaken on how the residual Barnett formula will interact with the abatements for the revenues foregone by the exchequer, and with the proposed “Holtham” mechanism for indexing these abatements. (Certainly, no official modelling on the operation of the new system appears to have been made public.) This is perhaps an understandable state of affairs, given the speed with which the Smith arrangements have been devised, and are being implemented: but nevertheless, the lack of modelling is a potentially critically important omission. The Fraser of Allander paper addresses this gap.

4. The conclusions of the Fraser of Allander paper are stark. The relative values of per capita public expenditure in Scotland and England will depend on three parameters in particular: namely, the rate of growth of public expenditure in England: the relative rate of growth of population in England compared to Scotland: and the relative rate of growth of the tax base in England compared to Scotland. The modelling shows how, other than in an unlikely special case, the system cannot run on indefinitely with fixed values of these parameters, without pushing the ratio of per capita public expenditure in Scotland relative to England down to levels which would be politically unacceptable. Moreover, there is the likelihood of the emergence of dynamic feedback effects on the parameters, which would act to accentuate the process. The fiscal framework is therefore likely to be unstable, with the likelihood

Page 46 of 420 Dr James Cuthbert – Written evidence (DPF0004) being that Scotland will fall into a cycle of relative economic decline, from which it would have inadequate powers to escape on its own.

5. The Fraser of Allander paper also suggests a modification to the system of Holtham indexation of the Barnett formula abatements, to take account of relative population change, which would make the system somewhat more stable, but would not remove the problems.

6. One implication of the modelling in the Fraser of Allander paper is that mechanisms will be required which will enable periodic adjustments to be made to fiscal transfers within the UK monetary union: in other words, the post-Smith fiscal framework is not a solution to the problem of funding the Scottish parliament: it is itself a problem. A further implication is that the funding of the Scottish parliament post-Smith will depart so radically, and so rapidly, from that implied by the existing Barnett formula, that it is actually very misleading to imply that the Barnett formula is being maintained.

7. The Gearing Problem. The second issue to which attention is drawn relates to the problems which will arise if, after the implementation of the current reforms, Westminster makes decisions on the rates which will apply in the rest of the UK, (rUK), for taxes which are devolved to Scotland: but where these decisions impact on services, like defence, which cover the whole of the UK. This issue is discussed in detail in the Reid Foundation paper referenced above, (in particular paras 3.9 to 3.12, and Annex paras 1.1 to 1.13.) There appears to be no standard name to describe this issue: for reasons set out in the Reid Foundation paper, it was called the gearing problem in that paper.

8. In its simplest form, the gearing problem would arise if a cut in rUK income tax was being funded wholly or partly by a cut in “reserved” services. To prevent damage to the economy which would occur if Scotland’s tax rates got badly out of line, the Scottish government would have to match a radical cut in rUK income tax, and hence the Scottish government would have to cut services under its control: but since the spending cut in Scotland would be spread over a narrower base, there would be a disproportionate, or geared, effect relative to the cut, if any, in “devolved” services in rUK. While the Smith Commission report did not specifically spell out this gearing problem, the Commission was clearly aware of it: and the second of Smith’s no detriment principles would, if satisfactorily implemented, have the effect of removing the problem. However, the way that it is proposed to implement this no detriment principle is flawed: (see, for example, para 2.4.14 of Cm8990). As pointed out in the Annex to the Reid Foundation paper, the effect of the Cm8990 approach would be that, if the Westminster government chose to use rUK income tax to fund an increase in reserved services, then the Scottish government would have to increase its tax rate, or cut its services, or both.

9. Overall, it is argued in the Reid Foundation paper that it is difficult to see how a satisfactory solution to the gearing problem could be arrived at without having a specific rUK Block Grant, together with an rUK chamber which would set rUK income

Page 47 of 420 Dr James Cuthbert – Written evidence (DPF0004) tax, and which would decide how “devolved” services in rUK would be run, and funded from the rUK Block Grant plus rUK income tax. There would also need to be a separate, overarching UK chamber, responsible for setting the Block Grants for the different countries of the UK. That is, a satisfactory solution to the gearing problem would require significant constitutional change at the UK level, involving something akin to a proper federal system.

10. Given this background, comments are now given on some of the individual questions in the Committee’s call for evidence.

Question1: What principles should govern the way devolved nations are funded, etc.

11. The principle that devolved nations should be given greater responsibility for raising their own revenues, and a greater ability to benefit if they successfully grow their economies, is in itself unexceptionable. On the other hand, the way this principle is being implemented through the Smith reforms has grave flaws, including the following.

(i) Putting primary reliance on a single major tax, (income tax), will limit the freedom of action of the devolved government, since in practice it will not be able to get far out of line from rUK on a single tax without suffering damaging economic consequences. Income tax itself is a problematic choice, because of the very different natures of the tax base between Scotland and rUK: note the evidence given at para 3.2 of the Reid Foundation paper referenced above, which indicates that rUK has very many more income tax payers in the higher income tax bands.

(ii) Giving a devolved nation responsibility to live within its own revenues implies that it should have adequate power to grow its economy. However, the economic powers which, for example, the Scottish government will exercise post-Smith are actually very limited: (the Scottish government will have control of only a single major tax, income tax: it will have restricted borrowing powers: and it lacks control of competition policy, international trade development, licensing of North Sea oil, utility regulation, and a number of labour market responsibilities.)

(iii) The current proposals do not adequately address the problems that arise, (the “gearing problem”), when the Westminster government makes changes to tax rates which are devolved elsewhere in the UK, and these changes impact on reserved services.

(iii) As the modelling in the Fraser of Allander paper indicates, the proposed fiscal framework is likely to be unstable.

(iv) As recent experience with the Euro indicates, it is difficult, if not impossible, to set up a rule based system for the satisfactory operation of a monetary union. What is also required is an appropriate mechanism for adjusting fiscal transfers within the union, as the need arises. However, the Smith reforms effectively gravely weaken the existing mechanisms for effecting fiscal transfers within the UK, (unsatisfactory as the existing mechanisms are), without putting alternatives in place.

Page 48 of 420 Dr James Cuthbert – Written evidence (DPF0004)

12. Addressing these weaknesses suggests some of the principles that should be applied to the funding of devolved nations: there should be an appropriate range of taxes, not just a single major tax: there should be devolution of adequate economic powers: there should be recognition of the constitutional implications of addressing the gearing problem: there should be a stable fiscal framework: and any rule based system should be supplemented by mechanisms for adjusting fiscal transfers as circumstances change.

In relation to this final requirement, there may well be a case for carrying out periodic needs assessments: however, it would be a mistake if such needs assessments were to restrict themselves to assessing the “need for public services”, as has been the case with previous attempts. It would also be important to consider whether the operation of the UK monetary union was achieving a reasonable balance of economic activity across the UK as a whole, avoiding the emergence of undue hot spots, and declining or depressed areas.

Question 2: Is the correct institutional framework in place, etc?

13. As regards political institutions, the current framework is deficient in two repects as regards the requirements post-Smith:-

(i) solving the gearing problem implies that there should be a separation between rUK, (or English) decisions on devolved taxes, (like income tax), and decisions on the funding of reserved services. As already noted, a full solution to this problem is likely to require something approaching a federal system.

(ii) There need to be appropriate structures in place to handle decisions on adjustments to fiscal transfers, (which will inevitably be required in any monetary union.)

14. As regards handling the mechanics of the post-Smith system, continuing the present system of leaving this to the Treasury will not do. The Treasury has been very opaque in the way it has run the Barnett formula: (e.g., the latest Treasury Funding Statement is dated 2010.) The post-Smith system will actually require many more judgements to be made than at present about critically important aspects of the system: (e.g., on how the different elements of the block grant abatements should be indexed: or what changes to tax in rUK represent policy changes which would require block grant adjustments under the currently proposed no detriment arrangements.) Judgements on topics like these should be made openly: there should be a forum where they can be discussed, and agreed, with the devolved administrations: and the full detail of the funding calculations should be published.

15. One thing which appears notable about arrangements in other countries is that most other countries appear to operate devolved tax systems in a federal context. This may represent an implicit recognition of the difficulty pointed out here, of solving the gearing problem without having federal type arrangements in place.

Question 3: How should block grant funding reflect devolved powers, etc?

Page 49 of 420 Dr James Cuthbert – Written evidence (DPF0004)

16. As already noted, the currently proposed system is unsatisfactory in a number of respects: e.g., it does not provide an adequate solution to the gearing problem, nor a stable fiscal framework. Implementing the proposal made in the Fraser of Allander paper, which would involve adjusting Holtham indexation to take account of relative population growth, would provide some increased stability, but would not solve all the problems. Giving Scotland greater economic powers would reduce the need for adjustments to fiscal transfers. But such changes would never provide a totally satisfactory solution. Monetary union implies that there should be a political mechanism capable of adjusting fiscal transfers in a way which would, if necessary, over-ride any mechanical formula for adjusting the block grant.

17. The second Smith no detriment principle has been implemented in a particular way in para 2.4.14 of Cm8990. As already noted, (para 4 above), this interpretation has implications which will probably prove unacceptable. If the primary purpose of the second no detriment principle is to avoid the gearing problem, then this issue probably has to be tackled directly – but would have deep constitutional implications for the UK.

Question 5: What would the implications be of full fiscal autonomy for Scotland, etc?

18. Any arrangement, including “fiscal autonomy”, which sees Scotland remaining as part of the UK monetary union would imply restrictions on its freedom of action which would have to be agreed in advance with rUK: e.g., in relation to Scotland’s ability to borrow, its freedom to vary tax rates, etc. There would also have to be agreement on what share of existing UK debt that Scotland would fund, and on payments for common UK services. The uncertainties surrounding such issues are so large that it is not really fruitful to speculate on what freedom of action Scotland might actually have if “fiscal autonomy” were implemented: and about what it might be able to do about any funding gap.

Question 7: What is the rationale behind the choice of taxes?

19. It is not very clear what the rationale is, but it appears poor. Giving Scotland control of a single major tax lever limits Scotland’s freedom of action, since it removes the possibility of designing an overall tax package, higher in some areas, lower in others, which might nevertheless be attractive to taxpayers. Income tax, as already noted, is a poor choice, because of the marked difference in the tax base between Scotland and rUK.

20. There are also real problems about VAT, which, while not devolved to Scotland, will have about half of the Scotland’s estimated VAT revenues hypothecated to Scotland. These problems are discussed at greater length in para 3.15 of the Reid Foundation paper referenced above. These difficulties include volatility, and the uncertainty surrounding the estimation of Scotland’s VAT receipts. Overall, it is difficult to see that Scotland gains anything from the proposal to hypothecate to Scotland a share of VAT revenues. Scotland gains absolutely no extra powers: but is exposed both to the short term fluctuations, and the long run indexation risk, which will be associated with this tax. And given the large element of uncertainty about the

Page 50 of 420 Dr James Cuthbert – Written evidence (DPF0004) assignment of VAT receipts to Scotland, it is difficult to see that it adds much to the principle of fiscal responsibility.

A cynic might wonder whether a possible explanation for the decision to extend the proportion of VAT receipts hypothecated to Scotland, (as was done in Cm 8990), might actually be found in the modelling in the Fraser of Allander paper. The inclusion of VAT receipts increases the constant K in formula (3) in that paper: (K is the proportion of “devolved” expenditure in England funded by taxes which in Scotland are devolved or hypothecated): even in the most stable scenario considered in that paper, the formula implies that this will have the effect of reducing the limiting ratio of per capita public expenditure between Scotland and England.

Question 10: Will Scotland, Wales and Northern Ireland have the correct tax raising powers, etc.?

21. No. As noted above, there are problems with income tax, and VAT, and placing major reliance on devolving a single major tax limits the freedom of action of the devolved government.

But it is also wrong to concentrate solely on tax powers. The current Smith package falls into the trap of giving responsibility without power: that is, greatly increased responsibility to live within a country’s tax resources, without adequate powers to grow the economy.

31 July 2015

Page 51 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

Dr James Cuthbert – Supplementary written evidence (DPF0021)

Modelling Scotland’s Fiscal Settlement: Note for House of Lords Economic Affairs Committee following evidence session on 9th September. Dr. J. R. Cuthbert Introduction.

At the Committee session in Edinburgh on 9th September, I gave some examples pointing out implications of the system of indexation, (Holtham indexation), proposed in Cm8990. For example, if Scotland adopted a neutral tax policy, and if, as will almost certainly be the case, the devolved tax base is growing in England relative to Scotland, then public expenditure in Scotland will eventually start to decline in absolute terms and, left to itself, would ultimately go negative.

I undertook to provide the committee with a note giving proofs of the points I had made. The examples I gave orally, and therefore the analysis in this note, concentrate on the long term. The long term is important, because it is presumably the intention to put in place an abiding and stable fiscal settlement: but it is nevertheless only part of the story, so this note in itself should not be regarded as the definitive critique of Holtham indexation. Information on how the system behaves in the shorter term is given in the modelling paper, reference 1. That paper indicates how things could actually start to go wrong fairly rapidly – particularly given the potential, as identified in that paper, for dynamic effects which would change parameters adversely.

One implication of the material in this note, (and of the papers submitted with earlier evidence), is that neither Holtham indexation as originally proposed, nor in an adjusted form correcting for relative population change, can be regarded as satisfactory. So this note also fleshes out an alternative suggestion I made orally to the Committee. Part of the final section of this note looks at this possibility in some more detail.

In writing this note, I have tried to keep the notation in the main part of the note to a minimum, in the interest of readability. I have done this by expressing the relevant equations in the main part of the paper in simplified form. This simplified form is useful for demonstrating why the various assertions I made actually hold – but is inadequate for giving a detailed proof. The full detail of the relevant proofs, (and the necessarily heavier notation), is restricted to the Annexes.

Holtham indexation.

Under Holtham indexation as proposed in Cm8990, there would be an abatement to the Barnett formula block grant for income tax revenues foregone by Westminster, and this abatement would be increased each year in line with the growth in the overall UK tax base.

The resulting behaviour of this system is critically dependent on three parameters: these are:-

Page 52 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

 = the rate of growth in nominal public expenditure, (on “devolved” services), in England. (So, for example, a nominal rate of growth of 3% in nominal public expenditure corresponds to = 1.03 .)

 = the relative rate of growth in population in England relative to Scotland: again, expressed as a number, rather than as a percentage: so = 1.002 means that

(population in England in year t)/ (population in England in year t-1)

= 1.002(population in Scotland in year t)/ (population in Scotland in year t-1)

 = the relative rate of growth in the tax base, (of “devolved taxes) in England compared to Scotland: this is again, like  , expressed as a number. (Thinking in terms of income tax, the “tax base” is the aggregate of taxable incomes.)

Suppose that Scotland adopts a neutral policy on devolved tax rates, in the sense that it mirrors tax rates in the rest of the UK. Suppose also that the proportion of expenditure on “devolved” services in England which is funded by devolved taxes, (i.e., taxes which are devolved in Scotland), remains roughly constant: this seems an entirely reasonable assumption.

Then Scottish government receipts in year t, (from all sources, i.e., abated Barnett plus Scottish devolved tax revenues), will be given by a formula of the form

 a  b( ) t - c t (1 -  -t ) , where b and c are greater than zero. (1) 

(See Annex 1 for proof.)

It will almost certainly be the case that   1, particularly since the population of England has historically grown relative to that of Scotland, (i.e., ), so for that reason alone the English tax base is likely to be more buoyant. For large values of t, then, the formula at (1) will behave like

 a  b( ) t - c t (2) 

Since , this formula will be dominated by the - c t term for large t, and so will in due course decline in absolute terms, and ultimately, if left to itself, would become negative, (assuming  i.e., that there is nominal public expenditure growth in England).

Now suppose that, under a form of fiscal autonomy, Scotland no longer receives the abated Barnett formula block grant from Westminster, but instead receives its own tax revenues from non-devolved taxes, (that is, those taxes which are not devolved under the current Smith proposals.) Let  denote the annual rate of growth in Scotland’s non-devolved tax revenues.

Page 53 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

Then the difference between the revenues the Scottish government would receive under fiscal autonomy, as compared to what it would receive under the Smith fiscal settlement is, for large t, given by a formula of the form

  A  B t  C t - D( ) t  E( ) t , where B, C, D, E are greater than zero (3)  

(Again, see Annex 1 for proof)

Assuming  , this will ultimately be a positive, and increasing, function of t. In other words, Scotland would ultimately be better off under fiscal autonomy, no matter what the relative values of  and  actually are.

(Although the above indicates that Scotland would always ultimately be better off under fiscal autonomy than under Holtham indexation, this should not be taken as an endorsement of fiscal autonomy. There would be considerable problems in setting up a workable system of fiscal autonomy within the UK monetary union.)

Adjusted Holtham Indexation.

In the paper on modelling Holtham indexation, (reference 1), I noted that an adjusted form of Holtham indexation would correct some, (but not all), of the problems with the basic form of Holtham indexation. Under adjusted Holtham indexation, the income tax abatement would be indexed in line with the growth in the overall UK tax base, divided by the relative rate of population growth: (that is, divided by  , in the notation used in this paper.)

In oral evidence to the Committee, I noted that, if the relative rate of growth of the tax base in England to Scotland is greater than the relative rate of population growth, (which is very likely), and if the Scottish government adopted a neutral tax policy, then relative per capita public expenditure in Scotland to England will tend to a limit under adjusted Holtham – but the limit will still be unacceptable: (Scottish per capita expenditure would be about 50% of that in England).

This is a consequence of the following equation:

Relative per capita public expenditure in Scotland to England under adjusted Holtham in year t

 = Relative per capita public expenditure under Barnett formula - K(1 - ( ) t ) (4)  where the value of K is approximately 0.5 .

(See Annex 2.)

Page 54 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

The first term after the equality sign in equation (4), which relates to the original ( - 1) Barnett formula, will converge in the long term to something which is close to : ( -  (this is proved in reference 2). Assuming “normality” returns, and there is reasonable long term growth in public expenditure in England, this limit will be slightly greater than 1. If  , the last term in equation (4) will tend to - K, which is approximately - 0.5: so the limiting value of equation (4) will indeed be approximately 1 – 0.5 = 0.5 .

Policy Implications.

1. What Holtham indexation means is that the funding of the Scottish government will be aggressively penalised, unless Scotland grows its “devolved” tax base at least as fast as England’s. Since England has traditionally had a growing population relative to Scotland, this in fact means that Scotland has to grow its per capita tax base even faster than England to avoid penalisation. Moreover, the penalty involved is stringent: if Scotland were to adopt a neutral tax policy, the implication of formula (2) is that Scottish government funding would eventually go negative. In the face of these effects, it is difficult to see how Holtham indexation, as currently proposed, can be regarded as anything other than a mistake.

2. The adjusted form of Holtham indexation analysed above, which involves correcting the indexation factor for relative population change, is a more attractive proposition than crude Holtham indexation, but still involves serious problems. Under adjusted Holtham indexation, the system is more stable, in that, under reasonable assumptions, relative per capita public expenditure in Scotland compared to England will converge to a limit, (unlike crude Holtham indexation, where the system diverges.) However, Scotland would still be penalised if it failed to grow its per capita “devolved” tax base as fast as England: and in these circumstances, the limiting value of per capita spend in Scotland would be about 50% of that in England.

Effectively, adjusted Holtham indexation involves saying to the Scots: “We would be setting up a system where, if you adopt a neutral tax policy, and if you grow your devolved per capita tax base at the same rate as in England, you will be exactly as well off in public expenditure terms as under the Barnett formula. If you grow your tax base faster, you will be better off: but if you grow your tax base more slowly, in the long run public expenditure per head in Scotland will be reduced to about half that in England.”

Viewed in this light, the flaws in adjusted Holtham are very apparent. First of all, the target is a challenging one: given Scotland’s lack of economic powers, and the very different nature of the income tax base in Scotland compared to England, there are bound to be long periods when Scotland fails to meet the target. Secondly, the size of the eventual penalty if it fails to do so is so large, (about 50% of levels of English per capita public expenditure), that there is no realistic option of achieving something like parity by raising Scottish tax rates: and the attempt to do so would make the dynamics of the Scottish economy even worse. Adjusted Holtham, therefore, does not look a tenable option.

Page 55 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

3. It seems clear that a more radical re-think on the indexation arrangements is required. One possibility, which would avoid the problems with both forms of Holtham indexation, while still giving the Scottish government a real incentive to grow the tax base, could be as follows. This option would involve setting an absolute target for growth in the Scottish tax base, rather than defining a target relative to the growth in the tax base in the UK as a whole. Under this system, the indexation factor for the abatement would be set at x% in real terms per annum, where x is some appropriately chosen constant.

This would avoid the problem inherent in both forms of Holtham indexation, of penalising the Scots if they fail to match some version of growth in the English tax base. It would give Scotland a real incentive to exceed the growth rate target. And this approach solves another very significant problem as well: it could be applied equally well to the indexation of the abatement for VAT receipts – a difficult problem which does not appear to have been thought about at all as yet.

This approach does, however, raise the difficult problem of how to choose the constant x. Two comments on this are relevant:- a) It would be appropriate to choose a modest value of x: e,g., 1% in real terms. There are three reasons for this. First, the Scottish government has limited economic powers: so the influence it can have on the growth rate of the Scottish economy is fairly small. (Further, those powers it does have do not obviously impact all that positively on the economy, when exercised alone: for example, improving education, without being able to stimulate the demand for the resulting skills, could lead to increased emigration, rather than economic growth.) Secondly, income tax, which is the main component of Scotland’s devolved tax base, is not obviously a strong suite for Scotland: (given, for example, that Scotland has about 7.3% of overall UK income tax receipts, as against about 8.3% of UK population.) Thirdly, the inevitable downside of an absolute target is that Scotland will be penalised by the indexation arrangements on those regular occasions when the overall economic cycle turns adverse: setting too high an absolute target would make the lengths of such periods insupportably long. b) There should be a procedure for regular review of the indexation factor, (and of other aspects of the financial settlement). Without such regular review, relative public expenditure will eventually head off to levels, (either too high, or too low), which would be politically unacceptable. But the general rules for such reviews should be laid down and agreed well in advance. In particular, if Scotland was managing to outperform on any specific value of x, it should be well understood that the adjusted indexation factor following the review would not simply be the latest rate of growth in the Scottish tax base: this would destroy the incentive element in the system.

It is not being suggested that this absolute target approach to indexation is ideal: there is a pro-cyclical aspect to it which would be of concern. But in the context where Scotland is being shoe-horned into the very unsatisfactory framework set out in the Smith report and Cm8990, any solution on indexation is going to be unsatisfactory: and absolute indexation may well be a good deal less-worse than either Holtham variant.

Page 56 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

References.

1) Cuthbert, J. R.: “The Barnett formula under the Smith reforms”: Fraser of Allander Institute Economic Commentary, Vol (39)1, June 2015.

2) Cuthbert, J.R: “The effect of relative population growth on the Barnett squeeze”: Fraser of Allander Institute Quarterly Economic Commentary, Vol (26)2: May, 2001.

Annex 1: Holtham indexation.

Notation and assumptions

These are as in references (1) and (2). In particular, as in reference (2):

S Let E t denote expenditure in England in year t, and E t expenditure in Scotland under the original Barnett formula: (strictly, “expenditure” here is that covered in the relevant DEL).

S Let p t denote population in England in year t, and p t population in Scotland.

Let R t denote the ratio of per capita expenditures between Scotland and England at time t, under the original Barnett formula.

Let k denote lag, (in years).

It is assumed that

a) Et +1 =  Et : (i.e., expenditure in England grows at a constant rate.)

S pt+1 p t+1 b) =  S for all t, where   1: (i.e., there is a constant relative pt p t rate of growth of population in England relative to Scotland).

c) In the annual public expenditure planning round, the new final year baseline is determined as being equal to the previous end year figure: and Barnett applies only to that end year, with population shares determined at a lag k.

And as in reference (1):

E S Let Tt , Tt , and Tt represent, respectively, tax revenues in England, Scotland and the whole UK in year t.

Page 57 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

Let  be the relative rate of growth in the tax base in England as compared to Scotland. It is assumed that  is constant from year to year. In line with the assumption that tax take is proportional to tax base, it follows that

E S Tt Tt E   S , for all t. Tt-1 Tt-1

Let a t represent the abatement to the Barnett formula block grant in year t: S then a 0  T0 , (given the no-detriment assumption in setting the initial abatement),

Tt and a t  a 0 , under Holtham indexation, given the assumption that tax T0 take is proportional to the tax base.

S Let E t represent abated expenditure in Scotland in year t:

 S S S therefore E t  E t - a t  Tt .

 Finally, let R t represent relative per capita spending levels in Scotland and England, when Scotland receives the abated block grant, plus its own revenues on devolved taxes.

Proof of Equation (1)

S The formula for E t which is derived in the Annex to reference (2) can be rewritten as

S S S  t k ( 1) p 0 E t = E 0 + (( ) 1) E 0 .  (  ) p0

It is proved in the Annex to reference (1) that

S E a 0 -t - a t  Tt = - Tt ( )[1 -  ]. T0

It follows that

S  S S S S  t k ( 1) p 0 E t  E t - a t  Tt = E 0 + (( ) 1) E 0  (  ) p0

The assumption that the proportion of expenditure on “devolved” services in England E which is funded by devolved taxes remains roughly constant implies that Tt is t  S proportional to  . It follows that E t is of the general form given in equation (1).

Page 58 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

“Fiscal autonomy”

S S Let N t = non-devolved taxes in year t, and suppose that N t grows at rate  .

S Let F t = public expenditure in Scotland under fiscal autonomy.

S S Then F t = + Tt .

 S S S Therefore - E t =  E t  a t , since the Tt terms cancel out,

S t S S  t k ( 1) p 0 =  N 0 - E 0 + (1 - ( ) ) E0  a t .  (  ) p0

Now, it follows from (2) in Annex 1 of reference (1) that

E Tt t a 0 a t  (1 E )a 0 . T0 T0

S E t S S  t k ( 1) p 0 Tt t a 0 Hence - =  N 0 - E 0 + (1 - ( ) ) E 0 + (1 E )a 0  (  ) p0 T0 T0

E t Since Tt is assumed proportional to  , it follows that - is of the general form given in equation (3).

Annex 2: Adjusted Holtham indexation.

Notation is as in Annex 1.

Equation (4) in reference (1) gives a good approximation to relative per capita expenditure under adjusted Holtham as

E  a 0 p0 Tt  t R t  R t - ( E )( S )( )(1- ( ) ) T0 p 0 E t 

The first term in brackets in this equation is the ratio of initial tax revenues between Scotland and England, and the second term in brackets is the ratio of English to Scottish population, so the product of these two terms will be approximately 1: and the third term in brackets is the share of “devolved” expenditure in England funded by devolved taxes, which is approximately 0.5 in Scotland, and is likely to be broadly similar in England. So the ratio of per capita expenditure is given by an equation of the form of formula (4) in the main body of the paper, in which the constant K is approximately 0.5.

Page 59 of 420 Dr James Cuthbert – Supplementary written evidence (DPF0021)

21 September 2015

Page 60 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014)

Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014)

Thank you for the invitation to submit written evidence to the House of Lords Economic Affairs Committee inquiry into the devolution of public finances in the United Kingdom.

Before replying to some of the specific questions in the Inquiry, I would like to make the following point.

There have been a number of pieces of published research which highlight problems with the Smith proposals, including a number of serious technical problems. However, there has been a very limited response from government departments. (And on a personal note, to date there has been no response from the UK Government, the Scottish Government, the Treasury, or from the Scotland Office regarding the analysis of the Smith proposals given in our Jimmy Reid Foundation paper or in Jim Cuthbert’s Fraser of Allander paper.) This is worrying. It is very likely that in the short period of time given to coming up with the Smith proposals, serious technical issues were not properly considered by the Commission’s advisers. However, now that these problems have been raised, the least government advisers should be doing is addressing the issues raised, and government advisers making their detailed modelling public for further investigation.

1. Response to Question “What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?”

A. There is unlikely to be a satisfactory means of fiscal devolution, without there being a system in place of either transfers and/or debt relief. The current situation of Germany in the Eurozone shows what can happen when one part of a monetary union has a very different and successful economy from others, and, because of its economic muscle, the common currency and exchange rates suit its economy rather than that of the weaker members. Without transfers and/or debt relief, weak countries can be almost destroyed. Austerity measures appear only to exacerbate the situation and produce heightened political tensions. While there are clearly problems within the UK, such differences, at present, are not as great among the countries of the UK: this will be in part because of the UK wide transfers and spread of government expenditure across the UK. A fiscal only solution to the demand for more devolution will not work in a monetary union.

B. Transfers, however, are not enough of a solution. Decisions on the siting and type of ports, airports, communication links like the Channel Tunnel, and a host of other decisions affect economic activity. There is already some concern that Scottish devolution has resulted in some UK departments, with a remaining responsibility for the whole of the UK, not

Page 61 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014)

taking Scotland into account in their deliberations. A much more holistic system, rather than a needs assessment, has to be considered.

2. Response to Question “How should block grant funding reflect devolved tax and welfare powers? How should future changes to the block grant be decided? How should the Smith Commission proposal of “no detriment” apply over time?”

If any form of block grant funding is part of a fiscal model, then it is essential that the system is fully transparent, timely, that the underlying data bases are available for scrutiny, and that the terms of the block funding are agreed among the various parties.

Present problems include:

 A pivotal data base for the Barnett formula is the Treasury Funding Statement: this was last published in 2010, so that for the last five years it has been impossible to check what is included and what is not in the Barnett formula.

 Whether an item of expenditure is or is not included is up to the Treasury: so, for example, the Olympics were considered a UK item and were therefore reserved and outwith Barnett: there were no Barnett consequentials for Scotland. The Commonwealth Games on the other hand, were considered a matter entirely of Scottish expenditure to come out of Scotland’s block grant. This arbitrary system, determined by one participant body in the system, has to change and become fully participative and transparent.

 It is currently impossible to check outcomes of spend as detailed in the annual Public Expenditure Statistical Analysis (PESA, country regional analysis) with the funds allocated through the Block Grant.

 As Scotland is given more fiscal powers, it becomes more likely that greater attention will be paid to the amounts spent by UK departments on Scotland’s behalf. However, currently, scrutiny of the country regional analysis of PESA would suggest that a number of these estimates are pretty crude, with the same percentage of spend going to Scotland being used in item after item, and with no apparent basis for the percentage figure used.

3. Response to Question “What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill?”

VAT: The available documentation from HMRC on the estimation of VAT receipts and on the subsequent disaggregation of those receipts gives rise to concern.

There would appear to be considerable variability in VAT tax receipts through time with both home VAT receipts and import VAT receipts showing considerable movement. Yet, in their disaggregation methodology notes, HMRC records “It is assumed that the standard rated share and the reduced rated share are the same across the four subnational areas. It is also assumed that the tax gap is the same for each area and that historic litigation repayments are shared equally between areas.

Page 62 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014)

The split between import VAT, payments and repayments as well as input and output tax is the same across all areas.” No grounds whatsoever are given for this set of assumptions.

It would appear, therefore, that Scotland could end up with a VAT tax payment mechanism based on assumptions that have not been tested. Scotland would have no control over any aspect of the VAT system which might help grow the economy: with neither the ability to change the standard rate nor to reduce VAT on important items to assist the economy such as tourism or home repairs. And for this dubious benefit, Scotland would have an abatement made in the Barnett formula which in the future could be adjusted by an indexation mechanism which is itself faulty.

Income Tax: Concern with the adjustment mechanism to the Barnett formula is raised in our paper Cuthbert, J. R., Cuthbert, M.: “Smith Commission – Why the economic and fiscal arrangements need to be changed”: published by the Jimmy Reid Foundation, 26 May 2015.

19 August 2015

Page 63 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38- 46) (DPFOE0004)

Evidence Session No. 4 Heard in Public Questions 38 - 46

WEDNESDAY 9 SEPTEMBER 2015

Members present

Lord Hollick (Chairman) Lord Kerr of Kinlochard Lord Lamont of Lerwick Lord Turnbull ______

Examination of Witnesses

Dr Cuthbert and Mrs Margaret Cuthbert

Q117 The Chairman: Thank you very much for joining us today.

Mrs Margaret Cuthbert: Thank you for having us.

The Chairman: As I explained, we have had several sessions already, including with the Finance Committee. One of the issues that has really come up is the lack of transparency in this process, and therefore the lack of awareness and understanding. It would be interesting to hear from you whether you agree with that assessment and, if so, what could be done to shed light on this both now and over the coming years so that whatever settlement is reached can be robustly reviewed and understood, not least by the Scottish electorate.

Dr James Cuthbert: Interestingly, Jim Sillars, as you may be aware, had a book launch yesterday. The book is a post-mortem on the referendum. I asked a question at the press conference for his views on what seems to be an outstanding paradox in Scottish politics just now, which is whether what was supposed to emerge from the referendum was a politically educated electorate in western Europe, as some people said. Nevertheless, the Smith commission reforms are going through without an outstanding furore over what is proposed. On the basis of our analysis, it seems to us what is proposed is absolutely disastrous. Part of that is technical and relates to modelling. You have got the paper I did, the Fraser of Allander Economic Commentary on the modelling, which shows there is an unstable system. Part of it is constitutional. We identified this effect called the “gearing effect” which is a problem that arises

Page 64 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) when decisions are made when whatever body is making decisions on the rest of UK’s devolved taxes makes decisions which have an effect on reserved services.

Lord Lamont of Lerwick: May I interrupt? You have alluded to the modelling of Barnett post-Smith and this Fraser of Allander paper. You have given us this paper but your view is that the Holtham indexation will actually lead to public expenditure per capita in Scotland being driven down to what you call an unacceptable level.

Dr James Cuthbert: Absolutely.

Lord Lamont of Lerwick: Maybe you could just explain that.

Dr James Cuthbert: I do not know if you have had a chance to see it, but I did send a copy of that paper to your clerk.

Lord Lamont of Lerwick: I have not, no.

Dr James Cuthbert: The proposals were only produced in January this year so one is working continually on it. To put it in its crudest form, let us take Holtham indexation as it is proposed at present and let us suppose Scotland just matches the rest of UK’s tax rates, in other words it just keeps tax rates the same as in the rest of the UK; suppose that population is growing in England relative to Scotland, which is the case— it has been like that for many, many years and will continue to be so presumably; suppose the tax base in England is growing relative to Scotland which, given the population is growing, will almost always be the case and will certainly be the case at times when the City is booming; suppose these three conditions are met, which are perfectly reasonable conditions, and suppose that if you look at the devolved services down south, let us say health and education, and suppose that the proportion of expenditure on health and education down south, which is funded by those taxes which are devolved up here, basically funded by income tax that remains roughly constant, which will tend to be the case, you have four eminently sensible conditions that will almost always be met. Under those conditions in the long run, if Scotland managed to grow its own non-devolved tax resources at all, ultimately Scotland would be better off under fiscal autonomy than under the financial settlement we have got here. Under the financial settlement we have got here public expenditure would eventually go negative and then tend off to minus infinity unless something changes. Obviously that cannot happen but that is saying you are in an impossible situation which is going to head towards the rocks under the financial model that is set up. It is as bad as that. I will justify that statement in a note I can send to you later.

Q118 Lord Turnbull: If you made one change to the Holtham indexation, which is on a per capita basis, how much of this system would you use?

Dr James Cuthbert: If you take out the heading “off to minus infinity” aspect of it, what would tend to happen then would be that what would kick in would be what is actually formula 4 in the Fraser of Allander paper, which you have, which would say that under reasonable conditions public expenditure per head in Scotland would tend to a limit relative to public expenditure per head in England but that limit would be about 50%.

Page 65 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Although the thing is more stable, and it will diverge less rapidly, it will head towards a position—

Lord Turnbull: How much of this would happen in five years, 10 years?

Dr James Cuthbert: Not in five years. I always thought that talking constitutional change you were talking generations and that was the whole tenor of the referendum. Certainly major effects will occur within a notable time period. Again I would refer you to the Fraser of Allander paper. There are a couple of charts in that which show, first of all, the sort of things that happen under reasonable assumptions under crude Holtham indexation and then what happens if you do the adjusted Holtham indexation. It is much more stable but it is still making big changes and ultimately is heading up to around the 50% limit, which would be untenable. So it does seem to us that as it stands it is completely unstable and intolerable. Modified as we suggested it is still unacceptable. One asks the question why one is putting in place a system which effectively brings in an active penalisation of Scotland under crude Holtham unless we grow our tax base as fast as England, and under adjusted Holtham unless we grow our per capita tax base as fast as England. Obviously if one is going down the basic route we have got in Command 8990 you have these abatements and you have to grow them in some way.

There are alternatives. One alternative would be the index in line with the growth in the Scottish tax base, but that is nonsense because that puts you straight into moral jeopardy; it gives no incentives to Scotland to grow its tax base at all. It does seem to me that there is a middle course, which is that you do not index relative to anything that is happening in the tax base in England or the rest of the UK but one sets an absolute standard. So you would say, “Right, we will index the abatement in line with a modest assumption on the absolute growth in the tax base, if you grow your tax base in real terms at 2% per annum”. We do not know how the Scottish economy is going to behave—we have got limited powers—so I would be in favour of a very modest assumption, maybe just keeping it constant in real terms initially and then adjusting as the thing beds down. That does not actively penalise Scotland if we fail to grow as fast as the rest of the UK, but does give Scotland a positive incentive to grow its economy: the more it grows its economy the better, and if it fails to grow its economy it suffers. You are not setting this completely artificial penalisation in, you are giving a proper incentive. Then in due course one would hope that there would be adjustment mechanisms. Another point we make in our papers is that you cannot run a monetary union without revisiting periodically the question of fiscal transfers, and one would hope that that could be done in a mature fashion from time to time. If Scotland was indeed zonking ahead and you had said, “Grow your economy at real terms 2%, or your tax base at 2%, and you are actually managing 3%, we will up the indexation to 2.5%”, so you have still got an incentive. It could be adjusted in due course. That would take out a lot of the active penalisation.

Lord Turnbull: Could you just clarify again what we should be indexing to? You went quite quickly over it.

Page 66 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Dr James Cuthbert: I would say give a fairly modest absolute target. So you would say, “We will index your Holtham abatement, at least the bit of it relating to tax—”

Lord Turnbull: Indexing the abatement?

Dr James Cuthbert: We could come back to that in a bit more detail later because there is more than one kind of abatement. What is going to happen is that Scotland will get what it would have got under the Barnett formula, there would be a chunk taken off that in year zero because Scotland will be getting income tax receipts directly, so there will be a neutral amount taken off in year zero, and that abatement will then grow through time. It is perfectly reasonable it should grow through time. What they said in a very cavalier fashion in Smith and Command 8990 was, “Increase that abatement in line with the growth in the overall English tax base”—and that just sounds horrendous. Even the per capita adjustment is still bad. Why not say, “Okay, Scotland, we are going to index that abatement at 1%, 2% growth in real terms: grow your tax base faster than that, you are quids in, you get to keep the difference. Grow slower than that, you suffer. We will revisit the whole thing periodically in line with the processes that should be involved in any monetary union for periodically reassessing fiscal transfers”.

The Chairman: Did you explain this in detail to the Finance Committee and the Smith commission?

Dr James Cuthbert: We have had no contact with the Smith commission. We put in evidence to the Smith commission along with 800 other people.

The Chairman: Along these lines?

Dr James Cuthbert: No, not along these lines because, as I said, this is a moveable feast.

The Chairman: What about the Finance Committee?

Dr James Cuthbert: I explained to the Finance Committee in considerable detail the problem with crude Holtham indexation but not in the stark terms as I just explained to you. I had not then thought through what an appropriate way would be which give proper incentives. You are the first people to hear this idea of indexing in line with—

Q119 Lord Lamont of Lerwick: In your answer when you were talking about the incentive, you mentioned the incentive to grow the economy. There is an assumption there that of course it is within the gift of the Scottish Government to grow the economy faster than they have hitherto.

Dr James Cuthbert: It is not actually because they have very few economic powers. In an ideal world we would like to see the Scottish Government having more economic powers and an incentive to grow the economy and getting on with the job. We have issues about whether in fact the Scottish Government have made optimal use of the powers they have at present, for example in relation to the way they use public

Page 67 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) procurement. But they have very limited economic powers at present. The phrase we coined to describe one aspect of the whole Smith reforms was that this was “responsibility without power”. You have got responsibility for living within your tax resources. In fact, you have got responsibility for keeping up with what is happening with taxpayers in England or you will be actively penalised, but you do not have the power to do anything about it. The popular phrase we coined was “responsibility without power”. I have probably spoken enough.

The Chairman: Do you want to add anything to that?

Mrs Margaret Cuthbert: Mine is much more on the practicalities of the matter. I wrote in my note that the foundation of the Barnett formula, which is one of the things that would still be going on, has not been looked at. We have not had the Treasury funding statement since 2010. When you look at that Treasury statement, which is the basis for Barnett, you want to be connecting up that expected spend with what actually happened in the PESA document, which is the country regional analysis of how the different parts of the UK spend their money. There is no obvious connect. Despite many years of asking, there is no way that the two can connect even in the titles of the different headings on the way down. When you look at the Public Expenditure Statistical Analysis, you find that what is allocated to Scotland is a rule of thumb in so far as under the renewable heating incentive, for example, we have 18.79% of the total UK spend. It goes on like that. Among some of the research councils—and Scotland has always been told that our universities are extremely good because they bring in a lot of money—when you actually look at the percentages year after year and across the different research councils there is a uniformity about it to the second decimal place which suggests that things are not right. Over the years we have asked through the Treasury to get the departments themselves to do that. It is a big task. Some of them have been fixed but a lot have not. All of these things add to transparency and our understanding of what benefits we are actually getting from the non-devolved services and therefore how it is going to be affecting the Barnett formula and the amount of money we get in the future.

The Chairman: Do you plan to publish this shortly?

Mrs Margaret Cuthbert: The paper that Jim did is already published except for this new bit.

Dr James Cuthbert: The Fraser of Allander paper is already published.

Mrs Margaret Cuthbert: This type of detail is ongoing background research which other things have taken precedence over.

Dr James Cuthbert: I will drop you a note on the point I made relative to fiscal autonomy.

The Chairman: That would be very helpful.

Page 68 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Dr James Cuthbert: We will put that on our website in due course. I said that the model that has been set up would mean that Scotland will always be worse off in the long run than under fiscal autonomy, if Scotland manages to grow its non-devolved taxes at all. I would not want you to take that as my saying that we should have fiscal autonomy. There are all sorts of problems in defining fiscal autonomy because in a monetary union there are obviously going to be various agreements and concords about what freedom you would have, how you would pay for debt, what share of debt you would pay for, how you would pay for common services, et cetera. To my mind it is quite difficult to define what fiscal autonomy is. More importantly, the idea of having fiscal autonomy with relatively limited powers in a monetary union strikes me as a recipe for ending up like Greece. So I am not advocating fiscal autonomy. What I am saying is that, although this does not appear to be noticed, the Smith commission set up an own goal when it put forward a settlement that will always be worse than fiscal autonomy no matter how badly the Scottish economy is doing.

The second point I would like to make is picking up something you said earlier. We have been talking about indexing the abatements to the Barnett formula under these proposed arrangements. There are two types of abatement. There is the abatement we have been talking about where the Barnett formula block grant has been reduced because of resources that are going directly to the Scottish Government, but because of the no-detriment principles in Smith there is also another type of abatement. The second no-detriment principle says that neither England nor Scotland should benefit or gain from decisions made by the other party on devolved matters. That means that there will have to be a range of abatements to the settlement to do with adjusting— cancelling out the Barnett consequence. Suppose that down south the rest of UK’s income tax was raised and that was spent on devolved services or Barnett consequences of that, then what is set out in Command 8990 is that there would need to be a downward adjustment in Scotland’s block grant to compensate for that so that public expenditure in Scotland did not rise because of the decision on the rest of UK income tax. You have got that whole range of abatements coming in as well.

Those abatements raise very difficult technical issues. Take income tax, for example. When in most years the thresholds in income tax are uprated for inflation, is that just housekeeping or is that a policy adjustment that you would want to do an abatement for? If some years you do not do that, is that a policy decision? You are in the paradox situation that you have not done anything and yet that is potentially a positive decision for which there should be an abatement. You have got all those sorts of things. Secondly, however you index those abatements it cannot be in line with the overall growth in the tax base. Imagine the decision down south was to bring in a 10p tax band. The financial consequences of that will grow in line with the number of taxpayers, not in line with the overall growth in the tax base. Any temptation to index this second class of abatement in line with Holtham indexation would be nonsensical. Thirdly, however you index it you would want the thing to be self-cancelling. If a change was made in tax down south and then subsequently reversed, you would want to end up where you started. However, it is very difficult to think of ways you could do that. The technical issues surrounding the second type of abatement seem to completely escape scrutiny and yet are actually horrendous.

Page 69 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Q120 The Chairman: May I just stop you there for a second? When we had our meeting this morning with Finance Committee members, they made the point that they had looked long and hard at the second principle of no detriment going forward and concluded it was extremely difficult to model it and very difficult to make it work. They would like to see it as a high-level principle which was then reviewed on an annual or biannual basis so that changes could be made on a fair and reasonable basis. In other words, it is like kicking the can down the road and looking at the facts as they then were, rather than trying to come up with a formula that would work. In that sense I think they said they were recognising the dangers that you have raised.

Dr James Cuthbert: That was an area that I did cover in considerable detail with them when we gave evidence to them.

Mrs Margaret Cuthbert: On that specific point, looking again at the Barnett formula and what has happened in the past as far as these negotiations would go as to how we should deal with things, there are very few negotiations at all on the Barnett formula at one level. In other words, the Treasury, or someone, decides that the London Olympics will not be taken into account in the Barnett formula whereas, for example, the Glasgow Commonwealth Games were taken out of Scotland’s share. The Channel Tunnel was not included in the Treasury funding statement. The Queen Elizabeth Hall was not included within it. The decisions are made like Juncker making the decisions and the rest of us have to follow. I really do not see that what the Finance Committee thought we will get is likely to happen, because decisions are imposed, not negotiated.

Q121 Lord Kerr of Kinlochard: A consistent thread throughout all the evidence we have got today is the need for more transparency. Yet nobody seems to want the outside world to know about the negotiations that are going on now behind the scenes. On a continuing basis, annually, what you say about no documentation since 2010 is new to me and cannot be right. We may be unable to avoid rows but at least the rows would take place on the basis of agreed fact.

Mrs Margaret Cuthbert: Absolutely.

Dr James Cuthbert: There is another reason why transparency is extremely important, which is that one of the problems which the Scottish Government will have in setting up the new Scottish Fiscal Commission, which will almost certainly be charged with modelling and forecasting of the finances of the Scottish Parliament, is that you cannot do that unless you thoroughly understand how you got to where you are. Unless the whole process of setting the block grant is completely open and there is a great deal of openness about future assumptions made down south about growth in the tax base and things like that, and unless there are as few arbitrary judgments in the process as possible—as Margaret was saying, up to date the whole process of calculating Barnett has been riddled with arbitrary Treasury adjustments which could go one way or another—how can you forecast if the process is in riddles? The whole thing needs to be more open and less subject to arbitrary judgments or it is going to be impossible for the Scottish Fiscal Commission to forecast.

Page 70 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Lord Kerr of Kinlochard: We were playing with the idea—at least I was playing with the idea—of some sort of new independent institution which would be tasked with presenting the facts. Of course, Chancellors and Cabinet Secretaries can still wish to have a negotiation but it would be rather good if the public saw that negotiation taking place on the basis of agreed facts. Do you think there is a case for putting alongside the OBR and the Scottish Financial Commission a new UK institution to take some of the tasks of both?

Mrs Margaret Cuthbert: Our view is that the OBR works as an extension of the Treasury. It is not independent. We have written on this subject before. Its views have tremendous weight way beyond what they should have because it is still an arm of government, despite Robert Chote being there.

Dr James Cuthbert: Perhaps I can just say that I am not sure about a UK institution because the problem of forecasting the finances of the Scottish Government is not just a question of taking an OBR forecast and disaggregating it. That is the sort of thing that was done in the referendum and it produced forecasts of the public finances for Scotland: not very good forecasts, but they were forecasts of the public finances for Scotland. What we are talking about is the public finances of the Scottish Government, who are only responsible for half the expenditure and will only be getting income tax and an element of VAT: the other half of their finances will come through the complicated adjusted Barnett formula. So forecasting the finances of the Scottish Government is almost a separate question from the OBR-type forecasts. To do that kind of forecast would be very difficult. To get an idea of the difficulty, that is the area I dipped my toe into in my Fraser of Allander paper and the algebra is quite complicated if you look at it. It is a very difficult problem, quite distinct from what the OBR is doing, and will depend upon decisions that have been taken in government. It is not a question of looking at facts about the economy. The key thing will be looking at facts about what the Treasury was doing in working the Barnett formula, working out these abatements, working out the indexation of the different kinds of abatements, et cetera. An outside body would only be able to do that (a) if it was well resourced, (b) if it had its hooks right into the Treasury, the OBR, HMRC and so on, and (c) if it was getting access to the assumptions that these bodies were making. If indexation is based upon the growth in the English tax base, you need to know what assumptions are being made about the growth in the English tax base. So it is not obvious that an independent body is well placed to do this kind of work. It is work that critically needs to be done, and difficult work that will be so resource-intensive that you do not want to duplicate it. So whoever does it—and presumably the Scottish Government will want to do that work—maybe you want an independent body that can validate what it is being done and is in a position to do variants if it wants. There is a real problem here to which there is not an easy solution.

Q122 Lord Lamont of Lerwick: Could you talk to us a little about what you call the “gearing problem” where you described a scenario where the UK Government cuts a tax that has been devolved to Scotland and this has impact on reserved services such as like defence? You say the eventual effect would be a disproportionate cut in public spending in Scotland.

Page 71 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Dr James Cuthbert: In its crudest form, imagine that whoever was setting the rest of UK income tax decided to make a cut in income tax and fund that by cutting services across the board—defence, social security and devolved services in England. If there was a significant cut in income tax stemming from that, the Scottish Government would broadly have to follow suit. Scotland is not going to be able to get too much out of line on income tax or the economy will collapse. It will have to fund that cut over the smaller base of devolved services while down south it is funded over the larger base. There will be a disproportionately larger cut in those services in Scotland. That is why we called it the “gearing problem” because of that gearing effect. That is a basic problem.

Although Smith did not spell that out, clearly they were aware of it because they came up with this second, no-detriment principle—the people who wrote Command 8990 were completely aware of it—and they said, “We will solve this by this principle that decisions taken south should not be able to affect what happens”. For example, if down south it was decided to raise income tax and spend that money on reserved services—the example that we gave when we wrote this was Trident, because that is popular in Scotland—because a reserved service is regarded as benefiting the whole of the UK, overall public expenditure in Scotland would go up by Scotland’s population share of the increase in UK public expenditure and, according to Holtham’s second, no- detriment principle, you then need to adjust Scotland’s block grant down by a corresponding amount to compensate. You would now be in a position where a decision taken down south on income tax and on reserved services would force either a tax rise or a cut in services on Scotland, which is entirely counter to the principle that we were led to believe we were getting of greater autonomy and freedom of decisions under Smith. Instead, we are a bit like a puppet at the end of a chain that can be jerked.

My own view is that you can only get round this by some sort of federal system where you separate out decisions on the rest of UK income tax from decisions on spending on reserved services. If it is the same people making those decisions, effectively you get a residual problem and you have not solved it. A solution to the problem would be to have an overarching federal Government making decisions about the allocation of a block grant to the different parts of the UK, and then English MPs would take their block grant and make a decision about the rest of UK income tax and what they were going to spend on health and education. That would be fine.

That system would have another huge advantage as well. It would completely sweep away the difficulties we have been talking about with the various forms of abatement. We are in the ridiculous position at present where we are saying, “Okay, we will have a hybrid system where public expenditure down south depends on decisions made on the rest of UK income tax by English MPs. That affects overall public expenditure, which affects the Barnett formula, which affects Scotland’s spending, but we must correct that”. That is nonsense. If each party just got a block grant, then you could have a Barnett formula relating the block grants to the different parts of the UK. What they did on top of that in the different parts of the UK by way of income tax would be fine; it would be an entirely internal matter and there would be none of these

Page 72 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) consequences working their way through the Barnett formula as at present. Federalism would not merely be workable to my mind but the only workable way of approaching this. It would also sweep away these horrendous complications we have at present. That seems to me to be the second big fault line.

The Chairman: That is where we are.

Dr James Cuthbert: I appreciate that while your Committee may be able to make strong recommendations on technical aspects, you are unlikely to be able to sell federalism to Westminster. There is a fundamental problem there about the whole thing.

The Chairman: Putting words into your mouth, and going back to your Jim Sillars remark, we are far from reaching calm water.

Dr James Cuthbert: Why are the crowds not out in the street saying, “How do they solve that”?

The Chairman: This will become apparent as each year passes.

Dr James Cuthbert: We are actually in a worse position than Greece, with a financial settlement that actively penalises us if we fail to grow as fast as the rest of the UK and with far less powers than Greece. Greece went through its initial honeymoon and then things hit the fan. This will happen exactly like that in Scotland.

Mrs Margaret Cuthbert: There are a couple of other points I would like to make, one of them I made in the paper. As we get more fiscal powers in Scotland, the trend—it has been apparent since Scottish devolution—of UK departments which are partly looking after devolved services but partly looking after UK services is increasingly that those looking after UK services are thinking that Scotland is looking after itself. For example, it would be entertaining for you if you looked at the Department for Culture, Media and Sport and looked up tourism. It has responsibility throughout the United Kingdom and says it spends 7.79% of its budget in Scotland. You would be hard pushed to see any mention of Scotland in any of its publications, other than the financial one; in any of its promotions we just do not exist. That is not uncommon. That is a worry as more gets devolved. Smith only looked at the finance. They should also have been looking at the services which are not devolved to make sure that no harm was going to be happening there.

Q123 The Chairman: Are you suggesting in that particular case that the 7.79% that is mentioned in the DCMS report is in fact not finding its way to Scotland?

Dr James Cuthbert: I think that would be educational.

Mrs Margaret Cuthbert: Part of it will be finding its way because part of it, for example, will be that we can go and use promotions overseas. What I am saying is they are not doing enough. UK Trade & Investment is exactly the same. Today if you looked up events in various parts of Britain to see what UKTI was supporting and looked up

Page 73 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Scotland, it would say, “Oops, sorry, there’s nothing happening in Scotland”. It has been like that since the end of March when I wrote to them and to the Minister to complain that what it said for March was, “The Commonwealth Games in Scotland”, which were last year. That gives you an idea of what people are seeing on the websites as to what UK Government departments, which are looking after UK interests, are doing for Scotland right now. That was the first point.

The second point I wanted to make was, within the course of Smith being looked at, if you remember the VAT position was changed. When this comes into being it will take some time to work out the VAT position. This is going to take a long time because VAT, as you know, is assessed and then various amendments are made to it as the process goes on. As for the amount of VAT that the Government thinks should be collected and the amount that is actually collected, there is at least an 11% difference between the two. They have no idea how that allocation should be across the country so they use a formula to separate it out. All of this will have to be looked at. Since it has taken them years of not looking at it, I have no idea how long the process will take. We are embarking upon a process like the VAT where we really have not a clue what the figures will be because they have never been worked out and at the same time they are putting the existing Barnett formula at threat.

Dr James Cuthbert: I would like to comment on what Margaret said about the powers. There is another side to the coin of whether English departments or UK departments are exercising the reserved responsibilities for Scotland properly. If Scotland has only a relatively restricted set of policy clubs—at present it has very few economic powers— that is potentially very damaging. You often hear particularly opposition politicians in the Scottish Parliament saying, “The Scottish Government should be getting on with the important matters of health and education”—in other words, “Get on with your domestic powers”. In one sense that is true but, on the other hand, if the main thing you can do about the economy is to seek to improve the skills and education of your workforce and you are not able to do much about seeking to improve the demand for those skilled people, all you are doing is educating people to emigrate.

I mentioned earlier this question of relative population growth. The population over many years has consistently grown faster in England than it has in Scotland. It was only relatively recently that I dug out the corresponding ratios for Wales and Northern Ireland and was absolutely staggered to find that their populations have tended to grow in most of the recent past relative to that in Scotland. That is quite bizarre, particularly given the economy, et cetera.

The Chairman: Growing faster?

Dr James Cuthbert: The populations have been growing relatively faster, yes. One possible explanation for that is the vaunting of the Scottish education system, that we have been putting too much into education and too many people through university for whom the world is their oyster and they are off to the detriment of the Scottish economy.

Page 74 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) The Chairman: You are exporting talent.

Mrs Margaret Cuthbert: Yes.

Dr James Cuthbert: We are exporting talent. If it is true, that is a classic example of the kind of policy bias you get when your main policy levers are concentrated on only one part of the toolbox.

Q124 The Chairman: So are you arguing that the powers and taxes that are being devolved are inadequate for the purpose of having a balanced fiscal strategy and control over the levers which are necessary to grow the economy?

Mrs Margaret Cuthbert: Absolutely.

Dr James Cuthbert: There are two separate questions. There is the question of which taxes have you got. The major tax we have got any control over is income tax, which, as we explained in our paper, is a poor tax for that purpose because our distribution of earnings is quite different from that in the rest of the UK, with many fewer at the higher end of the scale, which means that we are going to grow at different rates at different points of the economic cycle. It is a poor choice of tax and too limited a set of tax powers we have got. The other thing is: what non-tax powers have you got, particularly what powers have you got in the economy? There is a whole swathe of things there that we do not have. The overall thing is we do not have the powers to grow the economy and we will concentrate on those things we can do, which in a perverse way could have a detrimental effect rather than a positive effect.

Mrs Margaret Cuthbert: For example, VAT is just a handout of a percentage. We have no control over those. If you go to France or any European country, while adhering to the overall EU regulations they will have different systems of VAT. In France, when you are paying your hotel bill, that money will go to the local council, which will use the money to boost tourism in the area—that might be putting in flowerbeds or training or whatever. If they feel there is a need for improvement of people’s housing—as there certainly is in Scotland in many places—that will not be subject to VAT. Once you have the full power over VAT, within the European Union you can change various aspects of it. We have no such powers.

The Chairman: So you would be in favour of a block grant and allowing that money to then be spent—obviously it is set at an adequate level—to iron out some of the imperfections that you describe and allowing the devolved parts of the United Kingdom full powers as to how they should invest it and what they should do with it.

Dr James Cuthbert: Not full powers—obviously they would have to be constrained.

The Chairman: With central responsibility for defence, security and things like that.

Dr James Cuthbert: In any practical union there would have to be some oversight which would limit tax competition, et cetera.

Page 75 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) The Chairman: That is a very long journey from where we are.

Dr James Cuthbert: It is very long.

Q125 The Chairman: Cutting to the chase, if I can put it that way, it would be very helpful indeed for you to give us the benefit of your additional work and an explanation that we can then discuss amongst ourselves and share with our readers. What would also be very helpful is to know, given that we are where we are, what steps and what measures can be put in place to address the perverse outcomes that you have described. I think you are also describing a situation in which some perversities exist because that is just the way that the dust has accumulated over the years.

Mrs Margaret Cuthbert: Yes, but they actually add to the problem now because they are not being dealt with.

The Chairman: I accept that. I think it would be very helpful to be able to read and understand what your remedies are.

Dr James Cuthbert: Can I raise one other issue which you mentioned in your questions but I do not think we have touched on yet, which is the question of needs assessment? I think that periodically the nation would have to revisit the question of adjustments of finances in different parts of the monetary union. Any monetary union that is going to be a success has to do that. Probably some form of needs assessment would be part of that. When I was a civil servant I took part, from both the Treasury and the departmental side, in previous assessments of needs, which are pretty hairy exercises. What was coming out was there was greater need in Scotland. A figure of 10% seemed to be what stuck. It did strike me, and it strikes me now, that that sort of exercise, while difficult, is only part of the story. It should not just be about need for public services that you are talking or thinking about; there should also be an element of needs assessment which looks at the distribution of what might be called economic pressure across the country. We are profoundly bad at that at present. We have got pressure cooker south and south-east, while Scotland is pegging along in the middle at present but will soon drop back, and parts of the north and so on are really suffering very badly. Evening out that economic pressure should surely be a part of any future needs assessment exercise.

Mrs Margaret Cuthbert: For example, although many of our ports are private companies and they can choose where they would like to settle themselves around the country, it is our infrastructure that determines where they think it is a good idea. For example, the Peel Group in Liverpool is expanding their huge container base, but it is the same Peel Group that own Clyde port authorities and have interests in a number of others. You can see easily that, where that is the case, on such an important matter of infrastructure, other areas of Britain could lose out. We need a system where it is not just a needs assessment but where we are looking at the whole infrastructure and the physical things that make it a United Kingdom, which is presumably what is intended at

Page 76 of 420 Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) the end of the day, despite both of us being interested in independence. These things need to be put in place.

The Chairman: When you raised this at the book launch, you said that far from a period of calm we were getting into a period of great turbulence.

Dr James Cuthbert: What I raised was the paradox that we were not in a period of great turbulence just now.

The Chairman: Moving from calm to turbulent.

Dr James Cuthbert: The turbulence should be now to get a decent settlement in place.

The Chairman: How was that message received?

Mrs Margaret Cuthbert: Jim Sillars agreed.

Dr James Cuthbert: He agreed very much. One of the concerns in the academic community is they are not shouting this from the rooftops. We have not talked to any civil servants first hand but one hears second-hand rumours trickling back, “Oh, they don’t think it’s workable. It won’t happen like this. It can’t”. It is very bizarre.

Mrs Margaret Cuthbert: In the past we have had regular meetings with civil servants and when this paper was produced there was utter silence. There have been no papers produced commenting on the work done. There have been no academic papers— maybe David could correct me—published on commenting on the work done. We know that it went round the Treasury with notes and we have had no feedback from the Treasury.

Dr James Cuthbert: We know the Treasury did an internal briefing on the modelling paper. We have not seen it.

Mrs Margaret Cuthbert: So you cannot comment.

The Chairman: Thank you very much indeed for a very interesting session.

Dr James Cuthbert: We will send you a note.

The Chairman: If you could do that, that would be very helpful. Thank you very much indeed.

Page 77 of 420 Mrs Margaret Cuthbert and Dr James Cuthbert – Written evidence (DPF0014)

Mrs Margaret Cuthbert and Dr James Cuthbert – Written evidence (DPF0014)

Submission to be found under Dr James Cuthbert and Mrs Margaret Cuthbert – Written evidence (DPF0014).

Page 78 of 420 Mrs Margaret Cuthbert and Dr James Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004) Mrs Margaret Cuthbert and Dr James Cuthbert – Oral evidence (QQ 38- 46) (DPFOE0004)

Submission to be found under Dr James Cuthbert and Mrs Margaret Cuthbert – Oral evidence (QQ 38-46) (DPFOE0004).

Page 79 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003)

The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003)

Evidence Session No. 3 Heard in Public Questions 28 - 37

WEDNESDAY 9 SEPTEMBER 2015

Members present

Lord Hollick (Chairman) Lord Kerr of Kinlochard Lord Lamont of Lerwick Lord Turnbull ______

Examination of Witness

Mr Alistair Darling

Q126 The Chairman: This is the fourth meeting that we have had of the Committee on this topic. We are aiming to publish a report in November, hopefully early November, in time for it to be part of the consideration before the Bill comes to the House of Lords. That is the timetable that we are looking at. It is also fair to add that we have asked for, but so far not secured, an agreement from either John Swinney or a Treasury minister to come; I think they prefer not to give a running commentary on this. We have got a number of questions which have been shared with you. Perhaps I can start with the Barnett formula. We were told this morning by the Finance Committee that is a done deal, that is the politics of it, nobody is going to accept anything else, notwithstanding the difficulties of making it work in a new world. What is your take on that?

Mr Alistair Darling: Firstly, can I just formally record that I have been nominated to become a Member of the House of Lords but I have not taken my seat. I should say that for the sake of completeness. I think part of the problem we have just now is that the process is under way in the sense that the Scotland Bill is going through the House of Commons and a lot of its content was determined at the tail end of the referendum in terms of promises made by the Government and then the subsequent Smith commission, which took the process that much further. In light of that, various political promises have been made which are going to have to be kept. I say that because there are a number of things that are now happening, or appear to be happening, which if you sat down in the clear light of day you might do slightly differently. I shall come to your funding point in a moment. We do not have a clear picture of what the final

Page 80 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) settlement is going to be and, until we have, it is very difficult to say in what shape or form the Barnett formula will continue.

At a simplistic level, firstly it has been said by all the parties, and it is almost a given, that the Barnett formula will continue. Even if you have substantially more devolution, as you will do, given that the Barnett formula is simply the mechanism by which you adjust the block grant—the Barnett formula and the block grant, which is the main funding, are very often confused—there is no reason why it cannot continue. But quite clearly it is very different from the Barnett formula that we knew when the Scottish Parliament was established in the Scotland Act of 1998, because then basically what happened was everything the Scottish Office was responsible for was devolved and with it the funding. There have been various adjustments and one or two changes since then. This is radically different. I suppose one of the points that I wanted to make to your Committee is that the very fact that we do not know, for example, how much welfare is to be devolved and what the cost of it is, means it is very difficult to answer your question.

The second thing I have to say concerns the process by which this is going about. Unless you are a Minister in either Administration, or a civil servant, nobody has a clue what is going on at the moment. I think that is a massive problem because people in Scotland, who ultimately are going to have to live with this and pay for it, do not know what the discussions are and do not know what consideration is being given to the various choices before them. The result of that will mean that presumably we will be presented with a done deal and, rather like the Smith commission, it will be denounced by one side vociferously and the Scottish public will have had no opportunity to evaluate these things in their own mind because they did not know about it. I have been a Minister for long enough and a Member of the House of Commons for nearly 28 years. I have seen rotten processes before but this one is pretty difficult to understand and to justify. Sorry, it is a long answer to your question but that is a wee bit of context there.

The Chairman: Given that that has already been settled, the question then is how to make the Barnett formula and the block grant work effectively, given devolved taxes and given the new arrangements that are in place.

Mr Alistair Darling: It is going to be difficult because the Scottish Government will have responsibility for 40% of what they spend. It is very difficult for me to offer a concluded view on what the settlement ought to be because I do not know what it is going to look like. Indeed, it is not even finished yet because there may be more aspects of government or spending responsibility actually devolved. What I am saying to you is, you can honour the promise to keep the Barnett formula in so far as what is still subject to the grant because there is the adjustment formula. Frankly, I think the very act of reopening the whole thing will reopen the bigger question. Bear in mind that already the First Minister has said that she does not necessarily accept even this process, if she says, “It’s a bad deal for Scotland”—of which she will no doubt be the sole determinant.

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The Chairman: The no-detriment principle is presumably designed to ensure that Scotland is no worse off at least at the beginning.

Mr Alistair Darling: What I understood it to mean is, if the Scottish Government or the UK Government decided to do something that affected the other bodies, through no fault of their own, they would have to compensate them. I have looked at what was called An Enduring Settlement, the White Paper which was published in January of this year, which seemed to me to be a triumph of hope over experience if ever there was one, and they talk about there being some sort of mechanistic formula for sorting this out. Who are you kidding? This is about politics. I am afraid this is providing rich feeding grounds for people who dine out on grievances. The answer to your question is, yes, Barnett, in the sense that it is the adjustment mechanism, you can preserve in one form or another and still call Barnett, but actually this is so radically different because all income tax is being kept in Scotland, which again raises another issue altogether. I am a Scottish taxpayer. Who am I paying taxes to and what am I paying them for? My income tax is all going to the Scottish Government. How am I funding overseas aid or pensions? This is not clear. In many ways the Barnett formula, although it is one of these totemic things in Scottish and UK politics, to my mind it is not the big thing that we need to be looking at. Rather there is complete opacity and lack of clarity as to where we are going to end up and the process by which we are arriving there.

The Chairman: Is your understandable frustration widely shared, because one of the issues is how this is being covered by the media—or has this now dropped out of sight?

Mr Alistair Darling: One of the advantages of being a member of the public for the last six months is that you see the world differently from when you were going down to the House of Commons every week. This is not a talking point in the pubs and clubs or even in people’s houses in the way that the referendum was. Everything is now seen through the prism of independence or not, or what is good for Scotland or not. This sort of thing is just not being discussed outside the chattering classes. Another problem is that Scotland does not really have a think-tank community like you find in the UK. I just make the general observation that there is a real problem in the Scottish press now; as they are coming under more and more pressure from their owners, they are cutting back on staff. Thirty years ago there were experts in just about every field, but that does not happen now. The actual commentary on all this is a lot less than you would expect in a normal, healthy democracy. Were issues like this taking place on a UK scale, there would be so many people publishing this, that and the next thing. We had a lot of it during the referendum, though a lot of it incidentally had to come from people like the IFS and so on, but that has rather died a death now. What worries me is these are crucial issues that could actually determine the future of the United Kingdom if we get them wrong, and they are all being discussed—not because anyone is being particularly malevolent—behind closed doors. Speaking as a member of the public, which I am at the moment, I find that very frustrating.

The Chairman: To finish on the detriment issue, there are two elements to it. One is upfront no detriment, so nobody is worse off from day one, and then there is the

Page 82 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) continuing second phase of no detriment, where formulas and mechanisms have to be put in place. It was interesting meeting members of the Finance Committee this morning; they have clearly looked long and hard at this and the longer they looked at it the more difficult it became. It was described as being elevated to a principle only and no rules or guidelines were put in place. Indeed, they have done no work around modelling or anything like that. This is unknown territory.

Mr Alistair Darling: It is completely unknown. It would be difficult enough if you had two groups of people who basically wanted to see a sensible or workable outcome. But you cannot ignore the politics of this. They say the settlement will work and they have referred to a sub-central government, and if you are a nationalist that is the problem. Unless you have independence this is not going to work, and they are not inclined to make it work for obvious reasons. If you take the sum fixed to pay for welfare that is devolved—the idea is that a lump sum is going to be transferred—everybody knows that what you actually spend on benefits changes partly because of the economy, partly because of demography and so on. The most obvious difficulty I see is the idea that you could fix it, seasonally adjust it every now and again without compromise. The first time the Scottish Government were faced with the possibility of making cuts, they would not say, “This is what we’ve got to do because we’ve got to live within our means”, they will say, “This is imposed by the UK Government. This is another reason to leave the United Kingdom”. You cannot look at this without understanding the politics of what is going on in Scotland. I am sure the Committee is aware that the situation is as febrile as it has ever been, frankly.

Q127 Lord Lamont of Lerwick: Your point about the process and nobody knowing what is going on is something I had not really focused on but was becoming more aware of sitting on this Committee. Do you have a view on the overall fiscal regime that might be agreed between the two Governments—and by that I mean debt levels, borrowing and the framework?

Mr Alistair Darling: The Chairman referred to “no detriment”; I think you would need a little more definition as to what that actually means. Certainly for borrowing you would have to have some framework because otherwise, in the extreme, you could see one side or the other running up huge debts, and particularly if you look at it from the UK’s point of view people would say, “How do we know your debt levels if somebody else can change them that much?” I think that might be easier to resolve, if you like. I can see the problems with the White Paper. The civil servants have done their best to write something to make what was designed on the hoof work. The benefit of publishing some of these considerations would be that it would allow people from outside to say, “Well, actually there’s a better way of doing it” or at least understand what the issues are. I suspect the prospect of publishing what they might hope would be a done deal will fail—not just politically, but commentators will say, “Actually, this isn’t going to work”. The answer to your question is there are some things you can define but it is the things you do not define, or that are always going to be changing, that will cause conflict from grievance.

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Lord Lamont of Lerwick: Just to give an example, one of the issues that arose in our previous discussion was the argument that if the UK was in a position where the Government were having to reduce their deficit over a period of time but the Scottish Government felt that they were in a different situation and wanted to not entirely follow the same trajectory as the UK Government in the overall UK fiscal position, should it or should it not be allowed to do that? One of the SNP Members made the argument, “Well, provided we’re keeping to our parameters, provided we’re keeping to our medium-term objective in terms of the fiscal balance or the stock of debt, it should be accommodated by the UK Government because it’s only part of the overall”. I must say I did not find it unreasonable per se.

Mr Alistair Darling: What was envisaged is there would be times when the Scottish Government might, for example, want to borrow to build another Forth bridge or a railway line or something like that, or they might want to borrow a limited amount to tide things over. If you accept fairly strict parameters, any state can stand that if you like. Where the real problem arises, and you see this in the eurozone, is if you have got a currency union there is a limit to how far your economic management can diverge as part of that.

Lord Lamont of Lerwick: We are really talking about devolution.

Mr Alistair Darling: It depends on the scale of it. What I would find difficult to imagine is, if you take an extreme example, suppose you have got the present UK Government saying, “We’re going to pursue an aggressive policy of austerity” and the Scottish Government saying, “We’re going to have a very aggressive Keynesian expansion”, it depends where you draw the lines as to how far they go. I just see tensions arising if you do that.

Q128 Lord Turnbull: Can you commend the Barnett formula, if you distinguish between it as an updating mechanism and then the block grant that has arisen? One of the problems with it, even as it is at the moment, is that it is entirely incremental, so if you find the population is not quite what you thought it was, you change ten eighty- fifths to nine eighty-fifths or whatever, but any kind of growing advantage to Scotland is simply locked into the system. One would hope, if we are starting a kind of four-way constitutional financial settlement in the United Kingdom, it would start out with all parties thinking, “At the moment it is not ideally what I want but it is reasonably fair”. No one in England or Wales thinks this starting point is reasonably fair; they think it is manifestly unfair. It was put very bluntly to us that if you touch a hair on the head of the Barnett formula there would be a “yes” in the next referendum. Are we just stuck with this or can some concept of needs get introduced so that the baseline, the stock, so to speak, gets revised and then you can see whether you can push a bit more money in the direction of Wales or a bit less to Scotland? They seem to argue that is complicated.

Mr Alistair Darling: I suppose, like many of my predecessors, when I was Chancellor I looked at the Barnett formula and my starting point was, if you were coming up with something today you would not start from where you have got, and after 10 minutes I

Page 84 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) could see why none of my predecessors had got any further than receiving a submission and sending it back marked “noted”. Once you open it up, the whole process of working out needs is difficult. If you look at Scotland, and you assess the need of Edinburgh as opposed to the east end of Glasgow, they are very, very different. They are different countries in many ways, as you can see round England. Within England, what you might think is a need in the north-west of England is very different from what you might think about the south-east.

Lord Kerr of Kinlochard: This is a counsel of despair if you are saying that we cannot have a logical system because it would be quite difficult to work it out. It seems to me that we have got five years. Thanks to the Vow, Smith and all that rubbish, we are stuck with Barnett for five years but we could use these five years to devise and start a transition towards a sensible system.

Mr Alistair Darling: I am sorry that we have turned the tables. I am rather like the civil servant advising the Minister, “Don’t be courageous, Minister”. There is a broader point here. I think trying to reform Barnett on the basis of trying to assess what needs look like in the second decade of this century, would take you a long time and I am not sure you would ever come up with a satisfactory answer. I think there is a bigger question, which I hope the Committee will address, and that is what we now have is a very lopsided devolutionary settlement where all of income tax is being kept by the Scottish Parliament. That is completely different from what is happening Wales and Northern Ireland, and there will be a different settlement again if the structure is set up in England. Perhaps in the light of that we will have to look at how these things are funded, especially if you complicate that with a political English votes for English laws and that is applied to finance Acts and basically voting on income tax—then a whole lot of things are called into question. What worries me is we are doing that in the most unsettled political time that this country has seen for a long, long time.

In answer to Lord Turnbull’s point on Barnett, I think trying to adjust it on its own would be politically toxic. If you want to walk down Princes Street you would be hard- pressed to find anyone who could tell you what it actually is. They will have heard of it but not how it works. It is not their fault; if you go round the Cabinet table you might find one or two struggling to understand what it is.

Lord Turnbull: They know it is a good thing for them and they must defend it.

Mr Alistair Darling: To be fair, as a leader of the campaign to stay in the UK, I made that point time and time again. What has happened subsequent to that, the settlement we have now got and the lopsided nature of that vis-à-vis the rest of the UK means at some point you have to fund and establish something so people actually know what they are paying for in a way that is acceptable. I accept that you have got an English nationalist problem as well and the perception south of the border to deal with at the same time, but I am not sure that an adjustment of Barnett per se would do the trick.

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Lord Turnbull: The opposite strategy is to increase the amount of taxes for which they are responsible, so the deduction from the grant gets bigger and the Barnett formula becomes less of an issue.

Mr Alistair Darling: There is quite a substantial move towards that at the moment. My problem is that if we were in a federated country—and we know the arguments there—you would pay some of your taxes for what you get in Scotland and some of your taxes for what you get at the UK level. This settlement has rather blurred that to the point where it is not at all clear. What is half my VAT going to? I do not know. Other countries have managed it. The whole Smith process was truncated into a couple of weeks and that is a very short time in which to fundamentally change a lot of our constitution. I do not say this is an argument for not doing anything, I just think if you are going to look at it, before we go too far down this road, we need to try to fix some of the bigger things. Once you have got principles that underpin a constitutional and financial settlement, it is easier to see how these different allocation mechanisms slot in.

Q129 Lord Turnbull: Supposing you were still Chancellor and the proposal came up that there should be a kind of Australian Grants Commission which is collectivising your decision-making, and a Committee like this recommended it, would you endorse it?

Mr Alistair Darling: I am not familiar with it. Is this a committee of non-politicians?

Lord Turnbull: Yes.

Lord Kerr of Kinlochard: It is mainly ex-politicians.

Lord Turnbull: They collect relevant data and they make a view about whether Queensland is doing better than Victoria and so on.

Mr Alistair Darling: I think you have just heard evidence in your last session, and I tend to agree with the views expressed, that you cannot depoliticise the spending of money. As far as I know, there is no move for any part of Australia to break away from the country. Where you have got almost half the population voting for a party that wants to break away from the rest of the UK, I think to believe that you could take highly charged decisions and give them to a body of experts or whatever, I just do not think would work.

Lord Kerr of Kinlochard: I agree with you about the SNP’s motivation, so I agree with you there is no way of avoiding controversy if a party has an interest in causing or stimulating controversy. However, is not the controversy more likely to be easy to stir up if the block grant size and allocation are determined by a non-transparent process of politician talking to politician, rather than, at least in the question of the allocation of the cake, by some needs-based system where the needs are assessed by an independent authority?

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Mr Alistair Darling: This is an argument for saying, “Look, end Barnett and we’ll get some experts to recommend how you divvy up the cake throughout the whole UK”. What I am saying is you can do that but I suspect it will take some considerable time before you did it. Politicians are guilty of many things but experts too can be guilty of coming along with their own prejudices. I am not sure who we would turn to. Solomon is not around at the moment, as far as I am aware, to determine these ways so everybody says, “Yes, that is a jolly good thing”. As I said right at the start, what worries me about where we are at the moment is the fact we are actually marching in the opposite direction and providing more and more scope for there to be highly charged, highly disputed arguments.

Q130 The Chairman: Taking where we are now as the starting point, and we do not have any choice but to do that, how would you chart a way forward? Given the politics which you know well, what are the issues that could be resolved which would give us a workable system?

Mr Alistair Darling: Entirely taking your point, to my mind I am talking about trying to salvage something here. There are two points I would make. Firstly, the process of discussion is now taking place and there is no reason why that cannot take place in public. There is no security or any other issue that I am aware of that could possibly stop that, so at least people could see what the thinking is. The second thing is, we need to get clarity as to exactly what we are in for here—what has been devolved, what is the cost of it and what we are going to pay for—so at least we know the starting point. Remember, the Scottish Government are going to have to strike their own income tax rate from next year and then they will get further powers in relation to rates, banding and so on. But things are so obscure at the moment that no one is going to understand what the relationship between spending and tax is. If we had known all this a year ago, I would have said, “For goodness’ sake, let us look at countries that have been here before and at how they organise it because it might be an awful lot better”. I understand the reluctance to open up huge constitutional issues but we are stumbling into a constitutional hole here. I cannot overstate how febrile things are. My big plea to you, when you come to your conclusions, is to recommend that some light is starting to be shone on this so that people understand what is going on. You cannot also look at this without looking at the Government’s separate consideration in relation to voting, because if, for example, they said Scottish MPs cannot vote for the income tax rate outside Scotland, you are then calling into question the very existence of the union.

Q131 Lord Kerr of Kinlochard: I agree with that. On the fiscal side, where Lord Lamont was taking us a moment ago, do you think a no-bailout rule is worth fighting for?

Mr Alistair Darling: In terms of things going wrong?

Lord Kerr of Kinlochard: Yes.

Mr Alistair Darling: The eurozone has a no-bailout rule, which we can see works very well.

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Lord Kerr of Kinlochard: Exactly. My understanding is this is an important point for the Westminster Government, and I cannot see why the markets would believe that while Scotland remained part of the United Kingdom, if it got in deep doo-doo, it would not be bailed out. The markets would not believe that.

Mr Alistair Darling: Also if you are operating with a single currency it is difficult to see how you could. For example, had the lion’s share of bailing out the banks in this country fallen on Scotland it would have bankrupted it. If it was still in the United Kingdom, would the rest of the UK have stood by? No. If we had left the UK then you could certainly say, “You are on your own. These are your banks, you actually backed what they were up to, so you pay for it”. But if you are part of a union, as we see in the eurozone, although they are approaching it in a very tortuous manner, slowly but surely they are getting to the bailout point.

Lord Lamont of Lerwick: They did have an absolute no-bail out clause and the moment Ireland went under they decided to adopt a reverse position. Is not the logic, as John has said, that Scotland ought to have a fiscal framework for debt and stock of debt, but apart from that it ought to be able to borrow in its own name in the capital markets?

Mr Alistair Darling: Yes, and therefore pay the costs of doing it. I do not have any problem with that. What I thought we were getting at earlier on was the scope or the level at which you allow Scotland to do that. The Scottish Government have never used the power yet so it cannot be perceived at the highest levels in that Government to be a great obstacle.

Lord Kerr of Kinlochard: It is a grievance up here, is it not, that there is talk of a no- bailout rule? That seems to me to be an unnecessary grievance.

Mr Alistair Darling: Again, one of the points that we made on our side of the referendum was that one of the strengths of the UK is the pooling and sharing of resources. I mentioned on many occasions that if you look at what has happened in the last seven or eight years, had Scotland been on its own it would have been in much the same position as Ireland or Iceland. It is unhelpful to have things that are unnecessary and downright provocative and actually sound very patronising.

Lord Kerr of Kinlochard: That is my view, too.

Mr Alistair Darling: I am part of the UK as well; do not tell me I cannot be bailed out by a country that I happen to be a citizen of.

Lord Kerr of Kinlochard: As Lord Lamont says, one would need to have a framework which would implicitly or explicitly include limits on the amount that Scotland could borrow in the markets.

Mr Alistair Darling: Which I agree with.

Lord Turnbull: If it really got to a bailout, Scotland’s whole bargaining position, which is very strong at the moment, would be lost and it would be then in thrall to the UK

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Government which could enforce all sorts of things. That is why I think the Scottish Government will not actually push this to the limit, because they know if they really go bust and the UK Government have to help them out they have lost the argument. I would not go anywhere near a no bailout because (a) it will not happen and (b) we do not need it. What we do want is, below this sub-nuclear level, to get some decent understanding. Their Finance Committee talks about a series of rules not a million miles from what the Labour Government had, balancing the current deficit and a debt rule, a debt-servicing maximum. They put some constraints on themselves.

Mr Alistair Darling: You can design a framework and you can have whatever parameters you want—there would have to be something there—but, no matter what the Finance Committee may say, do not rely on them not denouncing the same thing 24 hours after it has been agreed. A lot of these issues, which people really ought to know about before we are presented with them, we just do not know about. I am sure these things are being discussed, but in private not in public.

Q132 Lord Lamont of Lerwick: I am not saying this as a criticism but your answers have been overtly quite political. Can I just ask you a question that is political but relevant to trying to decide where we are going? The puzzle for me is why the Government of Scotland are not held more responsible for the decisions they have made. I understand all the time they are trying to place the blame on the British Government: inadequate funding and so on. Do you think the degree of devolution in fiscal matters now being proposed could alter this climate and create an atmosphere in which the Scottish Government are held and perceived to be more responsible for its own situation?

Mr Alistair Darling: I do not think this settlement will achieve that. It is a huge mistake to think that if only a few more things were devolved that would remove the number of votes for independence. Most people are not entirely clear as to who does what anyway. The Government you remember wrestled with local government and, no matter what their councils are doing, people blame the Government. They are not the same but it is similar to that. What you have to understand is for a lot of people in Scotland what they want, or are voting for, is something better. If you want a political answer, it is a bit like UKIP in England, and you see it across the continent of Europe; people are fed up, they want something better and they blame the current state of affairs on Westminster and they want out of that. You can see that happened in the Scottish elections here in May. Most people do not know what Smith was about in terms of what it actually did.

To take a ludicrous example, I have yet to meet anybody who was that bothered as to whether or not the British Transport Police were devolved. They have been devolved, there was a bit of fuss in the papers mainly from the union representing them for understandable reasons because they have now disappeared, but people do not know that. Former politicians round here, and I suppose others, will know that people do not think politics every day. If your starting point is whether this is going to stop the movement for independence, no it is not, there is a bigger settlement that needs to be

Page 89 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) done as far as that is concerned. My fear is that a lot of what is in here is likely to stoke the fires rather than put them out.

Lord Lamont of Lerwick: Are you saying more fiscal devolution would achieve this?

Mr Alistair Darling: What I think would do it is, if you take the Canadian example, where you are clear you are sitting here in Edinburgh, you are paying your taxes to that body which provides health education or whatever, and you are paying to another body which provides pensions, defence and the rest of it, then you know who is responsible for doing the things you do not like and you can vote them out. This way is so opaque that for a lot of people voting, they are voting on what the Westminster Government are doing rather than what is being done here.

Lord Lamont of Lerwick: If you were redesigning it from the start, forget the Vow and Smith, what would your devolution in fiscal matters be to achieve the right balance?

Mr Alistair Darling: If I was starting again, there is something we should have looked at perhaps; I understand the difficulty with a true federation when you have got 80% living in one country, but you would have to start somewhere like that. Spain, for example, has different levels of devolution in the different regions. I think the Canadians do to some extent. The key thing for me is, it is a matter of principle that if you are paying taxes you need to know where they are going and who is spending them and what they are doing with them. The minute you change that or, as I say, you get to a situation where the income tax rate for the whole of the UK can only be voted on by some MPs and not others, where you have got two classes of MPs, you are well on the way to breaking up the union. I just do not think it will work. It is not sustainable. My starting point—and I know it is difficult because, as Lord Hollick has said, we are not in that position—would be to stand back from this and say, “Okay, the UK as presently constituted isn’t working the way we want it to, let us see if we can do something about it”. It is probably the work of a very full Parliament, if not two, to try and sort that out. Where I am now, given the politics and where we are, is how do we stop this? I do not want history to look back at this and say that having won the referendum the whole thing was compounded by putting in place a system that was going to lead to more and more grievance, and ultimately to what I would regard as a very bad outcome for the whole of the UK, Scotland included.

Q133 The Chairman: The direction of travel that you are advocating is that creating a system where spending and funding are in the same hands, and it is clear where responsibility is, would argue for greater devolution of funding and greater devolution of spending, although it would appear at the moment that spending is quite wide whereas the taxes that have been devolved are much narrower. Is your solution that there should be a much greater devolution of taxes?

Mr Alistair Darling: I do not have any problem with that provided I am clear as to where my taxes are going. Beginning next year and continuing thereafter, when I pay my income tax it is apparently all going to the Scottish Government in Edinburgh, but what about my pension, for example? Is half my VAT paying for it? I do not know.

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Lord Kerr of Kinlochard: It depends whether it is VAT in Glasgow or Birmingham.

Mr Alistair Darling: How do you explain to someone starting out in life, or coming to this country, what it is you are paying for? I think that is inherently unstable because the scope for blaming somebody else—and in Scottish politics you do not have to go too far to find that—is immense.

The Chairman: So however well designed this is, it is unstable?

Mr Alistair Darling: I think it is. It was designed over four or five days.

The Chairman: There is no rescuing it?

Mr Alistair Darling: My view is you are talking about salvaging. As you know, since 1998 the Scottish Government have been able to vary the income tax rate, and it is a moot point whether they would ever have a different rate from the rest of the UK because most politicians are not daft when it comes to putting up taxes. During the referendum campaign I made it clear that I did not have any problem with giving the Scottish Parliament more power in relation to tax but still reserving a lot of the income tax stuff. But we have just got ourselves into a mess here. It is compounded by the fact that when people say, “Well, how is this going to affect the block grant?” I do not know because I just do not know the value of what has now been devolved, or how indeed you fix the value.

Lord Kerr of Kinlochard: It looks as if the taxes that are being devolved are the ones that are easiest to devolve: things like the landfill tax, airports and so on.

Mr Alistair Darling: I do not have any problem with that.

Lord Kerr of Kinlochard: But isn’t it the wrong way round? Surely you should be devolving a sufficient quantum of tax to match the expenditure freedom that you have devolved, to get your point across that people should be able to spot where their taxes were going. If the quantum of devolved fiscality matched the quantum of devolved expenditure, that would be possible; you would be able to see that what was going to London was for defence, security of the realm, all that sort of stuff, and that what was staying in Edinburgh was for education, health, welfare, with the block grant coming in to deal with the problems of peripherality, sparsity of population and so on. That is an ideal system. To get there, would it not be better to get away from this ragbag of particular taxes that are being devolved again and again, and now these curious new moves on income tax, and instead decide how much you want to devolve by how much expenditure you have agreed you are going to devolve? In other words, the thing is being done back to front.

Mr Alistair Darling: If you look at the mechanism for this, Smith was set up to actually reconcile the political differences between the three unionist parties over income tax proposals. That is what the Vow was. What happened was Smith convened his commission, and it was like people reversed up a cart and everybody threw on to it all the things they had ever wanted and then tried to reconcile them. It is not a great way

Page 91 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) of making any policy, never mind stuff that is supposed to last for another 300 years or whatever. The problem we have got, as I understand it, is this Bill is only to complete its Report stage in the Commons before it comes to the House of Lords, and there are constitutional difficulties in the House of Lords radically rewriting something given the provenance of all this. What your Committee can do I think is just point out some of the difficulties we are getting ourselves into. I do not think you can solve this as a Scotland-only problem, I think you have got to look at the knock-on effect on the rest of the UK. Given what is happening in Northern Ireland now with the uncertainties there, we know there are different issues in Wales where the Welsh want more power, and we have yet to see what exactly a northern powerhouse is. Then there are the voting rights of MPs and whether two classes of MPs is sustainable or not; there is an awful lot here. And by the way, we are fighting a European Union referendum and the outcome cannot be taken for granted. There are an awful lot of things going on. I have been in a government where the temptation is, when you look at this, to run a mile and concentrate on something that voters are talking about. In this part of the kingdom there are a lot of people who want something different. It may be what they want is not the same thing, or it may be inchoate in terms of what it is, but do not forget for one minute that the country was split in May.

Lord Kerr of Kinlochard: You encourage us greatly.

Mr Alistair Darling: Being here for six months and spending two years on a referendum campaign concentrates the mind wonderfully.

Q134 The Chairman: One of the arguments behind devolution—certainly the Scottish Government have made this point—is that greater devolution gives them a serious set of powers which they can use to help stimulate the economy. We have heard evidence from people who say there are no examples of that working. Do you have a view?

Mr Alistair Darling: They have lots of powers. In education there is a controversy here at the moment about the qualifications that students from poorer backgrounds are coming to school with. The Scottish Parliament has total control over that. The problems with the centralised police here, with the tragic case of a couple who were left on the side of a motorway for three days—again, it is totally devolved. On industrial development, it is not clear what the Scottish Government have done at all. The only promise they have, which I think is still extant, is whatever the corporation tax set in Westminster is, it is going to be 3p less. As the Chancellor in July announced a further cut, there comes a point where if you come to Scotland and you are in Starbucks you will not be troubled by corporation tax, not through evasion but simply because nobody is charging you. There is not a single policy that you could describe as redistributive that the SNP can point to in Scotland. It is not really about powers, it is about an idea; if you are a nationalist you simply believe that Scotland has no place in the United Kingdom, and frankly the rest of it is neither here nor there.

Lord Turnbull: They have a kind of each-way bet. If they make a success of this then they will take the credit and if it fails—

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Mr Alistair Darling: You see that in the monthly unemployment figures. When they go down here it is because of the Scottish Government and when they go up it is because of the UK Government’s austerity.

Lord Turnbull: It is very difficult to shift. You are almost recommending a kind of “do no harm”: in other words, try to make something pragmatic and sensible out of this Scotland Bill but do not kid yourself that it is going to change the landscape.

Mr Alistair Darling: As a former politician I am practical about this. I think for the House of Lords, or one of its Committees, to say, basically, up-end everything that has been done so far, is not going to work. If I were writing your report I would do it almost in two parts. I would say, “This is the problem that has now been created, the opacity of the process, you have not looked at the rest of the UK, these are things that are just storing up trouble for the future. However, the UK Government are going to have to form a view on that because they are the Government of this country, but in the mean time here are things you certainly ought to be doing in terms of the process and proper discussion about what all this means in terms of the grant and fiscal frameworks and the rest of it”. When I received the invitation to come here, it would have been tempting to come here and say, “Actually, if I was starting from here I would start 10 steps back”—but we are where we are. I would be very wary about suggesting something that is simply going to provide yet another grievance; there are plenty around and I do not think you should be the authors of yet another one.

Q135 Lord Kerr of Kinlochard: In the Scottish Parliament this morning, I was struck by the stress on the need for transparency in the way the system works. They are obviously frightened that the Treasury, massively competent, secret, judge and jury, will be laying down what the upratings are in the various taxes and what changes are required under the Barnett formula. I think there is a role for the House of Lords in thinking about institutional proposals. It seems to me that the Scottish National Party Members liked the idea of taking the uprating of taxes partly out of the political process. In their report they talk about the Scottish Fiscal Commission and they also mentioned the OBR and they seemed to like the idea of a body drawn from both subsuming their purposes while maintaining independence. It seems to me there might be something in that. Going back to your first point, nobody knows what is going on. We probably cannot cure that for the present negotiations but for future negotiations, perhaps you could cure that.

Mr Alistair Darling: I do not know. I was struck by the fact that if you take the Institute for Fiscal Studies, which is by and large accepted as a very reputable and thorough body, when it pointed out that under fiscal autonomy the gap between what Scotland spends and what it gets in is about £10 billion, it did not take long for nationalist politicians to start rubbishing the IFS. Yet by and large all political parties, mainly because we all rely on it at various times to back up what we are claiming, will say that it is pretty good. As I said earlier, I do not think you can depoliticise this. What I do think is absolutely essential is there has to be some open process where you can actually see how these calculations are being made, so the Treasury or the Scottish Government can say, “These are the rules, these are what we think the figures are and

Page 93 of 420 The Rt. Hon. Alistair Darling – Oral evidence (QQ 28-37) (DPFOE0003) that leads you to the answer”. At the moment it is not there. I was wondering if you were leading to, “Could you have an OBR?”, although it has to be said that the OBR’s record on forecasting was about as good as mine. In turbulent times it is rather difficult to forecast these things. On welfare spending people would argue, “Why has it not changed? Is it because the Scottish Government did not do anything about it and why should the rest of the UK pay for that or was it simply because the population was getting older, sicker or whatever?” My answer is, I do not know if you can depoliticise it.

Lord Lamont of Lerwick: I do not think you could transfer the decision to some OBR- type body. In public expenditure, when there is an overwhelming case for an increase in X, often you have to have a corresponding decrease or a partial decrease in Y, Z and W. These decisions are forced by the envelope. I do not think just the shedding of light and having a certain amount of glasnost is going to make it acceptable by itself. The logic of what John is saying is really to give an independent body the power to make the decision on public spending when that body does not have to live with the consequences.

Lord Turnbull: I am not sure that was what Lord Kerr was saying. The OBR does not decide anything. What it has stopped is—

Lord Lamont of Lerwick: I was clarifying what he wants the OBR to do.

Lord Turnbull: There is something useful that an OBR-type body can do, which is maintain the dataset and display it and update it regularly in a consistent way and reduce the extent to which either side in the debate can choose different ways of assembling the figures, different time periods or whatever, and then make it clear what is going on and why. That makes it more difficult to—

Mr Alistair Darling: You can do both. Both you and Lord Kerr are right in terms of more openness. The more clear where the sums are derived from the better, even though there is always going to be argument, but the actual decision as to how much is spent is going to be political. I am afraid I come back to the point that, if your starting point is that we are in the wrong kingdom and we want to be separate, frankly the provenance of the stuff that you are debating matters not a jot.

The Chairman: I am very conscious of the fact that we undertook to finish by half past two.

Mr Alistair Darling: Those powers are devolved!

The Chairman: Thank you very much indeed for this helpful discussion and we look forward to seeing you in the House of Lords in due course.

Mr Alistair Darling: I shall look forward to reading your report.

Page 94 of 420 Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001) Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001)

House of Lords Select Committee on Economic Affairs The devolution of public finances in the United Kingdom

Note by Prof. JD Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow

I am grateful for the opportunity to give oral evidence to the Committee. This note is not comprehensive written evidence, but suggests points the committee may explore.

Moving towards “fiscal federalism”

The UK has always been highly fiscally centralised, and got more so in the last quarter of the 20th century, as local government’s spending and tax powers were curtailed. Fiscal centralisation has advantages, like keeping down the cost of public borrowing. But it is not consistent with political decentralisation. It was inevitable the devolved administrations could not keep being funded just like departments of central government. So we are all learning about “fiscal federalism”, how tax and spending powers allocated across different levels of government.

The broad principles are quite simple. Sub-state governments should be funded by a mixture of resources they raise themselves and shared national resources. It cannot be all “own resources”, nor should it simply be an allocation national resources shared out by central government. Funding solely through “own resources” creates two problems, of principle and of economic management, discussed below under “full fiscal autonomy”. Conversely, funding only through national allocations removes from sub-state governments both accountability and the fiscal incentives to promote economic growth.

There's no hard and fast rule about where the balance should be set. It depends how much difference in living conditions is regarded as tolerable across the state. The USA is willing to tolerate a lot. Australia much less. Canada is in the middle. The UK is edging towards Canada, at least so far as Scotland is concerned.

Tax devolution, grant distribution and borrowing powers

It's much easier to devolve spending than tax. Tax bases move round, if they can, to get the lowest rate. Property taxes devolve best; income taxes adequately, corporation tax less so, taxes on online transactions (say insurance premium or betting) not at all. So broadly speaking, the proposals in the Scotland Act 2012, the comparable Welsh legislation, and in the Scotland Bill before Parliament at present are in the right areas. The problem with corporation tax is “tax stealing”, one country levying low rates of tax on revenue which results from economic activity elsewhere. It's easy for companies to

Page 95 of 420 Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001) recognise profits in different jurisdictions. The government’s proposals for Northern Ireland are said to reduce this risk; if they succeed, then I see no objection to devolving it in Wales, and even Scotland. It then becomes a tool of regional economic development.

Starting from scratch, we probably would not share out UK resources using the Barnett formula. But there is no clean slate here, and in my view it is better to proceed by adjusting Barnett than by trying to replace it. Those calling for a radically different system see the shortcomings of Barnett, but are blind to its strengths. UK public spending has long been an incremental system, of “baselines” and reviews. That has big advantages of stability, and will remain. Devolution finance has to fit in with it, and Barnett does.

Barnett has to be adjusted to take account of the new revenue streams available. The principles here are also straightforward. The devolved administrations should carry the risk from the new tax bases as well as their own tax decisions. Indexation to the comparable English revenue streams may achieve this. This has been successfully negotiated for the Scotland Act 2012. Many, notably from Wales, argue Barnett should also be adjusted to reflect relative need better. I certainly agree with the idea that there should be a “floor” in the formula so that Welsh spending does not converge to English per capita levels. Nor is it possible to justify on need that Scottish devolved spending should be so much higher than in the rest of the UK at the same tax rates. This is more difficult to deal with. The main cause has been the relative decline of Scotland's population–by 10% or so–over the decades of the formula. This can only be corrected at a time when public expenditure is once again growing.

In general, I favour giving the devolved administrations more borrowing powers. They need them for cash flow reasons when they rely on tax income. But it would be better if they also borrowed for all of their capital expenditure (not just spending additional to that funded by the UK government) so they would feel its full economic cost, and get signals from the markets about the riskiness of their fiscal policies.

Living with asymmetry

Fiscal federalism is (arguably) quite straightforward in wholly federal countries. But the UK is not one, and is not going to be one. Loose talk about UK federalism following the Scottish referendum is just that. Westminster will remain England's Parliament, and the UK government will remain England's government. [If not, the UK will not remain.] So neither grant distribution nor tax devolution can be the same as if there was an English Parliament and government. In setting its spending priorities, the UK government has to make a choice between “federal” spending, such as defense or social security, and spending like health which is devolved outside of England. Because it is responsible for both, it has no incentive to prioritise one over the other, or export unpopular spending decisions to the level of government below. This is an unsung advantage of the Barnett system.

Page 96 of 420 Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001) Asymmetry is also a challenge for tax devolution. If a tax is completely devolved, then there will be pressure for MPs from the devolved nations not to be allowed to vote on it in Parliament. We have seen this with income tax in the government's recent “English votes” proposals. But there is no matching English spending budget. This problem does not arise when income tax is shared, under the Scotland Act 2012. This is a problem which will need to be resolved before the current Scotland Bill completes its processes. [For more detail see http://bit.ly/1I1Hi3N ]

“Full fiscal autonomy”

The committee has expressed an interest in full fiscal autonomy. I understand it to mean the idea that Scotland should be responsible for raising all of its own taxes, and should make a fiscal transfer to the UK government to cover common services such as defence. This is wrong in principle for any part of the country, and would be catastrophic for Scotland in practice. The first problem of principle is it would mean that the public services available at a particular part of the country depended solely on the taxable resources available there. So a rich area could have generous public services, and a poor area poor ones. But their needs might well be exactly the opposite. The second is a problem of economic management. An area with economic problems would find its revenues dropping swiftly, and the resultant reductions in public spending would further depress demand and exacerbate the downturn. Greece and the eurozone stand as examples here.

The practical effect in Scotland, now oil revenues have collapsed, would be very large reductions in public spending. The table below estimates Scotland's fiscal position over 6 years3. The data was drawn from Scottish government publications and the OBR forecasts, by the IFS and updated by Fiscal Affairs Scotland4.

Table: Scotland's structural deficit compared to the UK

2014-5 2015-6 2016-7 2017-8 2018-9 2019-20 Scotland Spending 68.4 68.9 68.7 69.0 70.4 74.0 £bn Onshore 52.3 54.1 56.8 59.3 62.0 65.2 income £bn Offshore 2.3 0.6 0.5 0.6 0.7 0.6 income £bn Deficit -13.8 -14.1 -11.3 -9.1 -7.8 -8.1 £bn

3 Since then the oil forecasts have fallen further. 4 Fiscal Affairs Scotland 2015

Page 97 of 420 Professor Jim Gallagher CB FRSE, Nuffield College, Oxford, University of Glasgow – Written evidence (DPF0001) Deficit per -2583 -2643 -2103 -1687 -1429 -1599 head £ UK UK deficit -1398 -1158 -603 -193 +80 +105 per head £ Difference Difference -1186 - 1485 -1501 -1494 -1509 -1599 per head Difference -6.3 -8.0 -8.1 -8.1 -8.2 -8.7 £bn

20 July 2015

Page 98 of 420 Professor Jim Gallagher, University of Glasgow; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Jim Gallagher, University of Glasgow; Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001)

Page 99 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001)

Evidence Session No. 1 Heard in Public Questions 1 - 13

TUESDAY 21 JULY 2015

Members present

Lord Hollick (Chairman) Baroness Blackstone Lord Forsyth of Drumlean Lord Lamont of Lerwick Lord Layard Lord Sharkey Lord Teverson Lord Turnbull ______

Examination of Witnesses

Professor David Heald, Professor of Accountancy, University of Aberdeen Business School, Professor Alan Trench, Professor of Politics, University of Ulster, Professor Jim Gallagher, Visiting Professor of Government, University of Glasgow, and Dr Angus Armstrong, Director of Macroeconomics, National Institute of Economic and Social Research (NIESR)

Q136 The Chairman: Professor Heald, Professor Trench, Professor Gallagher and Doctor Armstrong, I welcome you to the Economic Affairs Committee. I fear that our afternoon may be a little interrupted, because a Motion before the House from Lord Butler is currently being debated. It has some bearing on our inquiry. There is likely to be a Division at around 4 pm, so we will disappear and return as fast as possible.

Page 100 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Thank you very much for coming, and thank you to those of you who have already submitted some helpful written evidence. Perhaps I might start by asking about the Barnett formula to get your views. To help this session along, ideally if you agree with what the previous speaker has said you do not need to repeat it. The Barnett formula is proposed to remain at the centre of the funding formula for Scotland in the new devolved settlement. Do you think that that is a robust, workable and sensible approach?

Professor Jim Gallagher: I will start by saying that the joke I make on these occasions is that there is a small society, of which I am the president, called the Friends of the Barnett Formula. It has one other member, who is the Chancellor of the Exchequer of the day, because the Barnett formula works. It has been remarkably robust. It obviously has a political dimension in the Scottish debate, in that during the referendum campaign all the three main UK political parties undertook that Barnett would remain. Therefore, the probability is that it will for a substantial period, at the very least.

It has advantages that people do not recognise; no doubt my colleagues will point to its disadvantages, but it is easy to disregard the advantages. The first is that it fits with the UK system of public expenditure planning, which is based on an increment, so it is driven by increments. The second is that it puts the UK Government in the position of making the decision that only the UK Government could make, which is the division across the UK between expenditure and what you might loosely call federal spending, reserved spending and devolved spending. The UK Government have the right set of incentives in making that choice, because they are responsible for devolved spending for England and federal spending for the whole UK. In that respect, the Barnett formula works. It requires to be adjusted in reasonably complicated ways to take account of tax devolution. I confidently predict that my society will still have a member in 10 years’ time.

The Chairman: So you do not see a case for fundamental reform of the Barnett formula?

Professor Jim Gallagher: I think that is politically not sensible, given the promises that were made. Nor do I see a replacement approach that would have the advantages of Barnett and get rid of all the problems.

Professor Alan Trench: I thoroughly disagree with Jim Gallagher. Notwithstanding the advantages of Barnett that he notes, and there are other advantages that he does not note, it is now fundamentally inappropriate for the situation that we have. It does not work in the constitutional conditions that we have created, because it assumes that devolved Governments will continue to want broadly the same package of public services that the UK Government will deliver for England. I specifically disagree with Professor Gallagher that the UK Government is the Government with the right incentive about the split between devolved and non-devolved spending. It does not

Page 101 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) seem that the UK Government have any meaningful incentives other than political happenstance. That drives a sequence of fairly arbitrary decisions.

Scotland notices these difficulties much less than the other parts of the UK because it is generously treated by the Barnett formula. We have now created two further difficulties, each of which is serious and, which compounded, are fatal. The first is that we have introduced this opaque and rather confusing no-detriment principle into how the block grant will be adjusted for new devolved spending functions and devolved tax functions. We continue to the leave the Treasury in sole control of all decisions relating to these matters. That means in effect that the Treasury will make up some numbers and apply them. The numbers that it makes up might happen to be the right numbers, but no one will believe that. Unless there is a much more robust administrative machinery surrounding the block grant, I do not see how it can work. By the time you have made all those changes, you get to the point where you have to accord the late Lord Barnett his wish and take his name off the formula.

Professor David Heald: I am much closer to Jim Gallagher’s view than to Alan Trench’s, but there are some fundamental questions. I do not understand the vow to keep the Barnett formula. If it remains the Barnett formula in its old form, I do not know whether that means it is a block grant plus adjustment mechanism rather than a needs assessment. I always expected that the Barnett formula would become politically toxic, that the name “Barnett formula” would go but the substance might stay the same. It is equally possible now that the name will stay but the substance will change.

The United Kingdom is in a very difficult situation, which I do not think is fully appreciated. The only way that one can make any kind of system work from where we are politically now is on three things. First, we need to have some high-level principles, not mechanical rules. Secondly, we need a referee. It is intolerable that the Treasury should dominate everything, as it has done in the past. Thirdly, we need data transparency. For example, for the past 20 years the Treasury has pretended not to understand my attempts to get the information for what the relative indexes are for comparable, rather than identifiable, expenditure. It has pretended not to understand both in response to freedom of information requests and to questions from Members of the other House. The situation is critical.

One more point about the Barnett formula that Jim did not emphasise is that it preserves the block grant nature of the funding. Once one goes down the route of a detailed needs assessment, the block discretion, which is one of the significant, positive features of the UK devolution system, will come under much greater challenge.

Dr Angus Armstrong: My position is that rarely has something become so totemic when it is due to become less important with the powers that will be devolved. When a formula gets changed it is usually not the same formula, but this one seems to be. Given what is going to happen in Scotland, the time is right for a much broader discussion about transfers across the whole of the UK, including in England. That would

Page 102 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) open up the whole discussion on Barnett. It does need to be opened up. It is much more a legacy issue to do with the balance of power, rather than asking the economics question of which risks you are trying to share here. That would give very different answers in relation to how it is currently set up, which is comparable services. I do not think that is the economic answer to the question of why you would do transfers across the various devolved Administrations in the UK.

The Chairman: It does not sound as though there are many recruits for your club, Professor Gallagher.

Professor Jim Gallagher: There never have been, Lord Chairman, but it is still going.

The Chairman: I recall that the late Lord Barnett was not a member of your club either. He felt that it was long past its sell-by date. You raised many issues, and perhaps we can now deal with those in the subsequent questions.

Lord Lamont of Lerwick: Before I ask my question about the needs-based assessment, I want to ask Professor Trench a question. Did I understand from what you said that you think that the no-detriment principle should not apply, that there should be no no- detriment principle?

Professor Alan Trench: You could not get away without some form of no-detriment principle, but far too much weight is put on far too nebulous a concept, frankly as an excuse for the Treasury thinking about a problem. Instead of solving a problem, it has used as a convenient phrase that was first dreamt up for these purposes in 2010, at which time too much weight was being put on it for a much more limited form of tax devolution. One needs a much more effective mechanism with much more robust machinery around it. The no-detriment principle has to lurk somewhere in the framework that one would put in place, but as a failsafe to be applied primarily at the political level, not as a concept to be operationalised day to day and to underpin the amount of funding that devolved Governments get.

Lord Lamont of Lerwick: But is not fiscal devolution partly about assuming responsibility? Should that not therefore carry a risk?

Professor Alan Trench: Absolutely. I would say that that is the entire point. The problem with no detriment, in the way that it is being framed and applied, is that it creates scope to wash that out of the system and instead simply to have political recriminations and blame shifting. For example, someone says that because this was to their detriment, they are owed some money and so are going to take some from the block grant, or, if someone makes enough of a row, some money will be added to the block grant. None of that will be in the slightest bit transparent and no one will be able to tell whether or not it is justified.

Q137 Lord Lamont of Lerwick: I go back to the idea of replacing Barnett with a needs- based assessment. Is that so complicated? How should these needs be assessed, and in your opinion what principles underlie a needs adjustment? Have we not been through

Page 103 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) this often enough? I know that it is always argued about with the local authorities, but is this such difficult territory?

Professor Alan Trench: I was adviser to the Select Committee of this House on the Barnett formula about six years ago, along with, among other colleagues of yours, Lord Forsyth. We outlined a relatively simple and straightforward means by which to do this. I noted that Professor Heald said a while ago that a comprehensive needs assessment would be a very complex affair. The Committee did not consider that it would be so. Partly building on the work that that Committee did, the Holtham commission—the Independent Commission on Funding and Finance for Wales, to give it its full title—subsequently came up with a methodology, which has not been meaningfully challenged or questioned, as a straightforward and largely accurate way of accomplishing that aim.

Professor David Heald: It is no coincidence that that formula was rather favourable to Wales. There are several ways in which you can do this: there are the quick and dirty Holtham commission proposals or the more comprehensive Australian grants commission-type proposals. I make two quick points. The first is that the political climate around these matters is toxic and the future of the United Kingdom remains at risk. Therefore, we are not doing it in a low key political context. The second point is that to run a needs assessment you need a degree of agreement across the territories and the political spectrum about what the state actually does. There are significant disagreements. One example that affects the operation of the Barnett numbers is the question of higher-education fees. If there is significant disagreement about what is done, there will be enormous conflict surrounding that. No doubt technically you could do it, but the people who feel that they are not doing as well as they should be from a particular proposal will complain extremely vociferously. Unless it is a reasonably comprehensive assessment, I think that we will end up with a lot of ad hoc adjustments being made to whatever is proposed.

Lord Sharkey: Who would be the arbiter of these different assessments of need?

Professor Jim Gallagher: That is the difficult question in all this. It is very easy for one institution, such as the Holtham commission or indeed the Treasury, to have a view as to what it thinks need is, but need is essentially a contested concept and people disagree about what needs are, how they should be measured and how much they should be paid for. It is easy to do it in the abstract; it is very, very difficult to do it in practice. I do not agree with my colleagues, in this or other contexts, who suggest that there can somehow be a referee between the Governments. In both cases, the Governments have an electoral mandate and the process that should resolve disagreement between them is politics, not the teacher coming along, marking the paper and saying which of them has the right answer. I do not think that the idea of a referee, in a needs context or any other, is a good one.

Professor David Heald: I will just come back on the referee point. The Australian grants commission proposes, then government decides. It is a question of control of the

Page 104 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) apparatus of data collection and where the knowledge in the system lies. The crucial point about the role of the referee is that the biggest immediate role would be on data transparency. The Parliaments would have to decide in the end, but the information would be in the public domain for people within the Parliament with different views to advocate their case based on the evidence as they saw it.

Lord Teverson: I would not necessarily advocate this myself, but could it be argued that under very devolved systems a needs-based formula was a reward for failure? However badly a devolved Government do, they are going to be bailed out by someone else. Is that an issue in any way?

Professor Jim Gallagher: Absolutely not. It is not Governments who would be rewarded but people, who would retain public services that they would not otherwise have. Needs for public expenditure are largely driven by demography. In the UK, needs will be driven by the age structure of the population, and the geographic variation in need is substantially driven by that too. That is not a reward for failure.

Lord Teverson: As I said, I am not necessarily advocating that, but I can see that applying on a static basis in year 1, which a lot of these arguments are based on, but in years 3, 5, 10 or 30, is not that more important?

Professor Alan Trench: If you put any system in place, you have to keep it under review. You cannot simply put a system in place, let it run and then come back in year 30 and say, “Oh dear, this is not working very well”. You have to maintain it and conduct periodic reviews. The Australian system, which Professor Heald mentioned, changes the numbers that are allocated every year and goes through a review of the basic structure of the formula every five years. That is the sort of system that I think you would need if you were going to do that. Secondly, if you do not have some external body to review that, you are going to run into very grave difficulties indeed.

Q138 Lord Lamont of Lerwick: Did you have any criticisms of the way in which this was fed into the rates support grant for local authorities? I know that lots of local authorities felt, inevitably, that X was advantaged and Y was not. Data on this were collected in much smaller, in a sense much more targeted areas. As a student of this, do you feel that that mechanism was defective?

Professor Alan Trench: The problems with standard spending assessment mechanism—the RSG, or whatever the current abbreviation is—were twofold. One was that it was massively politically gamed. Authorities would argue that they were done a disservice in a particular year and would secure attachment to a particular indicator that favoured them. So the formula becomes a Christmas tree, and that is a problem of the political process. The second problem is that you end up with something that in many ways is rather like the Australian mechanism that Professor Heald talked about. While I support the architecture of the Australian system, I do not like what the Commonwealth Grants Commission does. It uses something like 70 different indicators, from memory, and is therefore a very data-intensive process. It is

Page 105 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) equally prone to being gamed by finding bits of data that advantage you and pushing the case for the inclusion of these in the formula. When I went there about 10 years ago, I was amused to discover that in one large state that has done very well out of the formula for quite a long time, the same official was responsible for running the state’s division in the finance department which was responsible for fiscal relations with the federal Government, and the state’s Bureau of Statistics.

Professor Jim Gallagher: I used to run the local government finance system north of the border. You find a great industry that makes very little difference to distribution in the end, because the advantage that one area gains from one measure is offset by the advantage another area gains from another measure, and they all make sure that their measure is in there. The fundamental difference between local government finance and the Australian system, which is virtually indistinguishable conceptually from our rate support grant system, is the asymmetry in this. The Australian Government are not handing out money to themselves but to different sub-national subsidy institutions. The UK Government, in the Department for Communities and Local Government, are handing out money to local authorities and not themselves. The system inside the UK is one in which the UK Government are a recipient of the money as well as the distributor. That asymmetry means that an Australian-type system would not automatically work in our case.

Professor David Heald: Could I come back to Lord Teverson’s question about whether it is a reward for failure? Yes, of course, it could be a reward for failure, but it depends on what you think the dynamics of the United Kingdom are. I will give you two examples. In my view, the United Kingdom is hugely geographically imbalanced, with the effect of what happens in London and the south-east. The rest of the United Kingdom was writing implicit guarantees to the south-east, London and the financial sector during the boom period. For the second example, I will take two local authorities in Scotland. One is Aberdeenshire, which has benefited enormously from the oil development, and the other is Inverclyde, on the west coast, which has suffered from the rundown of heavy industry. You could probably argue that Aberdeenshire is a better-run council than Inverclyde, but clearly there are massive economic dynamics behind that. So yes, you have to be aware of the possibility that you might reward failure, but – unlike in countries such as Canada, the United States and Germany – where one city dominates everything and has an economic area that stretches up the east coast main line, there is a very serious issue with distribution. One of the reasons why Barnett has become politically toxic is because it has been blamed for what is perceived as the bad treatment of the north-east of England. It is absolutely nothing to do with the distribution of money within England, but it is perceived to be. One of the standard arguments against Barnett that one hears is that it treats the north-east of England badly, but that is nothing to do with it; that is an internal English distribution question that is driven by the local authority funding system and by the health funding system.

Lord Turnbull: I start from a fundamentally different position from Professor Gallagher’s. You are saying that the Barnett formula works. I do not think that it does.

Page 106 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) It has failed two very, very important tests. One is equity. I do not think that you can look at how it has worked and say that the outcome now between the different geographies is fair. Secondly, it does not work because it has no correction convergence mechanism. It seems to me to be a bit like a tax coding that is too generous to you. At the end of the period, the taxman says, “I’ll readjust it so that your tax in the next period is correct”, but he does nothing about the fact that you benefited in the past. With a relative population decline in Scotland and a population adjustment but working with a lag, you are then dealing with the increment. As some of our papers show, this whole thing started being very generous to Scotland and has become more and more so. There are more technical things about the way it interacts with the business rate and the way it has acted in the last five years; the pattern of spending of spending has also been very favourable to Scotland. You may say that you want a Barnett formula, but I do not think we should be saying that we want the Barnett formula. What is missing is any idea of the equilibrium level of grant and then finding some way in which the system over time—that could be five or 10 years— gradually converges. But that mechanism does not exist.

I agree with those who commented that the RSG having 70 measures was ridiculous, because five of them explain 90% of the variation and the rest are all part of the argy- bargy: “I am running a fire service, but there is no fire station out on the coast, so I am disadvantaged”. I think you could have something that is simpler, but the fundamental thing is that it is not fair. We have already recognised that by having to do a special deal for Wales, this underpinning, and simply starting a whole new era of constitutional position on something that is so broken is a fundamental mistake.

The Chairman: Can we move on?

Lord Turnbull: We are going to pick up a lot of those points in subsequent questions.

Q139 Lord Sharkey: I will pick up Lord Turnbull’s question. The Smith commission recommended that the future growth in the block grant should, after the first year, be indexed appropriately. It did not say, or even hinted, what “appropriately” might actually mean. How do you think that such an index might operate, and what might it be?

Professor Jim Gallagher: This is the indexation of the reduction from the block grant, however that block grant is calculated, whether it is calculated by Barnett or otherwise, to reflect the fact that the Scottish Administration now has the flow of tax revenues. The principles—going back to David Heald’s suggestion, let us not talk formulae but principles— are which risks should be allocated to which level of government. Let us take income tax as the simple example. The UK Government will continue to control the tax base in the form of the definition of income and the minimum level. Therefore any changes in the revenue stream that result from changes to those should be a risk borne by the UK Government. The Scottish Government should take the risk from their own tax decisions on the bands and on the rates, and they should also take the risk from differential growth in the tax base between

Page 107 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Scotland and the rest of the UK. That way it is taking on some economic risk. That rather encapsulates the no-detriment principle, which should be confined essentially to the first of those points.

The technical way of doing that may be by indexation to the relative growth in English tax revenue, but the important thing is to sort out what the right principle is before we worry about the index.

Professor Alan Trench: I largely agree with that but I will amplify it a little. A very good analysis of this was done by the Holtham commission for Wales, which located precisely these concepts of who bears what risks for what. That remains the lode star. The key point that the Holtham commission made was that these risks are different for different taxes, so it is appropriate to consider different mechanisms for different taxes because the risk profile that goes with a land tax is different from the risk profile that goes with income tax and is different again from the risk profile that goes with corporation tax, for example. So one needs to think about these things quite hard. That is one problem, because I understand that Treasury is looking to use simply one mechanism in this context rather than actually going through the hard process of thinking about this problem and how you match these mechanisms.

The second problem, which I understand is under way in Treasury, is that Treasury is looking at a single fundable pool of reductions from the block grant in relation to all devolved taxation, rather than saying, “This relates to this tax. That relates to another tax”. There may be a sense in which this simplifies the matter and means that you smooth out various problems by letting losses in one area being picked up by gains in another. I suspect that the Scottish government would not let this go forward if they were not fairly sure that this was not going to be a reasonable bet in the longer term, but this is a fraught and distinctly rough and ready way of proceeding, and I strongly urge your Committee to ask some hard questions of Treasury about this when the time comes.

Professor Jim Gallagher: We cannot argue that it is a bit rough and ready in relation to the distribution of grant and very complicated in relation to the reduction of grant.

Professor Alan Trench: Indeed. It is a very peculiar approach.

Dr Angus Armstrong: I do not share the same views as Jim. I think that what the Smith commission has got itself into with its no detriment is in practice almost impossible to put into place. So the idea that you can say that actually the UK controls the tax base but the tax rates are for Scotland and you are going to work out how much the tax revenue is due to one and not to the other—well, good luck. Any sensible economist will tell you how hard that is, let alone when you have people on different political sides with a stake in the game. I think you are putting far too much on the powers of econometrics ever to disentangle these effects.

“No detriment” as a whole is just a legal phrase; it is just dreadful. The idea in the Smith commission is that there is no detriment in the initial devolution of the taxes

Page 108 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) and then going forward. In the initial devolution of the taxes, because more of the revenues will stay in the devolved Assemblies there is going to be less risk-sharing. Risk-sharing is like the gains from trade; it benefits everybody. How are you going to compensate everybody when all sides lose? Somebody has to pay. The benefits of these things seem to be completely devoid of any notion of risk-sharing.

Going forward, what should you be basing any transfers on? Presumably you are interested in risk-sharing things such as pension risk between the devolved Assemblies and not simply deciding whether you can try to work out what are duty or policies or not duty or policies.

You do have to index the Barnett formula so that it moves forward in time. Some people argue that it should be on a GVA basis. Some people argue that it should be on a tax revenue basis. I think you can get into the problem of rewarding failure when you go down that route. My preference would be an aggregate tax revenue basis so that it depends on the UK’s tax base overall, because I happen not to believe that you will ever be able to completely separate what effect one policy and one part of such a porous border has had on the others. So I would just take it on total revenue and make it as simple as possible.

Professor David Heald: I would draw the Committee’s attention to a paper in the Fraser of Allander Institute quarterly review by Jim Cuthbert, who talks about the effect on Holtham indexation of differential population growth and proposes a modification to Holtham indexation. That is just an example of starting with quite a simple idea that becomes much more complicated, and it is why we need data transparency.

Lord Turnbull referred to the treatment of non-domestic rates. The Treasury decided how that was going to work. The enormous reductions in the context of local government in England had a beneficial effect for Scotland and Northern Ireland, but that was not the intention. One needs the data in the public domain so there can be an intelligent debate at the time about how the system works.

Q140 Lord Teverson: I will pursue the no-detriment principle. It seemed to me when I first read about this concept that I would love to enter into agreements that in no circumstances were detrimental to me. I thought, “That’s a really good invention”. I was interested in your views, Dr Armstrong, because it seemed to me that no detriment was a zero-sum game in that if you had no detriment on one side, the other took the risk. But you were saying that by balancing risk you can have gain on both sides. Could you go through that in a little more detail and persuade me that it is not a zero-sum game?

This has already been mentioned, but do the other witnesses think that this is a completely unfulfillable condition, that it is practically impossible, and perhaps whether any other devolved nation state has tried to implement this in any way?

Page 109 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Dr Angus Armstrong: As regards why it is not a zero-sum game, one of the benefits of risk sharing is that it is like an insurance contract. For example, with the collapse in the oil price and the fall of oil revenues, Scotland shared that risk with the rest of the UK, so the impact on Scotland was much less than if it had controlled all the North Sea oil- related revenue. Other shocks affect the rest of the UK that to a much lesser extent get shared throughout the UK, including Scotland. This insurance contract, which works for all the nations of the UK, leads to a higher level of welfare, because you do not have to make the very difficult adjustments at the difficult time. Scotland did not have to cut back its spending in line with declining revenue. Just as with insurance—your home insurance and so on—not everybody’s house burns down at the same time. That is why you can pool it all and it works to insure each other. That leads to an overall net benefit for the whole of the UK. You can all gain and, for once, there is a free lunch. I know that people always think that that sounds a bit odd, but actually there are such things as free lunches—in insurance contracts for example. It benefits people to go into these contracts. The no detriment principle, if you start untying all that, makes everybody at the margins slightly worse off. How will you compensate everybody? Somebody has to pay. So they obviously did not really think about the function of some of the UK tax system, which is about risk sharing across geographical space.

Professor Jim Gallagher: It seems to me that people have got into a terrible state of excitement about a couple of carelessly drafted words in a political agreement. The Smith commission did its work in a great hurry. It sought to set out some principles on which the system should be based. No detriment is, at best, a piece of loose drafting to reflect the point I made earlier about the allocation of risks. It was introduced, as Alan Trench said, in the context of what became the Scotland Act 2012, where the income tax base was shared, and the proposition was that each Government should take responsibility for the effects of their own policy decisions. If, under that system, the United Kingdom Government had substantially increased the threshold for the payment of income tax or substantially decreased the boundary between the higher and other rates, they would take the financial consequences of that decision for good or ill. There would therefore be no detriment from that decision to the devolved Administration. People are carrying that across conceptually into areas where it is not at all suited.

Dr Angus Armstrong: I accept that you can take it too much from a purist’s point of view. It covers so many sins, but it is actually really important. Suppose that Scotland is allowed to issue its own debt. We know from just about every devolved or federal state in the world that sub-central debt can have feedback effects on federal government debt. How will you measure that? Presumably you will have to measure it at some point, and that is an extremely difficult task. I would like to see how people think they can provide a strong evidence base in what is already a very partisan debate and say, “This is how much you should transfer for your change in tax policy that affected the other side of the border”. Bear in mind that Scotland’s trade with the rest of the UK is equivalent to 80% of its GDP, so just about anything that the rest of the UK does will have an impact on Scotland. You will be doing this all the time. It is a great industry for economists.

Page 110 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) The Chairman: Have any Government made the principle of no detriment work?

Professor Alan Trench: Can I just say something comparatively that may answer that question? The answer is no, but I am not aware that anyone has ever tried it either. As a student of these things, I am comparatively completely bemused by the way the UK has both picked up this principle and then elevated it to such remarkable standing. If one looks at significantly fiscally decentalised countries such as Canada, Switzerland or the United States, not only do they not have such a principle but they would positively laugh if anyone were to propose that they should. It is a very peculiar idea that comes out partly from the politics and partly from having a tradition of a relatively centralised Government responsible for resource allocation that is at least notionally meant to relate to need and therefore a desire to see that no one loses out as a result of fiscal devolution. However, we also get ourselves into a further difficulty in that we are trying to decentralise. Very few decentralised systems started by a process of decentralising. The club is a very small and select one: arguably Spain, Belgium, the UK and, if you want to throw it into the mix, Italy. I think Italy is a decentralised state. That is about it. Many of these other systems such as the United States, Canada, Germany, Australia and so on built their fiscal structures around constitutionally federal structures as well. The two grew up alongside each other. We are trying to move things out—to spin them out. I am sorry to say that it looks as if we are making almost as much of a mess of it as Spain has.

Lord Teverson: I just want to clarify something. Is one reason why none of this has been tried elsewhere perhaps because it is not so much of a problem, because Scotland’s economy is so much smaller that there is an imbalance? Anything that goes slightly wrong in England would have a magnified, multiplier effect in Scotland. Does that come into that anywhere, or is it a complete fallacy?

Professor Jim Gallagher: In most cases, a state inside a federal country will be small compared to the rest of the federal country.

Lord Teverson: But in somewhere like Spain there are a number of those places, so I would have thought there was more of a balance that worked. I may have got that completely wrong.

Professor Alan Trench: It is certainly the case that decisions made for England have a profound impact on Scotland in a way that decisions made in Scotland can seldom have a profound impact in England. I remember that problem once described as “being in bed with an elephant”. It is a long-standing problem that Scots are only too familiar with. In a sense, all these debates going back hundreds of years are an attempt to deal with that.

Dr Angus Armstrong: If you look at the big five federal OECD countries, the biggest state relative to GDP of the entire country is about 35%. Now, with the UK you are dealing with 85%. There is a fundamental difference. You are creating what looks to be a federal sub-national Government called Scotland in a completely centralist system.

Page 111 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) The UK cannot become federal until you do something with England. That is why every time England does something it has a multiplier effect: because of the asymmetric size. That asymmetry goes all the way through these problems.

Q141 Lord Turnbull: You described a case where the UK Government reduces basic rate tax or raises the threshold, and that reduces the income tax yield in Scotland, which you describe as a detriment. That is not a detriment at all. It may be a detriment to the Scottish Government but it is not detrimental to Scotland. The citizens of Scotland keep the money. Their personal disposable income is increased.

Professor Alan Trench: There are two potential detriments there. The first is in relation to the decision about how the UK Government deliver their reduction in income tax for taxpayers. Under the Smith proposals, the impact of an increase in personal allowance is different from a reduction in the standard of tax rate. If you increase the personal allowance, that will take money out of Scottish tax receipts, because Scotland gets all the tax receipts from personal income.

Lord Turnbull: The money is still in Scotland. It is available to the Scottish Government to recover it.

Professor Alan Trench: The solution to accomplish that would have to be that they reduce the rate of income tax for Scottish taxpayers. The problem is that there is an asymmetry between those two decisions. I do not think it necessarily a huge asymmetry, but there is one. There is a second aspect to no detriment where the An Enduring Settlement White Paper gets into a very great tangle to my mind. It says, “Let’s assume that the UK Government have not reduced their tax receipts but increased them”. It then applies those tax receipts to pay for services that trigger further Barnett consequentials as well. It says that Scotland, on that rationale, wins twice. No detriment is meant to come into effect to stop Scotland winning twice, once by way of extra tax receipts, then by increased block grant. I am not sure that that is so—I think they have over-read the problem and overanalysed what in reality would be quite a small amount of money. Even if that is so, there have to be better ways of solving that problem. Those involve making other, quite significant consequential changes to the machinery and structure of the block grant, both in terms of the laws that support it and the way it is applied.

Lord Turnbull: But is the way in which no detriment is being interpreted in Scotland that a cut in the basic rate of income tax—

Professor Jim Gallagher: A cut in the basic rate of income tax is irrelevant to this question. The only thing that would be relevant would be a change in the threshold at which income tax is paid.

Lord Turnbull: Okay. Well, that is probably the way in which it would happen. So let us assume that that takes place, the threshold is pushed up quite a lot and a lot of people advocate that. I cannot see why that creates detriment.

Page 112 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Jim Gallagher: You have to look at the expenditure as well as the revenue side. Let us imagine that the Government decided to increase the basic rate threshold and take the money, for the sake of argument, out of the welfare budget. That would be a proportionate reduction in welfare expenditure in Scotland at the same time. That is what has happened over the last little while. So in answer to the question, “Is the welfare money still in Scotland?” the answer is that the loss to the welfare budget is equal to the gain from the tax budget, but the effect would be to cut the revenue of the devolved system as well. You have to look at the spend aspect.

Lord Turnbull: But the detriment is coming about not through the raising of the threshold but through the change in the proportion of devolved and non-devolved expenditure.

Lord Layard: Would there not be a case for making these calculations in relation to the previous year—the base year—rather than the one where the collected taxes have been affected by changes in the rates made after devolution?

Professor Jim Gallagher: I think not, because you would then be importing differential economic growth into that calculation, and that is a risk that needs to be borne by the Scottish Government.

Lord Layard: But in terms of this problem?

Professor Jim Gallagher: You might create a worse one. I will have to think about that.

Professor David Heald: There are two points that I would like to make. First, the distribution of income is different between England in aggregate and Scotland in aggregate. Scotland, Wales and Northern Ireland—if Wales and Northern Ireland had income tax powers as well—will be differentially affected by an increase in the threshold. Secondly, we are talking about a devolved Administration with significant expenditure powers but very limited tax powers. What happened with the abolition in Scotland of stamp duty land tax was that, quite remarkably, the Cabinet Secretary for Finance got 129 MSPs to vote for a change in the Scottish law—to the land and buildings transaction tax—on a revenue-neutral basis. The United Kingdom Government, having shown very little interest in changing the “slab” nature of stamp duty land tax, just happened to do it on a non-revenue neutral basis. Given that the UK Government have lots of other taxes that they could use to compensate for the loss of revenue, basically, in my view, that was actually targeting the tax base of the devolved Administrations. Equally, the UK Government could target the tax bases of the devolved Administrations by putting the threshold up.

Another issue that I am very concerned about is that the Scottish Government have to tell HMRC by 30 November what the Scottish income tax will be, but the UK Chancellor could change the tax in the March Budget. You can think of the political games that might be played. Let us say that in November 2015 the Cabinet Secretary for Finance tells HMRC—it does not have to be public, but it would obviously leak if he did so— that Scotland will keep the same rate structure in the first year of implementation of

Page 113 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) the Smith commission proposals. Then along comes the Chancellor in March, who gets rid of the additional rate, which puts huge pressure on the Scottish Government to do the same. You will have a very significant political problem, given the asymmetry in population size and a lack of respect within the United Kingdom between Governments regarding making the system work.

As I said at the beginning of my evidence session, it is not fully appreciated how much the union still remains at risk. The chances of seeing opportunistic behaviour will put the union at even bigger risk.

Q142 Lord Layard: What is the rationale for the choice of taxes to be devolved?

Dr Angus Armstrong: As you know, there is a whole literature on which taxes you should be devolving, and the usual place to start is with the ones with the less mobile factors of production. The example of the SDLT—the property tax—is quite a good one, because you cannot attract resources because they are stuck on the ground: they are properties. That was one that I thought involved healthy competition in the sense that it did not attract resources on the basis of the tax change. In my view, there was a political need to raise a certain amount of money in tax revenue to reduce the so- called fiscal imbalance: the difference between the amount of spending that is devolved and the amount of tax power that is devolved. Income tax, being the most buoyant and the largest-yielding tax that we have, became the easiest way to do it without changing corporation tax, which is really problematic. I do not think there was any rationale. In fact, it is quite bizarre that you devolve this tax, which is highly visible and really important to people—everybody pays income tax and is closely aware of it. It was bound to trigger a reaction in the rest of the UK, but Scotland probably cannot even use it. This is the irony of the whole thing. You have devolved basically all income tax—you can put the threshold at zero, and the definition is still UK-wide—and yet Scotland cannot go two or three percentage points away from the rest of the UK but you have given them the whole powers. I do not know whether it is good or bad. Part of me thinks that it is quite clever that, given this high-level, huge amount of tax, because you cannot use it—

Professor Jim Gallagher: I am not sure that I wholly agree with that. Income tax is the obvious tax to devolve. If you look worldwide, sub-national or sub-state entities have control over income tax in some places—even local governments have control over income tax—and they find over time that they do manage to have different rates. Switzerland has widely different rates of income tax, even in neighbouring cantons, and the market equalises to deal with that. Income tax produces a lot of revenue. It is highly visible and certainly makes the Government highly accountable, and it ties the fortunes of the Scottish economy and the budget of the Scottish Parliament more closely together than they have been in the past, so it is an obvious one to do.

Professor Alan Trench: I am responsible for designing this tax model, which we set out in a paper called Funding Devo More, published by the Institute for Public Policy Research in January 2013. It was based on a number of considerations, including best

Page 114 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) practice, as far as one could divine it, from federal and centralised systems around the world, and the practicalities of how the UK tax system work and the various constraints on it. That is why, for example, we proposed the idea, which Smith adopted, of assigning half of VAT receipts—10 points of VAT receipts—because under EU rules that cannot be devolved fully. There would be some very strong arguments for devolving sales taxes if one could do so, but it is not possible, so we used the closest equivalent we could find.

One of the problems that we have is that we are going down this path of trying to decentralise. This is not a good place to start from if you are trying to devise an effectively working, decentralised tax system. However, that is where we are, so we have tried to make the best of it. In that paper, we have set out the way you might do it and the arguments for doing so.

Dr Angus Armstrong: To clarify, I do not think there is any federal state that pays all its income tax to a sub-central state. They all pay some federal income tax.

Professor Alan Trench: But the UK has not done that either. The UK still has two income taxes. One we call income tax, and it is a properly designed income tax; the other is a not very well-designed income tax, and we call it employees’ national insurance contributions. Those, by the same argument, expressly remain, under this model, in UK government hands.

Lord Lamont of Lerwick: Do you think it was sensible to separate taxation and savings? Was that done purely for the sort of industrial strategy reason of financial services?

Professor Alan Trench: No, it was done for practical reasons.

Professor Jim Gallagher: It was done for practical reasons, essentially because the biggest number of taxpayers involved here are bank customers. It would require the banks to identify the tax that was held for all those customers, which would just be practicably impossible. This is a recommendation of the Calman commission going back the best part of seven years now.

Professor Alan Trench: That said, it has a significant disadvantage, because as far as one can tell about half the money paid out through savings and dividends income relates to small business. It therefore invites people who are owner-managers of small businesses to wash out their money, to take their money through dividends and be subject to UK tax rather than through income and be subject to Scottish tax, on the assumption that Scottish tax might be higher. They would equally be able to make the converse choice if the UK rate were higher. That is a design problem that one would want in the medium term to get around.

Q143 Baroness Blackstone: What do you expect the arguments would be if there were differential rates of tax between England and Scotland, or England and Wales? How will people react to that? What will they do and how will they behave?

Page 115 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Jim Gallagher: It depends how big the gap is, does it not? They will grumble furiously where they are on the wrong side of whatever border it is. Some of them might move. The fear has always been that they would move in Wales because it is a much more porous border. The fear is that people who commute from London to Edinburgh, particularly those with large incomes, might relocate to the most favourable domicile. The evidence elsewhere is that you can sustain different tax rates—Switzerland is a good example of that—essentially because the market compensates. Income tax rates in Zug are very low and house prices in Zug are very high. People learn to live with this.

Professor Alan Trench: You might think of it as part of the Zurich commuter belt.

Baroness Blackstone: Is it not going to encourage tax avoidance?

Dr Angus Armstrong: Yes. That is the usual thing whenever you get differentials in two taxes with a mobile factor: you get tax avoidance. Your question alludes to how much that is. My concern would be with the higher rate taxpayers who are probably the most mobile and many of whom work on both sides of the border already. I imagine that it would be quite straightforward to arrange their affairs so that they can avoid taxes. Then we have changes in how your income is counted: whether it is between dividends and company earnings or in fact in some of your pension payments, and whether you can start taking those as income. I am quite sure it is very porous, particularly for the high earners who, of course, tend to be disproportionate payers of income tax.

Baroness Blackstone: Does this not damage the political system in that those who are not able to avoid tax will feel pretty fed up that there are others with more resources of one kind or another who are able to? Does that not destabilise the tax system?

Professor Jim Gallagher: Do you not think they feel that today?

Baroness Blackstone: This will just enhance that, will it not?

The Chairman: I am afraid we have a Division. You can give us some tax planning answers when we get back. The meeting is suspended and we will be back within 10 minutes, I think.

The Committee suspended for a Division in the House.

Q144 The Chairman: Are we quorate? I exercise the Chairman’s prerogative. We are quorate but we are running out of time so I will resume, notwithstanding the fact that not everybody is here. I think I was going to take a question and then pass it on.

Page 116 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) We come to the institutional arrangements. A number of you have made comments about the fragility of the current or proposed arrangements. As far as I can see, that leaves the power entirely with the Treasury in London. What institutional arrangements do you think are required that could make this funding arrangement robust and fair?

Professor Alan Trench: Institutional arrangements will not in themselves make funding arrangements robust and fair. Institutional arrangements will make a system more workable and may help it to be seen as fair. I think it is in that spirit that one has to approach them. We have done quite a lot of work, particularly in the Bingham Centre’s recent report, A Constitutional Crossroads, on institutional design. I draw the Committee’s attention to that. Specifically, you need to do three things. First is the point that Professor Heald already made about data availability and transparency. We need much better information than we have about what tax revenue is raised by what sources across the UK, what is spent across the UK and how the block grant system works to change the amounts allocated through that. Secondly, we need an independent expert body to take on a variety of roles but in particular the calculation of the amount of block grant. That might well also be the appropriate body to be responsible for collating and publishing the data that must be disclosed, for example. Thirdly, we need an independent mechanism to deal with disagreements and disputes. At the moment under the memorandum of understanding we have a dispute resolution format of the Joint Ministerial Committee, which is chaired by a UK government Minister—just one who was not involved in the original decision being disagreed with. This means that not only is the adjudicator in any dispute part of one of the Governments involved but that the default option in the event that that adjudicator is not able to reach some sort of settlement will be one that favours the UK Government as well. This system is so structurally skewed that it is very hard to have much confidence in it. It is notable that after one trial ran out of the consequentials for the 2012 London Olympics it has not been invoked by any devolved Government. There is simply no point in a devolved Government using it, because they know it will not do them any good.

Professor Jim Gallagher: I do not wholly agree with that because it neglects the reality of the asymmetry between the UK Government and the devolved Administrations. It is not plausible to have a referee, teacher or important person over the top who can tell a Government what to do, because that person would have no democratic mandate. In the end, Governments have mandates. Most of the decisions are made by the Treasury, which people grumble about. The devolved Administrations—I speak as someone who worked for them—sometimes have a bit of a victim or grievance mentality. Sometimes I think they just need to grow up a bit and get on with it. In fact, by and large the Treasury has made decisions that seem entirely defensible. The place that they can defend them is in public and in politics. The way to make that effective— this is where I agree with Alan and David—is to publish more of the underlying data.

The Chairman: So you do not feel that there is need for another body to, as it were, act as referee?

Page 117 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Jim Gallagher: I do not mind another body producing the information. Data collection and publication would be a good thing. It may that the OBR rather than a fresh body could do it. I do not see why, for example, all the details of the Barnett calculation could not be published immediately or why the relative levels of expenditure across the devolved and non-devolved services in England and the UK could not be published. Transparency would be the best medicine, not the creation of a new adjudicator.

Dr Angus Armstrong: The only thing that is missing here is this no detriment principle. So far, I agree that it could be reasonably formulaic if people published the data and you had a reasonably clear and formulaic way of approaching this. However, the no- detriment bit will be art not science.

Lord Lamont of Lerwick: On the link between devolution of tax powers and economic growth, I cannot believe that anyone believes per se that it stimulates growth. Specific changes that somebody might favour might stimulate growth, but devolution per se surely has no connection with growth.

Professor Jim Gallagher: Agreed.

Professor Alan Trench: Agreed. There is comprehensive evidence to this effect internationally.

Professor David Heald: There is some literature about corporation tax. Ronald MacDonald at Glasgow gave evidence to committees on the basis of the use of corporation tax for stimulating growth, but on that point one thing that has not been mentioned this afternoon is the devolution of corporation tax in Northern Ireland. Leaving aside future changes to UK corporation tax, Northern Ireland is talking about having a devolved corporation tax of 12.5%. The Act enables it to have a zero rate of corporation tax. I am waiting for somebody to explain to me why that would not be counted as state aid. The other point is that if and when that is implemented, that will create political problems between the United Kingdom and Scotland.

Dr Angus Armstrong: On tax and growth, you can get an indirect effect. Let us suppose you had tax competition where the factories could not move so that it did not lead to inefficiencies. That sort of competition can lead to better tax policy. We are a long way from an optimal tax policy, certainly in this country. With the example earlier of the stamp duty changes, I think the Treasury was trying to go to a smooth system rather than a slab system for all the time I was there. Only after Scotland did it, and you got a bit of competition, did the rest of the UK do it. If that leads to a margin of improvement in mobility of labour because it makes it a little more sensible, you could just about eke out some sort of notion that it might lead to higher output. Strictly speaking, it is not quite productivity. The growth effect is a level effect. I think you could argue that there are some slight indirect effects, but this is scraping a bit.

Lord Lamont of Lerwick: Yes, and competition gets other people to change their behaviour in turn, as well.

Page 118 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Jim Gallagher: The point is not who makes the tax decision but what tax decision is made.

Lord Lamont of Lerwick: Yes, exactly.

Q145 Lord Sharkey: If the proposals in the Scotland Bill go ahead, how will the Scottish Government compare in terms of fiscal autonomy to devolved sub-central Governments in other countries? Does that matter?

Professor David Heald: There is a very important point here. I gave evidence at the end of last year with Professor John Kay to the Scottish Parliament Finance Committee. One of the points he made was that when you want more powers, you should decide what you will use them for. I think we have got into an environment where people are asking for more powers without any idea of what they will use them for. That is a fundamental difficulty. What worries me is that people are talking about Scotland having more control of taxes than other devolved Administrations, but it depends on whether you have policy discretion. If you are in a situation where technically or politically you cannot actually use that tax discretion, you will find that we get the same outcomes as we did with the tartan tax. It will then turn out that HMRC does not have the machinery to operate it. Baroness Blackstone raised the question of the avoidance industry just before the break. There is a real responsibility on HMRC to make the system work. If the system does not successfully identify Scottish taxpayers, and if obvious arbitrage between corporation tax and capital gains tax is allowed, that will discredit the system. So the first few years will be fundamentally important. The UK has such a centralist mentality that any discussion about taxes being different produces complete horror. Yet other countries have differential tax and the United Kingdom used to have differential domestic rates between areas. That is a whole different argument: one of the other things that has happened in the UK has been the loss of local accountability because of the loss of local discretion about property tax. Property taxes are ideal for holding local authorities accountable but the accountability mechanism has been destroyed by central control. Clearly, the way back will be very difficult.

Professor Jim Gallagher: There is a political point here. Arithmetically, we will see that the Scottish Parliament has very wide spending discretion already and will now have a very wide taxing discretion by international standards. What people often fail to understand is that the spending discretion has been around since 1999 and people in Scotland did not realise the enormity of the devolution that happened. Now it is a political story to explain to people in Scotland that they have an unusually decentralised system by international standards.

Dr Angus Armstrong: It is not particularly constructive to compare other countries. People often point to one or two small places, saying that they have an even greater degree of autonomy. That is true. You could argue that with the Basque Country, for example. However, most of these places are net contributors to central government finances. They are in a wholly different place. If you were to ask, “How will you divide

Page 119 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) up this existing debt?”, bear in mind that these places—whether it is in Spain with Catalonia and the Basque Country, or parts of Italy or Flanders—on the whole have been net contributors over the past 20 or 30 years. They would not have to take part of the debt, but Scotland would be in a very different position. That is the first point.

The second point is that in many of these countries, where you look at one state, it will be one of many states there. This is where the asymmetry comes back in again. When you are one of many, it is very hard for the others to agree to bail you out. When you are 85%, you can always bail out the smaller country, and that will always invite moral hazard. The structure of the UK matters very much to these discussions.

Q146 Lord Teverson: Perhaps one of the phrases used about Scotland is “full fiscal autonomy”, although it seemed to go in and rapidly out of fashion on occasions. I wonder, first, how practical that is within a unitary nation state. Secondly, is that feasible for Scotland in terms of running a budget and being able to have a sustainable fiscal situation within the country? Can that ever be achieved?

Professor David Heald: I have never understood the supposed attractions of full fiscal autonomy. I understand the intellectual argument for Scottish independence, although I disagree with it. I cannot think of any reason why you should assume that one part of a state will be fiscally balanced. That certainly does not happen in federal countries. The United States has very little intergovernmental grant but an enormous dependence on social security, Medicare and the defence budget. By definition, because of the way the pattern of economic activity and demography works across the territory, there will be implicit or explicit fiscal transfers. On the idea that one bit should balance and that that should hold, if you do that you take on enormous fiscal risks: upward risks if oil prices go up and negative risks if they go down. Scotland is obviously vulnerable in having a big financial sector and very significant dependency upon oil. So I have never understood the argument. There is a possible reason why this argument appeals: because people see it as a way to independence. I can understand the argument; I can see that if I was a Scottish National Member of the other House or of the Scottish Parliament, getting to full fiscal autonomy and showing that it does not work might be a good way to break up the union. Otherwise, I have never understood this position. To give a slightly trivial example, my own parliamentary constituency of Aberdeen South is one of the richest constituencies in the United Kingdom, let alone Scotland. Nobody argues that Aberdeen South or, even more so, AB15, where I live, should balance its budget. The fact is that there are enormous fiscal transfers between different geographical locations. I have never understood the argument that, except as a staging post, we want the powers because we want the powers or because we see that leading to a totally different constitutional settlement.

Lord Teverson: So it is totally a political milestone, in your view.

Professor Jim Gallagher: Yes, absolutely. It is like independence, only worse. The arithmetic in the short run, by which one means the next five or 10 years, would be fiscally catastrophic for Scotland. Its deficit would be structurally somewhere between

Page 120 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) £7 billion and £9 billion a year larger than the UK’s deficit. It is on all measures a completely crazy idea.

Professor Alan Trench: I think this is always the wrong question to talk about for fiscal autonomy, on the basis that it is a meaningful option that is compatible with the union. I find it very hard to understand how one can call for full fiscal autonomy, which is effectively a Scottish withdrawal from all the systems of taxation, interregional and interpersonal transfers, and of the welfare state that the UK as a whole has, but still claim to remain part of the United Kingdom. It follows that once Scots have decided, as they did last September, that they want to be in the United Kingdom, this is no longer a discussion that can really be had. If it can be had, it is not a discussion for Scotland alone. The discussion necessarily must engage the whole of the United Kingdom because its effects are so profound.

Professor David Heald: One of the things connected to full fiscal autonomy is the argument that Scotland sets all its taxes, gets all its tax revenues and then pays a contribution, very much like the imperial contribution of the Government of Ireland Act. Now, that disintegrated very quickly in the case of Northern Ireland. What it would do here is shift the argument from questions of devolved policy to, “Does Scotland want to pay for Trident?”, and, “Does Scotland want to pay for wars in Syria or Iraq?” Basically, the idea that you get full fiscal autonomy and then you pay would actually shift the nature of the constitutional conflicts from one set of issues to another.

Dr Angus Armstrong: There are other places that have a higher degree of autonomy, so is it possible? The answer is yes. Would it work here? That is a different answer. First, there are a number of risks that are completely forgotten about, very conveniently, in the debate. Deposit insurance: who pays for that? Financial-sector risk: I presume we want the UK Government to be paying for that. Catastrophe risk: who is going to pay for that? Collecting these payments after the event, which is kind of the argument—“Well, if it happens, we will pay you back”—means asking a country in a very difficult situation for a lot of money: “By the way, you owe us this many billion”. That is why you pay your insurance beforehand. You do not go around afterwards and say, “Do you mind coughing up now?” There are many parts to what makes the United Kingdom totally left out of the debate, remarkably.

Lord Teverson: Should we be reinventing the eurozone, monetary union, without fiscal union?

Dr Angus Armstrong: You do not have fiscal union, but it is even worse, because at least in the eurozone they have managed to work out that you need to have a banking union if you are to share some of the financial-sector risks. Here, we have not had the discussion, but I presume that the rest of the UK might feel a little aggrieved if it is paying deposit insurance for everybody else but they are not contributing to it. On that basis, Scotland would presumably issue debt, which it will have to do anyway in my view. If Scotland is issuing debt, got itself into trouble in 30 years’ time and then

Page 121 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) turned round to the UK and said, “We would like you to bail us out”, the UK could only credibly say no if there was no ongoing exposure of the rest of the UK to Scotland. That is called the existing debt stock. If Scotland paid off its fair share, whatever that might be, of the existing debt stock, then yes, it would be like the Basque Country and these net contributors, but it is not, and as long as we have this joint exposure of 80% of our GDP, of which Scotland is responsible for a share, then just receiving a cheque in the post to pay for the interest certainly is not reasonable and fair to the rest of the UK. So it is only net contributors that can do this.

Lord Teverson: May I pursue one thing? Professor Heald mentioned the Northern Ireland corporation tax, which I wanted to raise as well. I do not know whether Professor Trench, being from Ulster or based there, has an opinion on this, but that changes the state of play and affects legal bodies that are movable. They are not individuals, but they are corporations. Has there been a reaction to that change in terms of mobility? Is something being seen to be happening there? Is that an example that we can take?

Professor David Heald: That remains in the future. There was a degree of political planning in the timing of the passing of the corporation tax Act for Northern Ireland. There was a celebration in west Belfast, led by the First Minister of Northern Ireland, who comes from east Belfast. Clearly there is a belief in Northern Ireland that they will get a huge benefit from corporation tax devolution. The fact that UK corporation tax has been systematically coming down means that the actual potential benefit is less than it might have been in the past. There are two catches. One is at what point you will end up with a state aid issue. The second point—and this is something that might actually stop or delay implementation for quite a long time—is that the Treasury has calculated that every percentage point that brings Northern Ireland corporation tax below UK corporation tax leads to a reduction in Northern Ireland’s block grant. They are presently talking about 7.5 percentage points, and 7.5 percentage points at £40 million per percentage point leads to a deduction from the Northern Ireland block grant of £300 million. What is concerning Northern Ireland Assembly Members now is that they take the hit for £300 million and get this lower corporation tax rate, but if this miraculous cure turns out to be a miraculous cure, the higher tax revenue will go to the UK Treasury. It will not come back. If it turns out to be a miraculous cure, it will come back in the form of higher VAT revenues and higher income-tax revenues. That is basically one of the stumbling blocks that might delay implementation.

The Chairman: Are you saying that all this autonomy is a political slogan rather than a viable financial arrangement?

Professor David Heald: If you gave me a choice to vote between full fiscal autonomy and Scottish independence, I would vote for Scottish independence every day.

Q147 Lord Turnbull: Again on the question of borrowing, leaving aside cash balances, so to speak—you can set limits to that; that is not a difficult technical problem—in the arrangement that we have at the moment, how far can you take the principle of

Page 122 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) separate borrowing and separate credit rating, and how do you deal with the difference between the old stock and the new stock?

Dr Angus Armstrong: This is the most important question in the whole debate. We spent too much time on the Barnett formula, quite honestly. This is it, because Scotland will have to have borrowing powers. If you are the equivalent of a powerful federal state without borrowing powers, you will be the only one in the world. You would have to have a balanced budget all the time. That is very unlikely to be acceptable. I do not think it is what the people in Scotland think they are going in for. Something that is going to be tough for them is Osborne’s rules. It will come; there are enough references in the Smith commission to it coming. The question is whether you then insist on putting restrictions on it. Can the rest of the UK allow Scotland to issue debt and find mechanisms for market discipline where this thing gets priced as Scottish debt? Then you have responsibility, because now the Scottish Government will be able to say, “But this is costing us a lot. Ah, so you have to pay for your spending now. You cannot just have lower tax and higher spending; you now have some responsibility. I can work out the price for this responsibility, and you can fail”. You have changed the debate.

Lord Turnbull: It is rather good that there is a credit rating and a risk for that geography that relates to that credit rating. The question then is whether the threat of failure is credible. Scotland is not very big, but for the rest of the UK and for England is it too big for England to let fail, in which case the whole thing that it is supposed to become is pointless?

Dr Angus Armstrong: There is a contract that cannot be credibly committed to here. Even if the rest of the UK says, “We will write into our legislation that we will never bail out Scottish debt. We will not let it have the same rating in the UK banking system as UK debt, which currently it would have”, and takes every stop possible to say that this is separate, you can never guarantee that, come the crisis, the UK Government do not turn around and say, “You know what, we make the rules. Forget all about it. We’re changing it again”. You can never get round it, I agree.

Lord Turnbull: So there are two inconsistent things: one is that it is going to happen, and the second that it cannot be made to work.

Dr Angus Armstrong: On the question of whether it can be made to work, can you guarantee that you will never bail it out? The short answer is no, particularly when you can afford to bail it out, and Scotland can be bailed out because it is only 8.5% of the UK and you can afford to do it. The very fact that people know that you can afford to do it starts to play into that. That is where you get this behaviour.

Could you take enough steps to distance yourself to a reasonable degree to bring in some market discipline, so that at least people could say, “Actually, either we are paying the same borrowing costs because we are being very disciplined, or we are paying much higher borrowing costs and this is the equivalent of, say, two hospitals”?

Page 123 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) This starts costing Scottish taxpayers real money, and this is what then gets the discipline.

I would just point out that every decently sized federal state borrows in its own name. There have always been problems. Even a canton went to court successfully, and there are Länder in Germany where this becomes an issue. But overall there is enough evidence that market discipline can be a useful constraint on the decision-making

Lord Turnbull: The point is that the creditors can stop lending, but there is no equivalent to equity or bailable capital. How does anyone enforce this debt if Scotland does not pay?

Professor Jim Gallagher: The legislative way of doing that at the moment in relation to local government is to make the repayment of debt of the first charge on tax income. Local government has had that power since for ever, and that has been the constraint on it.

Lord Turnbull: Right, but does that become a nuclear option that is so powerful that the UK Government would not have the nerve to implement it?

Professor Jim Gallagher: It would be on Scottish tax income, and it would be in the hands of the creditors, not the UK Government.

Dr Angus Armstrong: The UK Government could still decide to come in and bail it out, but there are enough provisions that you can put around this to make it very clear that this is a bailout. That is not a position that I think the Scottish Government would like to be in in the future, but the key thing before that point is whether you can get to the point where the debt starts being priced properly to reflect risk and the behaviour, and therefore you build in this responsibility.

Lord Turnbull: To sum it all up, how far would you go down this path, and what essential safeguards would you need to put in?

Dr Angus Armstrong: I think it is inevitable that Scotland will start borrowing in its own name. On the safeguards that I would put in, I would like to put in legislation that the rest of the UK would in no circumstances bail us out.

Lord Lamont of Lerwick: Have we not been there before?

Lord Turnbull: Yes, it is called Ireland, and—

Lord Sharkey: It is actually called Panama. Is that not why the Scottish joined the United Kingdom in the first place?

Dr Angus Armstrong: At the moment there is no Scottish debt. The Scottish Government could behave very prudently and just issue a modest amount. We are

Page 124 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) presuming that this will all be a disaster and that they will behave in a certain way. Actually, perhaps the democratic process will force them to behave in a reasonable way. It is wrong to assume that as soon as they have this power they will blow the whole house. On the financial system, one of the mistakes in Europe is to say that all sovereign debt is zero-rated. We would not like to do that. We would treat it as other countries treat sub-central government debt, where they trade on the spread—and quite a significant spread. It is 2% higher for a lot of these large sub-central states, the Ontarios of the world, to borrow from us. That 2% makes a difference and becomes an issue when you go back to your constituents and say, “Yeah, we are building this and, by the way, paying 2% more than if we had been able to borrow from the UK like we used to”.

Professor Jim Gallagher: The place to start on this is with capital expenditure. There is already a proposition on the table that the Scottish Government should be able to borrow additionally to the capital expenditure they get from the Barnett formula. In my view, the next sensible step, which should have been the previous sensible step, would be to say that all Scottish Government capital expenditure is borrowed for rather than paid out of Barnett revenue. Some of it may be borrowed from the UK and some of it from the market. There is already a need for cashflow borrowing because the flow of tax revenues is not the same pattern as the flow of expenditure. The difficult one, and Angus may disagree on this because I do not know what I think on it, is the extent to which the Scottish Government should be able to borrow for macro- economic management purposes. Should they be able to say, “We are not really in favour of this austerity? We would like to borrow and spend some more, if you do not mind?” I am slightly hesitant about that. I know that the Treasury would have kittens at the very suggestion. Yet those are the three areas to which one might move. I would start with capital and move cautiously.

Professor David Heald: I will add a different point. While the United Kingdom remains a member of the European Union, Scottish borrowing would count as part of UK borrowing.

Q148 Lord Forsyth of Drumlean: I apologise for arriving here at the last moment. I think I generally explained that I had to speak on EVEL in the Chamber, but I will read the transcript with great interest. One of the points I made in the debate this afternoon is that, according to the pollsters, if you ask people in Scotland about the Smith commission, they almost without exception have no understanding of what is proposed. You get a large number who do not know what has been proposed, yet you also get an equally large number saying that the proposals do not go far enough. Do you think that there is enough awareness of what is involved with devolution and what the issues are? Has there been enough transparency? How can we get this on to a level of debate that is informed rather than aspirational?

Professor David Heald: I have been arguing throughout this meeting in favour of greater transparency. It might lead to more debate. What has been happening in Scotland is not to do with the fine detail of these proposals. Something very significant

Page 125 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) happened during the referendum campaign. Certainly something very significant happened during the UK general election in Scotland. So there is a disconnect between talking about what the mechanics are in putting a system in place and the broader political context. I could have made reference a few minutes ago to the fact that what worries me is the climate in which Scotland wants more powers without any sense of in what circumstances and in what way one would use them. That is very dangerous. At the end of the day people think, for example, that if you get welfare devolution the cuts will be less harsh without telling where the money comes from. You could devise a system whereby you had less harsh welfare cuts but you must find the money from somewhere within the programme that funds health and education. That is not the kind of debate that has been happening.

Dr Angus Armstrong: I do not think it is possible to get anywhere near that level of sophistication. Understanding the taxes that have been devolved, how they will work and things like the Barnett formula are just not what the public are likely to digest. We have seen in survey evidence that across Scotland even people who want more powers devolved are in favour of more welfare and less tax. There is a complete disconnect with reality here because there is no discipline. There is no market discipline or reason to change that. The mindset seems to be to just keep that attitude and keep asking for more powers and more money. We need to get away from what I call “pocket-money devolution”, where the rest of the UK says, “Here is £100. You go and spend it as you like”. That is not responsibility. The only way you get that is when you have borrowing powers and people can see the price they pay now for your decisions.

Professor David Heald: The only way you get responsibility is with tax powers that you can use. We have to be very careful not to get tax powers that are unusable because of technical reasons to do with either HMRC capacity or the political dynamic between Westminster and Holyrood. That would lead to significant disillusionment. In the present climate in Scotland, that would be extremely dangerous.

The Chairman: Is it your view that the Scottish Government have a firm grasp of all these issues?

Professor Jim Gallagher: The Scottish Government have a political grasp of these issues, which is entirely driven by their constitutional objective. At a technical level, I would be surprised if they were yet in a position to make good-quality tax decisions, but they have to start somewhere. They have struggled a bit with the establishment of the tax collection office for the initial two devolved taxes, which are very simple taxes. They will find the making of income tax decisions challenging, particularly as they get a bundle of new responsibilities for tax and welfare, and will not have the political or administrative skill set already to deal with them. However, in the end, to go back to Lord Forsyth’s question, the answer—if there is one—is not power but responsibility. I agree with David that responsibility comes where the Scottish Government will have to make tax decisions. At some point they will make the wrong tax decision and people will notice. That is the kind of explanation that will get through to people.

Page 126 of 420 Professor David Heald, University of Aberdeen Business School; Professor Alan Trench, University of Ulster; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) The Chairman: Thank you very much. Our next session is with the Chancellor in September, who I think you claim is the only other member of the Barnett fan club. We will inquire on that matter. We will also have the opportunity to understand in detail the Treasury’s grasp of these matters. Thank you very much indeed.

Page 127 of 420 Her Majesty’s Revenue and Customs (HMRC) – Written evidence (DPF0024)

Her Majesty’s Revenue and Customs (HMRC) – Written evidence (DPF0024)

Dear Lord Hollick Thank you for your letter of 19 October, in which you asked for some information about HMRC's devolution activities. The answers to your questions are as follows.

Timetable for implementation

You asked about the Secretary of State's statement that he would like to see the additional income tax powers contained in the Scotland Bill come into effect in April 2017. HMRC are currently preparing for the introduction of the Scottish rate of income tax in April 2016. This requires us to identify Scottish taxpayers and put into place the arrangements to ensure that employers and pension payers are able to apply a different tax rate to their income, and to account for the tax paid separately so that a proportion of the revenue can be attributed to the Scottish Government. The additional income tax flexibility proposed in the Scotland Bill builds on this foundation: it does not change the definition of a Scottish taxpayer or the income to which the rate applies. This means that the administrative implications of the Scotland Bill measures are relatively minor.

The basic mechanics of charging a different rate of income tax on the non-savings, non•dividend income of Scottish taxpayers has been in place since the Scotland Act 1998 introduced the Scottish Variable rate, although the rate was never used. Many employers will have had the facility to apply a different PAYE calculation to Scottish taxpayers, identified by an "S" prefix to their PAYE code, incorporated into their payroll software since then .·

In preparation for the introduction of the Scottish rate of income tax in April 2016, HMRC has consulted extensively on the application of the definition of a Scottish taxpayer in different circumstances (on which detailed guidance will shortly be published) and on how various aspects of the wider Income Tax system e.g . PAYE, gift aid, etc should continue to operate smoothly once the Scottish rate is in existence (included in Regulations recently approved by both Houses). Neither of these is likely to be affected by the additional flexibility to set rates and thresholds introduced by the Scotland Bill.

HMRC has also conducted significant work to check and refine its address records in order to ensure that Scottish taxpayers have been correctly identified. As the new powers in the Scotland Bill will still apply to the same definition of Scottish taxpaye rs this will not need to be repeated.

The flexibility to change income tax rates and thresholds introduced by the Scotland

Page 128 of 420 Her Majesty’s Revenue and Customs (HMRC) – Written evidence (DPF0024)

Bill will potentially change the calculation to be applied to the income of Scottish taxpayers by employers and pension payers operating PAYE, and by those completing a self-assessment return. These changes are relatively low risk and can be incorporated in the normal software updates made regularly by PAYE operators and by HMRC systems. We believe that the Scotland Bill changes could be accommodated by HMRC and employers without difficulty by April 2017.

Identification of Scottish taxpayers

You asked about our approach to identifying Scottish taxpayers, and whether there were any difficulties in doing so.

An individual's Scottish taxpayer status is determined by the location of their place of residence for the majority of the tax year. If this is in Scotland, they will be a Scottish taxpayer. The strategy for identifying Scottish taxpayers is based on the address information held on HMRC's systems.

In order to assess the accuracy of these addresses, they have been compared with other address databases (e.g. the Post Office) - in around 85% of cases HMRC held an address for a taxpayer that could be corroborated by another source. Analysis by HMRC of those cases where a match could not be achieved suggests that the vast majority of these individuals are living at a different address in Scotland indicated by, for example , a link to a local employer - this would mean that they were still Scottish taxpayers and would be treated as such by HMRC until notified otherwise . By this means we have established evidence that about 98% of the taxpayers for whom HMRC holds Scottish addresses are correctly identified as likely to be Scottish taxpayers.

HMRC plans to write to taxpayers for whom they hold a Scottish address in December, to inform them that they will be treated as a Scottish taxpayer and advise them of how to report a change of address. HMRC will also undertake additional communications and publicity activity to raise awareness of the SRIT and remind customers of the importance of notifying HMRC when they move house. The communications activity is likely to be a mix of proactive communications, offering material to the media and stakeholders, to inform them about HMRC's activity regarding SRIT and use their assistance in reinforcing our messages. This will be combined with a limited amount of paid for marketing to target specific customer groups to increase the confidence that we have reached the target audience in a way that represents the best value for money. This could include people who have recently moved house, for example.

HMRC also has undertaken extensive work to ensure that people who live in Scotland but do not appear on our current records with a Scottish address can be included in the

Page 129 of 420 Her Majesty’s Revenue and Customs (HMRC) – Written evidence (DPF0024) planned commun ications. This is not straightforward, as there is no single alternative set of address data that is constantly updated at all times. HMRC has worked with a third party data supplier (Transactis) as part of this work to assess the accuracy of its data. Transactis has undertaken a comparison of HMRC's UK wide data with the Scottish Electoral Register. The scan has produced a list of individuals for whom HMRC holds an address elsewhere in the UK, but who appear at a Scottish address on the electoral register. HMRC w ill be writing to these individuals separately to confirm whether they are Scottish taxpayers. ·

Basing the definition of a Scottish taxpayer on the individual 's main place of residence will mean that the answer will be clear for the vast majority of taxpayers. But there are some groups of taxpayers for whom it may be more difficult to decide whether they fall within the definition. HMRC has consulted widely on guidance which addresses the main areas of potential uncertainty, including mobile workers, North Sea workers, students and the armed forces.

HMRC's role in relation to other devolved taxes

The Scottish Government has set up Revenue Scotland to administer the taxes devolved by the Scotland Act 2012: Land and Buildings Transaction Tax, which replaces Stamp Duty Land Tax in Scotland, and Scottish Landfill Tax. HMRC has supported the establishment of Revenue Scotland, and is now developing an effective working relationship which includes cooperative working on compliance, and support for training and professional development including secondments and interchange. It will be for the Scottish Government to decide who should administer Air Passenger Duty and Aggregates Duty when they are devolved to Scotland.

The Wales Act 2014 devolved Stamp Duty Land Tax and Landfill Tax to Wales, and the Welsh Government have announced that HMRC is their preferred partner to operate the Land Transaction Tax (the devolved replacement for SDLT in Wales) on their behalf. The Corporation Tax (Northern Ireland) Act 2014 gives the Northern Ireland Executive the power to set a rate of corporation tax to apply to the profits of Northern Ireland companies. This will be a rate within the UK corporation tax structure (in the same way as the Scottish rate of income tax remains part of the UK income tax structure) and as such will be operated by HMRC.

I hope these answers are helpful to your enquiry.

SARAH WALKER 26 October 2015

Page 130 of 420 Her Majesty’s Treasury (HMT) – Written evidence (DPF0015)

Her Majesty’s Treasury (HMT) – Written evidence (DPF0015)

Lord Hollick Chairman – Economic Affairs Committee House of Lords London SW1A 0PW 18 August 2015

Call for Evidence “Devolution of public finances in the UK”

Sirs

Thank you for asking the Government to submit evidence to your enquiry on the “Devolution of public finances in the UK”. Please find attached detailed written evidence from HM Treasury covering the questions posed in your Call for Evidence.

2. I apologise that a Government Minister is not able to appear before you in person on this occasion. We are currently in discussions with the Scottish Government on a new Fiscal Framework to accompany the Smith Commission and the powers in the Scotland Bill. We have committed to aim to reach agreement on these by the autumn this year, which means it would not be appropriate to meet with you at this time. However, I would be happy for my officials to brief you informally if that would assist with your work.

3. As you can see from our evidence, the Government is working to ensure that we have lasting and credible fiscal devolution settlements in place for each of the Devolved Administrations. It will be crucial that each is compatible with the UK Fiscal Framework as a whole, and also that each is as transparent and mechanical as possible. Whilst each will be decided at different times over the coming months, they should be lasting settlements to give everyone concerned certainty for the future.

4. I am copying this to the Secretary of State for Wales, Secretary of State for Northern Ireland, Secretary of State for Scotland, the Parliamentary Under Secretary of State for Scotland (Lord Dunlop) and the Attorney General.

GREG HANDS

Page 131 of 420 Her Majesty’s Treasury (HMT) – Written evidence (DPF0015)

HM Treasury Written Evidence to the House of Lords’ Economic Affairs Committee August 2015

Fiscal framework

 What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

1. The Government believes that funding arrangements should be as simple and transparent as possible, while enabling risks and resources to be shared, and delivering a fair outcome for people across the whole of the UK.

2. HM Treasury’s “Statement of Funding Policy”5 sets out the current arrangements for UK Government funding of the Northern Ireland Assembly, Scottish Parliament and National Assembly for Wales. The core element is a block grant for each Devolved Administration calculated using the Barnett Formula6. The Government has committed to retain this formula as the devolution settlements are amended – it is well established, relatively simple, transparent, and has stood the test of time. It ensures that risks and resources are pooled and shared across the whole of the UK, thereby delivering relatively stable and secure levels of funding for each of the Devolved Administrations.

3. While the Barnett Formula and associated block grant will continue, it is important to recognise that funding arrangements are evolving alongside changes to the devolution settlements:

4. Under the Scotland Act 1998 (the 1998 Act), the Scottish Parliament is responsible for almost 60 per cent of public spending in Scotland (covering, inter alia, health, education, housing, policing, justice) but is responsible for only around 10 per cent of Scottish tax (covering just council tax and non-domestic (business) rates). As a result of the Scotland Act 2012 (the 2012 Act) and Scotland Bill (which is currently being debated in the House of Commons) the Scottish Parliament will become responsible for around 40 per cent of Scottish tax. This means that the Scottish Parliament will be responsible for more than 50 per cent of its funding.

5. This change significantly increases the Scottish Government’s accountability for funding its spending, and its autonomy to vary tax and spending in Scotland. By retaining the Barnett Formula, this new accountability and autonomy will sit alongside the stability and certainty of some block grant funding from the UK Government.

5 http://webarchive.nationalarchives.gov.uk/+/http://www.hm-treasury.gov.uk/d/sr2010_fundingpolicy.pdf 6 Under the Barnett Formula, changes in the block grants are determined by the quantity of the change in planned spending in departments of the United Kingdom Government, the extent to which the relevant United Kingdom programme is comparable with the services carried out by each Devolved Administration, and each country’s population proportion.

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6. The Welsh Assembly holds responsibility for over half of government spending in Wales including on education, health and housing. Like the Scottish Parliament, it is also responsible for council tax and non-domestic (business) rates. To increase the Welsh Assembly’s accountability for funding its spending, the Wales Act 2014 devolved both Landfill tax and Stamp Duty Land Tax as well as giving the Welsh Government the power to trigger a referendum on Income Tax devolution in Wales. As for the Scottish Government, this combination of autonomy over tax revenues and block grant funding balances increased accountability with stability and certainty.

7. Looking to the future, the UK Government has also agreed to introduce a floor in the level of relative funding it provides to the Welsh Government. The precise level of the floor, and the mechanism to deliver it, will be agreed alongside the next Spending Review. This agreement will help encourage the Welsh Government to use the autonomy given in the Wales Act and the powers it is gaining, to grow the economy and deliver for the people of Wales.

8. The Northern Ireland Assembly has spending powers set out in the Northern Ireland Act 1998 (as amended). In 2014 the UK Government committed to the devolution of Corporation Tax powers by 2017 as part of the Stormont House Agreement, should the Northern Ireland Executive parties live up to the range of associated commitments made in that Agreement. The Corporation Tax (Northern Ireland) Act received Royal Assent in March 2015. The principles underpinning the required adjustment to the Northern Ireland Executive’s block grant were also reflected in the Stormont House Agreement, and discussions continue to ensure that they can be practically implemented should the separate Northern Ireland rate provided for by the legislation be switched on.

9. For each of the Devolved Administrations, the Government believes that maintaining the Barnett Formula delivers a relatively simple and transparent funding arrangement, alongside increased autonomy and accountability provided in the current devolution settlements and anticipated changes to them.

 Is the correct institutional framework in place for the devolved governments and UK Government to discuss these matters? What processes will need to be in place to make new settlements sustainable and effective? Are there lessons the UK might take from other countries that have devolved spending and revenue raising powers?

10. The Government recognises the value of the current institutional framework. Bodies such as the Joint Exchequer Committee and Joint Ministerial Committee are important to ensure smooth intergovernmental relations that deliver for people across the UK. We will want to ensure that good intergovernmental relations continue as the devolved settlements evolve.

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11. The Joint Exchequer Committee for Scotland has met several times since the 2012 Act received Royal Assent, to discuss the financial provisions in that Act and implementation of the Scottish Rate of Income Tax7. Senior level attendance from both Governments, as well as rotating the location and the chair have enabled this forum to work well for that purpose. This forum has, for example, agreed arrangements for the sharing of tax information in order for the Scottish Government to take a decision on the Scottish Rate of Income Tax later in 2015.

12. Discussions between the UK Government and Scottish Government on the updated Fiscal Framework are also taking place in the format of a Joint Exchequer Committee for Scotland8. It was this format which established the parameters for work by officials over Summer 2015 and set a goal for finalising discussions on the fiscal framework for Scotland (of autumn this year). The format for any future governance, once the fiscal framework is agreed, will be looked at as part of those discussions.

13. Over a number of years, the Chief Secretary to the Treasury has also convened joint meetings with the Finance Ministers of each Devolved Administration in the ‘Finance Ministers Quadrilateral’ format, to discuss areas of common interest and seek consensus on ad-hoc issues9. It is expected that, despite the ongoing changes to each devolution settlement and the divergence in arrangements, such a forum will continue to serve a useful purpose.

14. Ministers meet to discuss broader intergovernmental issues (beyond fiscal and financial issues) in the format of the Joint Ministerial Committee. Heads of the administrations announced10 in 2015 a review of the Memorandum of Understanding which established the JMC.

 How should block grant funding reflect devolved tax and welfare powers? How should future changes to the block grant be decided? How should the Smith Commission proposal of “no detriment” apply over time?

15. As discussed above, the Government believes that the Barnett Formula and associated block grant should continue. This is a relatively simple, transparent and well established mechanism which has stood the test of time. However, as the devolved settlements evolve, the block grant will sit alongside increased accountability and autonomy for Devolved Administrations.

16. The Scotland Act 2012 established the principle that the Barnett-based block grant should be reduced to reflect the tax revenues that the UK Government will forego as a result of devolution. The UK and Scottish governments subsequently agreed a mechanism to adjust the Scottish Government’s block grant in relation to the

7 https://www.gov.uk/government/news/joint-exchequer-committee-communique 8 https://www.gov.uk/government/news/joint-exchequer-committee-communique-7-july-2015 9 https://www.gov.uk/government/news/ministers-meet-to-discuss-financial-challenges-of-future 10 https://www.gov.uk/government/news/joint-ministerial-committee-communique-december-2014

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Scottish Rate of Income Tax. Under this mechanism, the UK Government retains UK-wide risks and the Scottish Government holds the marginal Scotland-specific risks. This arrangement creates incentives to generate further economic growth, but means that the UK and Scottish governments will be no better or worse off if the income tax base in Scotland and the UK grow at the same rate.

17. Building on this approach, the Smith Commission11 developed the slightly broader concept of “no detriment”. The Commission’s report set out principles that the new funding arrangements for Scotland should deliver, notably:

 Block grant adjustments should reflect tax foregone and spending no longer undertaken by the UK Government;  Any policy decisions that affect the tax or spending of the other government are the responsibility of the decision-making government;  Changes in taxes that only apply in the rest of the UK should only affect spending in the rest of the UK (and, similarly, taxes that only apply in Scotland should only affect spending in Scotland).

18. Based on these principles, the UK and Scottish governments will agree updated arrangements as part of the Scottish Government’s new Fiscal Framework.

19. The UK Government is also discussing with the Welsh Government and Northern Ireland Executive how their block grants will be adjusted to reflect anticipated changes to their respective devolution settlements. The tax powers in the Wales Act 2014, for example, do not enter into force until 2018.

 Should devolved governments receive further borrowing powers? What form of contract between the UK government and the devolved nations will prevent bailouts of governments that do not stick to their borrowing limits?

20. Controlling borrowing is a central part of the Government’s fiscal policy. A lower debt to GDP ratio would reduce the burden of debt interest on taxpayers and strengthen the ability of future governments to respond effectively to economic challenges. This applies to Devolved Administration borrowing as to UK Government borrowing – as they are viewed and treated the same in international markets.

21. The Scottish Government has borrowing powers under the Scotland Act 1998 (as amended by Scotland Act 2012):

 Borrowing for current expenditure: Up to £200m per year, within a cap of £500m, for cash management or forecast error of taxes, to be repaid within four years (from the UKG only).

11 https://www.smith-commission.scot/

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 Borrowing for capital expenditure: Up to 10% of the Scottish Government’s Capital Departmental Expenditure Limit per year (currently allowing it to borrow up to around £300m a year), within a cap of £2.2bn (from the UKG, commercial lenders, or by issuing bonds).

22. In accordance with the principles of the Smith Commission, and to reflect the additional risks the Scottish Government will have to manage, the updated fiscal framework should provide sufficient additional borrowing powers to manage risks. These will be discussed as part of the fiscal framework discussions.

23. The fiscal framework discussions will also look to fulfil the Smith Commission’s conclusion that the Scottish Government should have sufficient borrowing powers to support capital investment. As the Smith Commission also set out, it will however be critical to ensure that Scottish Government borrowing powers are consistent with the UK’s fiscal framework – as Scottish Government borrowing and debt is not distinct from UK borrowing and debt.

24. The Welsh Government will in future have significant borrowing powers. The Wales Act 2014 provides for £500m total capital borrowing (limited at up to £125m in any one year), with these powers coming into force in April 2018.

25. The Northern Ireland Executive’s borrowing powers are set out in the Northern Ireland Loans Act 1975 and the Northern Ireland Miscellaneous Provisions Act 2006 to fund capital expenditure.

26. As described above, limits on borrowing by Devolved Administrations are generally set out in legislation; that is, each administration’s borrowing is legally constrained by Act of Parliament. Whilst discussions are open and on-going, it is expected that this will continue to be the case. The arrangements set out in the legislation are supplemented by official-level reporting and monitoring agreements between HM Treasury and the Devolved Administrations.

 What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?

27. “Full fiscal autonomy” would mean the Scottish Government funding all public spending in Scotland from its own resources. This means that the Barnett Formula would end and the Scottish Government would be fully responsible for raising all the tax from Scottish taxpayers required to fund all spending in Scotland (including, inter alia, spending on public services, benefits and pensions). This would include all the spending currently undertaken by the UK Government in Scotland, as well as all existing Scottish Government spending.

28. Under this arrangement, there would be an end to Scotland pooling resources and sharing risks with the rest of the UK. Scotland would also no longer be part of the UK’s single market.

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29. The Institute for Fiscal Studies12 has estimated that Scotland’s funding would be £7.6 billion lower this year under full fiscal autonomy, rising to almost £10 billion lower in the last year of this Parliament. Figures published by Fiscal Affairs Scotland13, as well as by HM Treasury, reinforce these conclusions14 [link]. This gap would need to be filled either by spending cuts or tax rises. In the last year of this Parliament, this would amount to extra taxes or reduced public spending worth around £5000 for each family in Scotland.

 What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland?

30. As set out above, the Government believes that fiscal arrangements for each of the Devolved Administrations must each be consistent with the UK’s fiscal framework. However they are also based on different levels of devolution and different individual circumstances. The Government has committed to implementation of each of the Smith Commission, the St David Day Agreement and the Stormont House Agreement, which set out the different settlements for each Administration.

31. There are therefore no direct implications for Wales or Northern Ireland from anticipated changes to the Scottish Government’s Fiscal Framework.

32. Treasury Ministers will work with their colleagues in the Devolved Administrations (using the fora set out above) to ensure that the fiscal arrangements for each Devolved Administration have no adverse consequences for other administrations and also that each is consistent with the UK’s fiscal framework.

Tax powers15

 What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill?  What is the rationale behind the choice of taxes devolved by the Wales Act 2014?

33. The Smith Commission took evidence from a large number of stakeholders as well as from both the UK and Scottish Government. This inclusive approach was set out in the Terms of Reference for the Commission’s work and reflected in the final

12 http://www.ifs.org.uk/publications/7652 13 http://fiscalaffairsscotland.co.uk/wp-content/uploads/2015/03/Supplement-on-GERS-2015-rev-180315.pdf 14https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/418694/Opposition_costing___full_f iscal_autonomy_for_the_Scottish_Government.pdf 15 The Scotland Bill proposes to devolve the rates and thresholds of income tax on non-savings and non-dividend income, Air passenger duty and aggregates levy. From 2018, the National Assembly for Wales will set business rates, stamp duty and landfill tax. Subject to a referendum, the Assembly will be able to vary income tax by 10p in the pound. The Corporation Tax (Northern Ireland) Act 2015 allows the devolution of power to set the rate of corporation tax in Northern Ireland.

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report16. As part of this, over 400 submissions were received from civic institutions, organisations and groups, and over 18,000 from the public.

34. On that basis the Commission’s Report set out which tax powers should (and should not) be devolved to the Scottish Parliament. The Commission reached cross- party agreement for these conclusions – those being agreed by all major parties in Scotland.

35. This gives a strong pedigree to the Commission’s conclusions. The Government is therefore committed to implementing the Smith Commission in full, and those tax powers are therefore included in the Scotland Bill.

36. The Wales Act implemented almost all of the recommendations set out in the first report of the Commission on Devolution in Wales (“Silk Commission”)17. The Commission was independent of Government and included academics and representatives of the business community as well as the main political parties. As with the Smith Commission, this gives the Commission a strong pedigree and legitimacy on which to base new powers for the Assembly.

 What are the implications of devolving corporation tax to Northern Ireland? Will it have an effect on business in the rest of the UK?

37. The Corporation Tax (Northern Ireland) Act 2015 devolves the power to set a rate of corporation tax in Northern Ireland to the Northern Ireland Assembly. The Act includes a commencement clause which will only be used if the Northern Ireland Executive can demonstrate that its finances are on a sustainable footing for the long term, which includes successfully implementing measures in the Stormont House Agreement and subsequent reforms.

38. If the power is devolved, it will allow the Executive to take steps to improve competitiveness and rebalance the economy towards a stronger private sector, boosting employment and growth.

39. This will affect an estimated 34,000 companies of all sizes. Of these, the majority (27,000) operate wholly in Northern Ireland, so the significant majority of companies working in Northern Ireland will potentially benefit from a lower Corporation Tax rate.

40. This new regime has been designed to ensure it will encourage genuine economic activity, minimise burdens on business, for example with a separate regime created for SMEs to spare them the disproportionate burden of transfer pricing, and minimise opportunities for artificial profits shifting. Guidance for business will be published by HMRC by the end of the year.

16 https://www.smith-commission.scot/about/ 17http://webarchive.nationalarchives.gov.uk/20140605075122/http:/commissionondevolutioninwales.independent.gov. uk/

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41. The impact on businesses outside of Northern Ireland will depend on the decisions taken by the Assembly on the rate which will apply, along with a number of other economic factors when the regime comes into effect. The Government believes that a thriving, prosperous Northern Ireland will have benefits for the whole UK economy, as well as for Northern Ireland.

 With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)?

42. Both the Smith and Silk Commissions looked in detail at a range of options for tax devolution before reaching their conclusions (and took evidence from a range of stakeholders, as set out above).

43. Once these agreements are fully implemented each devolved legislature will have significant tax and spending powers. The Scottish Parliament will become one of the most devolved sub-autonomous areas in the OECD. From a situation where the Scottish Parliament is only responsible for raising around 10% of what it spends, Holyrood will in future be responsible for raising more than 50% of what it spends once the Scotland Bill comes into effect.

44. The decision to devolve certain tax powers is based on the specific circumstances in each Devolved Administration. This is evidenced by the different conclusions reached by the Smith and Silk Commissions, as well as views of different stakeholders.

45. For example, that Northern Ireland has a land border with the Republic of Ireland, which has a 12.5% rate of Corporation Tax, is more reliant on public sector employment and has specific challenges around competitiveness and the economic legacy of the Troubles which means devolution of corporation tax is appropriate.

46. The Government believes that it is more important that the devolution settlements are appropriate to each Devolved Administration and work in the best interests of the people of Wales, Northern Ireland and Scotland, and of the UK as a whole, than that they are identical.

 Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?

47. Economic theory suggests that tax competition is normally a good thing because, like other forms of competition, it provides performance improvement incentives. Of course, tax competition needs to be fair.

48. Evidence suggests that tax competition does not necessarily lead to a “race to the bottom”. In the UK, the current local variation in council tax has not resulted in

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significant tax competition. International evidence from the OECD suggests that “sub-national” tax rates tend to go up rather than down18. One reason for this may be that these administrations are required to fund tax cuts and so need to balance them against the need to fund local services. As set out above, this will increasingly be the case in the UK as the Devolved Administrations take on additional tax and spending powers (as discussed above).

18 August 2015

18 http://www.oecd-ilibrary.org/taxation/tax-competition-between-sub-central-governments_5k97b1120t6b-en

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Professor Gerald Holtham – Written evidence (DPF0003)

Fiscal framework What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account? 1. Currently there are no principles underlying how devolved nations are funded. The amounts each receives per capita are the arbitrary result of historical accident and accretions. A simple extension of the Barnett formula would add four factors apart from population: demographics, specifically dependency ratios, incidence of poverty or multiple deprivation, incidence of chronic ill- health and sparsity of population. The first three are the principal determinants of differing needs for public spending and the last influences the cost of providing public services. The necessary data to quantify these factors are available for each country on a comparable basis. The weight to assign to each factor is essentially a political choice but the weights can be derived from decisions about geographical distribution of expenditures already made by the UK government and devolved governments. 2. In the UK formulae are used to distribute resources to health authorities around the country; formulae are used to provide local authorities with revenue support grants that make up over three-quarters of their funding. Until quite recently formulae were also used to distribute spending on education. All were based on indicators of need. The formulae are complicated but basically all their variables reflect the fundamental factors listed above– demographics (more young people, more schools, more old timers more health expenditure), deprivation (more poverty means worse health and other phenomena requiring public intervention) and cost (it is more expensive to provide services for example in sparsely populated areas). 3. The Independent Commission on funding Wales, set up by the Welsh Assembly government, looked at the consequences of the formulae and showed they could be replicated by a much simpler formula with a few proxies for those key factors. The simple formula was able to explain over 95 per cent of the variation in relevant public expenditure per head across the localities of England, Scotland and Wales. It therefore extracted the existing distributional choices and preferences of the governments and showed these could indeed be expressed in a simple formula. 4. When you apply the formula to the English regions and the other UK countries you find that Northern Ireland was roughly fairly funded but may now be somewhat overfunded, Wales was slightly underfunded but may now be roughly fairly funded. Scotland is clearly overfunded. Three English regions

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have greater needs than Scotland, the north-east, north west and west midlands but all receive much lower spending per head.

Is the correct institutional framework in place for the devolved governments and UK Government to discuss these matters? What processes will need to be in place to make new settlements sustainable and effective? Are there lessons the UK might take from other countries that have devolved spending and revenue raising powers? 5. Current funding arrangements have no statutory basis and devolved governments do not have to agree or sign off on dispensations. So-called Barnett consequentials, determining block grants are calculated by the Treasury and agreed by Secretaries of State. It is fair to say that while the process has been applied fairly even-handedly, there have been controversial rulings and the devolved governments have no confidence in the impartiality of the process. If the Treasury wishes to save money it will do so, if necessary at the expense of equity, they believe. The recent report of the Bingham Centre for the Rule of Law criticised this situation as falling short of appropriate standards of governance. A more transparent arrangement would be to have consequentials calculated by an independent body such as the OBR and to give the process some statutory basis with defined grounds for appeal and resolution of disputes. Australia provides some precedent.

How should block grant funding reflect devolved tax and welfare powers? How should future changes to the block grant be decided? How should the Smith Commission proposal of “no detriment” apply over time? 6. The block grant can be adjusted for devolved tax powers. This is not entirely straightforward but it is possible. The key is to ensure so far as possible that each government takes the consequence of its own actions. UK government policies that alter the devolved tax base should result in a block-grant adjustment; changes in tax base resulting from devolved government policies should not alter the block grant. Applying this principle means a devolved government can raise or lower the total resources at its disposal by altering tax rates and it bears the consequences of its policies on its tax base and revenue. It also means that the devolved government takes on risk that was previously born at the centre but that is an inevitable consequence of real devolution. These principles can result in some complexity and different formulae for different taxes. 7. Welfare responsibilities represent a greater challenge since they fall outside departmental expenditure limits and can vary unpredictably. Ideally responsibility for an agreed basic level of welfare protection would be decided at the UK level and administered from the centre. A devolved territory would not be allowed to subtract from that level but could add to it if it wished. The

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addition would come from its own resources and would not entail changes to the block grant.

8. The block grant would continue to be driven by expenditure decisions made for England, though remaining fully fungible and adjusted for devolved or assigned taxes (see above). The Barnett formula applies only to the annual change in the block grant. A formula incorporating measures of relative need would have to determine the entire grant, not just the annual increment. The determinations would be stable since the needs indicators are very slowly- changing variables. However since changes implied by the needs-based approach would be considerable, at least for Scotland, they would need to be phased in very gradually.

9. The no-detriment proposal is impractical and cannot be made operational unless it is dictatorial. Since counter-factuals cannot be observed it will give rise to endless irresolvable disputes. It cannot apply over time and trying to devise ways to make it apply are a waste of time. A different approach is necessary (see below)

Should devolved governments receive further borrowing powers? What form of contract between the UK government and the devolved nations will prevent bailouts of governments that do not stick to their borrowing limits? 10. Borrowing limits should be set on the basis of clear principles. Short-term borrowing should be sufficient to cover cyclical fluctuations in revenue and worst-case assumptions can be made to compute limits. Borrowing for investment should depend on prudential limits relating permissible debt to the actual and prospective resources of the borrowing government. Present limits are on the low side but, just as importantly, they are numbers plucked from the air without any explicit rationale.

11. The UK can announce a policy of no bail-outs, as currently applies to local authorities. The market will not believe the declaration unless and until there is a default. The devolved government’s access to borrowing would then be lost. The UK should ensure that basic services are maintained rather than worry about creditors – caveat feneror

What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap? 12. Full fiscal autonomy is inconsistent with the continuation of the United Kingdom as a union or even a federal state. All federal governments retain the power to levy some taxes on citizens in every region. All federations also have some sort of equalisation flows whereby richer regions support poorer ones,

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either directly or via the federal government. Full fiscal autonomy as discussed in Scotland does not seem to accept any such mutual obligation.

13. If the oil price remains low there will be no rapid or certain way to reduce the fiscal gap. Doing so will take many years.

What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland? 14. Given that the no detriment clause is either a strait-jacket or a dead letter, devolving higher rates of income tax with no protocols limiting their use could give rise to tax competition to the detriment of other areas. The same apples to the devolution of Corporation tax to Northern Ireland. If the promise to continue with the Barnett formula is interpreted to mean it cannot be amended at all, then Wales along with English regions will continue to be at a relative disadvantage.

Tax powers What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill? 15. The choice appears to be the result of political horse-trading and it is difficult to detect any particular rationale.

What is the rationale behind the choice of taxes devolved by the Wales Act 2014? 16. The best taxes to devolve are those where the tax base is as immobile as possible and therefore spill-overs on the economy and tax base of neighbours are as small as possible. Yet the argument for maximum accountability of devolved government also implies that devolved taxes should be evident, paid by a high proportion of the population and make up a material part of the revenue of the devolved government. The Wales Act, following a couple of independent Commissions, is a reasonable attempt to apply those principles.

What are the implications of devolving corporation tax to Northern Ireland? Will it have an effect on business in the rest of the UK? 17. Inevitably it will and more than it should. If corporation tax is to be devolved HMG should have determined appropriate rules for the geographical assignment of corporation tax liability, as is done in the United States for example. A company could be charged at the highest UK rate unless it demonstrated that a certain proportion of its business was conducted in a low- tax region. The same proportion of its total taxable profit would then be taxed at the lower rate applying in that region. This would reward companies moving real activity to a low-tax region but remove the incentive to “brass plate” by moving company registration without transferring economic activity. There are various ways of determining where a company’s business is located. One

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simple approach would be to assign geographical liability on the basis of shares of the company’s wage bill. HMG has declined to update or reform the basis of corporation tax liability and is wide open to brass-plate abuse. It attempts to prevent this with the no-detriment clause but that is open to endless dispute and will very probably prove unworkable.

With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)? 17 There is no clearly correct allocation of tax-raising powers. A study of federal states shows a very wide range of arrangements. Tax devolution increases the policy options and accountability of devolved governments but also increases the unshared revenue risk they bear and can lead to tax competition and economic distortions. Trade-offs are inevitable. Wales and Northern Ireland will still raise less than 20 per cent of the money they spend so there is an argument for their accepting more tax devolution. In the case of Wales this could be achieved by their accepting income tax and taking a larger proportion of the tax base than recommended by the Silk Commission. 18 Corporation tax could be devolved but only if reformed as indicated above. It is a moot point whether it should be devolved. It could be argued that its devolution can be seen as a form of regional policy which is appropriate only for poorer areas in need of special measures to foster their development. In that case Northern Ireland and Wales would qualify but Scotland would not since its income per head is similar to the UK average. Tax revenues could always be assigned without the power to alter tax rates. 19 In general more taxes can be sensibly devolved if government agree and accept protocols limiting their discretion to alter rates. Most taxes can be devolved in the sense that revenues can be assigned and some limited powers over rates can be given. Many fewer taxes can sensibly be devolved if that implies that there are no limitations at all on what rates can be set or how the bases can be changed. Most tax bases are geographically mobile to some extent so excessive d istortions and tax competition can arise without agreed protocols.

Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?

20. It might, depending on the political composition of governments. Surely even if we accept some competition it should be limited to avoid cannabilising the UK tax base. No-detriment clauses cannot work so

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agreed protocols are needed that limit reductions in sensitive tax rates. One approach would be to make permissible reductions depend on the objective development needs of each country or region. Then the tax revenue sacrificed by the UK as a whole to tax competition could be viewed as a tax expenditure on regional development. On that basis Northern Ireland and Wales would be allowed larger deductions than Scotland. It is not clear of course that they would take advantage of them

27 July 2015

Page 146 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007)

Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007)

Evidence Session No. 7 Heard in Public Questions 77 - 88

TUESDAY 13 OCTOBER 2015

Members present

Lord Hollick (Chairman) Baroness Blackstone Lord Forsyth of Drumlean Lord Griffiths of Fforestfach Lord Lamont of Lerwick Lord May of Oxford Lord Monks Lord Sharkey Lord Teverson Lord Turnbull Baroness Wheatcroft ______

Examination of Witnesses

Professor Gerald Holtham, Cardiff Business School, Chair of the Holtham Commission, Tom Crotty, Director, INEOS, and Charlotte Barbour, Director of Taxation, Institute of Chartered Accountants of Scotland (ICAS)

Q77 The Chairman: Mr Crotty, Ms Barbour and Professor Holtham, I welcome you to the Economic Affairs Committee. Thank you very much for joining us. Perhaps I may start by raising a question that has come up at a number of meetings, which concerns the paucity of evidence and information that is in the public domain to inform the debate about the finances for a devolved Scotland—in particular, some of the details about how the proposals will or will not work to the benefit or detriment of Scotland. Is it your view that sufficient care has been taken to provide enough information? If not, what further steps do you think should be taken to help to inform this debate which is going on and which will have a very important and long-lasting impact on the public finances of Scotland? Who would like to start?

Page 147 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Professor Holtham: I will start, Chairman. I concur with that. I do not think there is enough information in the public domain. That is probably because there is not enough information in the private domain either. There are a lot of questions that have been covered only in very broad terms. One does not really know what they mean until certain details are determined. If they have been determined, that has been kept very quiet. My suspicion is that they have not been determined and that the can has been kicked down the road in too many respects. One gets the impression that the thing is being busked, as it were, and that difficult decisions are being deferred or the parties are failing to reach agreement on them. It is therefore very difficult for the public— even the informed public—to understand exactly how these things will work out.

Charlotte Barbour: My speciality is tax, so I suppose that is my focus. I might come at this from two points of view. The Smith commission and the proposals are much discussed in Scotland. I ought to say that I suppose my evidence is from the Scottish end of things, because that is where I live and am based. Smith is quite widely discussed, but there is a slight disadvantage—well, two disadvantages. People tend to talk about Scottish taxes as though it is a case of, “Here, catch—here is a Scottish tax”, but there are quite a lot of different types of devolved taxes. We may come to that. Something that is completely devolved such as the land and buildings transaction tax, which is completely within the remit of the Scottish Parliament, is fundamentally different from the income tax or the VAT assignment that we are going to have. So, Scottish taxes, yes; the distinct features of each and what it will mean on accountability, perhaps not. Because Smith has been much more in the forefront of people’s minds recently, there is also a complete lack of knowledge of what we are getting already, which is the Scotland Act 2012 measures. Some of those—the purely devolved taxes—have been in since last April. The Scottish rate of income tax comes in next April. I do not think there is much awareness of that yet. In fairness to HMRC, it is doing its best, but that is on an operational front as opposed to a political front.

Tom Crotty: I can speak only on behalf of INEOS. I am not sure whether I am speaking on behalf of all business in Scotland, but our knowledge in this area, as probably the biggest manufacturer in Scotland, is almost non-existent and the engagement in the process has been non-existent. I would agree with your opening premise that we do not feel as businesses that we are fully cognisant of the likely changes or the impact on our business going forward.

The Chairman: Given that you agree with the basic proposition that there is inadequate information in the public domain, what can be done over the next few months? What information could be released over the next few months to help inform this debate? It is striking that a lot of the building blocks of the current arrangement— how much revenue is raised by each tax, for instance—are not available or in the public domain. What could be made available to help to inform this debate?

Professor Holtham: Apart from historical data and projections of what these various tax bases might be worth, it would be very useful, where the parties have not been able to reach agreement on exactly how to implement these things, for some

Page 148 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) statement of negotiating position, if you like, to be made public, so that people understand what the issues are and what is being deferred rather than agreed. The big one that sticks in my mind is that there will be a very complex interaction between the block grant, which all the devolved territories will continue to receive for the foreseeable future, and the devolved taxes. Some reduction in the block grant has to be made for the tax bases that are being handed over. Although you can get into rather arcane and technical detail, unfortunately those details have constitutional implications, because they determine, for example, who should be able to vote on what in the House of Commons. As far as I can see, none of these issues has been resolved. They just say, “We’ll settle it. It will be determined, with an appropriate formula”. If they cannot determine it, it will be rather difficult but, meanwhile, if they cannot determine it, let us at least know what the thinking is and where the debate is centering.

The Chairman: So a statement of differences, as it were, might be helpful.

Professor Holtham: Yes.

Charlotte Barbour: There have been quite a few criticisms and questions around the fiscal framework and the fact that a lot of what is being discussed is being discussed, I think, behind closed doors. On the one hand, that is understandable, because otherwise you would have everybody’s tuppence ha’penny-worth in relation to how it should or should not be done. At the same time, if it is behind closed doors, you cannot see it. What you need here is transparency and accountability, so that people feel involved and they understand what is going to come down. It is all very well having a tax power awarded to you, but if you cannot see how it operates vis-à-vis the fiscal framework, the Barnett formula and the block grant, because they are all intertwined, it is very difficult to know quite where you are going with this.

Tom Crotty: I cannot really add much to the expert view. From a business point of view, when we are looking for help on these issues, we tend to turn to the Department for Business, Innovation and Skills, so for us that would be a logical place to look to for advice and information.

The Chairman: Professor Holtham, when you chaired your commission, which looked into the finances of Welsh devolution, did you have access to information that was not readily available in the public domain or did you work entirely from information that was in the public domain? How did you come to conclude that that was sufficient for your purposes, if that was the case?

Professor Holtham: Yes, we mainly used information that was in the public domain. We had to carry out quite a lot of analysis on those data, so in a sense we produced our own conclusions, but the raw data were all public. We were not privy to any state secrets.

Q78 Lord Forsyth of Drumlean: May I ask Charlotte Barbour—without in any way leading the witness—whether she thinks it is sensible to bring forward legislation for

Page 149 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) discussion before both Houses of Parliament in the absence of having an agreed fiscal framework? I personally find it very difficult to look at the devolution of particular powers or the principles without actually knowing how it could work. That is the first point.

The second point is on the information that is available to companies. Have you found any evidence of people shifting companies from being Scottish-registered to English- registered? I think I read in the newspapers that Standard Life had moved its domicile south of the border. I am aware through other channels that some people are thinking about that. Is there any evidence of that? Do you think that that represents a real threat, or is it just people reducing the risk because of uncertainty?

Charlotte Barbour: Coming to your first question, I hope that you have not led the witness and that I do not cop out completely by saying that, as a member of ICAS, I represent chartered accountants, who are primarily interested in the operational sides. However, I completely appreciate your question. It is quite difficult to understand the tax powers in isolation, because your tax powers, fiscal framework and borrowing are three bits of a triangle and have to slot together.

Lord Forsyth of Drumlean: So I am not just being thick.

Charlotte Barbour: If you are, I will keep you company. I do not really understand it in isolation. It is all very well to have a tax power, but you cannot do much with it unless you know what is getting taken away or put together with it. That perhaps partly answers your fiscal framework question.

In terms of companies, we have completely anecdotal evidence from some of our members that pre-referendum they were advising that if people were to set up companies they might register them south of the border. I have not heard that kind of talk since then. As regards other anecdotal evidence, at the moment what we are really working with is the Scottish rate of income tax, because that is due to come in this coming April. There are a lot of questions about what it will be. Your experience seems to be quite common—that a lot of people do not know much about it. There is also quite a bit of talk about Scottish taxpayers, who they might be and whether the better-off ones will get up and go.

Q79 Lord Lamont of Lerwick: May I come to the proposal that has been put forward for an independent body taking responsibility for providing advice on block grant issues? Is this really feasible? Is it really suitable to be delegated to so-called experts? Is one not then attempting something rather impossible—depoliticising spending and accepting that there will be some body of so-called experts who will tell the Government where precisely to spend their money? Is that really a credible proposition?

Professor Holtham: I do not think that would be a credible proposition, but that is certainly not anything that I would advocate. Decisions on how public expenditure is to be distributed around a state are essentially political, of course. If the decision is being

Page 150 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) made ostensibly on the basis of certain criteria, there is no reason why those criteria should not be applied by an independent body. If the Government then want to override the criteria and make a political decision to do something different, they are, of course, completely free to do so. What you do not want is political chicanery, if you like, or political influences intruding—

Lord Lamont of Lerwick: But if there are elements of public expenditure determined by formula, are you really saying that you do not trust the Civil Service in Whitehall to adhere to that formula?

Professor Holtham: There is always enough latitude in a formula for it to be manipulated. It is not my view particularly, but you would probably find that every devolved politician in this country can think of at least one instance where he thought the Treasury pulled a fast one. I am sure that the Treasury thinks otherwise, but that is the case. There is not total mutual trust; that is just a matter of fact.

Lord Lamont of Lerwick: You might say, “They would, wouldn’t they?”.

Professor Holtham: Of course, but everybody is competing for resources. That is one of the arguments—if there are criteria, which will be determined politically? After all, we set interest rates without its being done politically. The Government have a general policy and somebody is charged with implementing it. I do not see that it is very different. If you have a formula, it is then applied by independent people, so people have more confidence that it is being rigorously applied. The Government can still override it at the end of the day, if they wish to. Ultimately, it is a political process, but it is not bad to keep the politics and the implementation clean, if possible.

Lord Lamont of Lerwick: Do the others want to say anything?

Charlotte Barbour: I do not want to comment on that.

Tom Crotty: I cannot comment on it at all.

Lord Griffiths of Fforestfach: If there were sufficient transparency in the process, would that not be good enough for you?

Professor Holtham: It would certainly help. I cannot see that it is very different, for example, from having the Office for Budget Responsibility not making any decisions but providing independent projections on which policy can be based. It is rather similar. You are setting up as one element of the policy an independent body to carry through the technical side of it.

Lord Griffiths of Fforestfach: But rather than having a new body, you would conceive of it being given to, say, the OBR.

Professor Holtham: Yes. The Australians, of course, have an enormously complex procedure, which I do not think we would want to replicate in this country. They have

Page 151 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) a very large independent agency that carries out lots of calculations. That would probably not be in the British tradition, if you like, but I do not see why the OBR could not do it.

Q80 Lord May of Oxford: I want to offer some second-hand opinions about the Australian thing—second-hand because my brother is a quite senior economist and Australians have quite a bit to do with it. I know what he thinks about it. The circumstances are a bit different. After all, Australia was six independent countries until it was federated about a century ago, which was a trickier thing—and still is— than dealing with just one or two, namely Wales and Scotland. The way that body is put together is basically sensible, but it is riven with not just Scotland-England, as it were, but every one of six countries having different views about things. In principle it is good and sometimes it works well, but the second-hand impression I have from my brother is that in Australia, when you have a really efficient Government and people who know what they are doing, it works quite well. However, as everywhere, you cannot always count on having that. Relatively recently, Australia has had a rather unfortunate set of chief executives, as it were.

Professor Holtham: The procedures in this country are a great deal simpler than those in Australia. In Australia, they attempt to have a fairly complicated needs assessment of each of the states. That then determines flows of public expenditure. In this country, we do not have a complicated needs assessment; in fact, we do not have a needs assessment at all. It is a very simple Excel spreadsheet, basically—there is not a hell of a lot to it. I think it would not be the same anyway.

Lord Forsyth of Drumlean: You say that we do not have a needs assessment. It is certainly true that under the Barnett formula the money is sent to Wales and Scotland, but how they distribute it is based on a needs assessment, is it not?

Professor Holtham: Yes, indeed. That is absolutely right. The devolved Governments behave like the UK Government in England in having needs assessment formulae for distributing expenditure around their states internally.

Lord Forsyth of Drumlean: If you are doing a needs assessment to work out how to spend the money on health and education, what is the complication with having a needs assessment to work out what you think it should be in the first place?

The Chairman: I think you are anticipating Lord Turnbull’s question.

Lord Forsyth of Drumlean: I am sorry.

Lord Lamont of Lerwick: We have not finished this one yet.

The Chairman: Go on.

Lord Lamont of Lerwick: I do not mind.

Page 152 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) The Chairman: No—continue, please.

Lord Lamont of Lerwick: It has been suggested that there is not adequate parliamentary scrutiny of intergovernmental relations. I think ICAS has even put forward the suggestion, which I do not find very attractive, that there should be an office of the regions, so that the devolving of powers to the different regions could be co-ordinated. Are we not going slightly mad, just having one quango on top of another?

Professor Holtham: I do not really have a view on that. I think a little more co- ordination in certain respects would not be bad. A lot of devolution seems to be—

Lord Lamont of Lerwick: What about variety and competition?

Professor Holtham: You can organise for that, but it is still not bad to organise for it, rather than just busking it in a series of bipartite discussions and ending up where you happen to end up, which is more or less what has happened.

Charlotte Barbour: From where I sit, based in Edinburgh, there are certain powers that are coming to Scotland. We argued quite strongly against devolving corporation tax. The Smith commission accepted that—not necessarily our arguments, but generally speaking—but corporation tax is being devolved to Northern Ireland. There seem to be different things going in different directions. I have given evidence to a number of different committees in Scotland and here. An office of the regions might be quite the wrong term or might be another quango that you do not want, but you wonder whether it needs some kind of co-ordination somewhere, somehow, because otherwise it seems a bit disjointed. When you come down to something much more elementary and practical, such as who is a Scottish taxpayer, I do not think you will identify all Scottish taxpayers until you also identify English taxpayers, Welsh taxpayers and Northern Irish taxpayers. That is because the system is such that HMRC is going to write to everybody it thinks may be Scottish taxpayers, but I do not know what happens to the ones it does not pick up. They will just fall down, because they are not being written to at all. In part, that is where that suggestion came from.

Tom Crotty: From a business perspective, you always want things to be as simple as possible. You need things to be as simple as possible. Certainly, that is the case when it comes to interaction with Government. If you take the situation we have today, we interact with two Governments to do business in Scotland. The process works reasonably well. The Scotland Office is very helpful in making sure that is co-ordinated and provides a useful link between both those Governments. From a business perspective, you do not want to introduce yet more complexity. Simplification is the watchword for us.

Q81 Lord Turnbull: Charlotte Barbour correctly pointed out that the nations are being funded from three boxes. There are devolved taxes, there are shared, assigned taxes and you have the grant. The first question is: is that a workable system? Do there have

Page 153 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) to be the same shares, roughly, between those three boxes in each of the territories, or can you make them bespoke in some way?

Professor Holtham: I believe it is a workable system. There is no reason to try to impose a uniformity that probably is not welcome in the three areas, anyway. The key problem is that it is not clear that what has happened is derived from a set of clear principles. I know that sounds dreadfully academic, but it would be helpful if people knew where they were trying to go and had a set of principles. Then the different circumstances of the different areas would automatically lead to somewhat different results. However, it is not clear that that initial clear-sightedness about principle has existed, so we have a much more random set of provisions. For that reason, too, people are having a lot of difficulty resolving the issue of how you adjust the block grant for the devolution of taxes. There are certain principles that should be applied there, but I am not confident that they will be.

Lord Turnbull: May I come back to that? Let us deal just with box 3, the grant—the Barnett formula. It will be a smaller box than it used to be. When people say that there is not a needs assessment, I say that there is a needs assessment. The problem is that it has only one variable, the number of people—the number of mouths to feed.

Professor Holtham: Not even that. The number of people is applied to the increment. There is no adjustment for the main block grant, even for population. It is an historical accretion, with a population adjustment applied to the increment.

Lord Turnbull: It seems to me that the starting point should be that under that system the grant per head should be the same in all three territories. How far adrift of that are we?

Professor Holtham: We are quite far adrift of that. The numbers I have in my head are not fully up to date, but if England is at 100, Wales is around 114, I think, Scotland is nearer 120 and Northern Ireland is nearer 120-something—the low 120s. I could be wrong to the nearest few percentage points, but it certainly is not the case that expenditure per head is equal—nor would you expect it to be.

Lord Turnbull: If you were to look at it on a population basis, imagine we were trying to equalise grant per head. Then these things should all be the same, should they not?

Professor Holtham: That is done in quite a few states. If you are just saying that poorer areas have less revenue, so we are going to equalise revenue per head and therefore expenditure per head, that is certainly one possible approach.

Lord Turnbull: Under the Barnett formula, we do not take account of relative income, dependency, the number of old and young, geographical issues, sparsity and so on. We have just this one thing—population—and it seems to me that we do not even do a good job of that. Step 1 would be to have something that enshrines the principle that that is where we ought to be getting to, and the new system should have some kind of

Page 154 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) convergence mechanism in it. We are always told that Barnett had a convergence mechanism, but, if anything, it has got worse rather than better. Is that the case?

Professor Holtham: The Barnett convergence mechanism fails simply because there is no population adjustment for the bulk of the block grant. The block grant works by saying, “What did you get last year? We are going to give you the same this year, except we are going to give you the same increase per head in cash terms as England”. That means that the increase per head is adjusted for population, but last year’s grant is not. If your population falls, they do not go back and reduce your block grant for that—they just reduce the increment. That is why Scotland has not had much of a Barnett squeeze, whereas Wales has—for that very reason. There is not even a population adjustment. You are absolutely right. If you were going to equalise expenditure per head, you would need to adjust the whole grant for population. Of course, that is a very controversial thing to want to do. As you say, if some area has many more old people, young people, sick people and people out of work, you will still have the same expenditure per head.

Lord Turnbull: Is it not a very controversial thing not to do it or not even to attempt to do it? That is how it looks to me, looking at this objectively. The analogy I come up with is that you send a return to the tax man and he gives you a tax code. At the end of the year, it turns out that he has not collected the right amount of tax. The next year, he changes your tax code so that you are then paying the right amount of tax and making the correction for the underpayment the previous year. The way this system works at the moment, which we are apparently going to perpetuate, is that the previous error is left in the system. The previous errors have accumulated to something that I can only describe as grotesque.

Professor Holtham: I do not disagree. I have been as severe a critic of this system as anybody else. You are absolutely right. It has nothing to recommend it except simplicity. It is extremely simple. There is nothing else to be said for it.

Lord Turnbull: You have argued for widening the variables—not to the kind of Australian grant complexity of 50 or 60, but maybe five or six would explain 90% of the difference. I cannot see how you can get that far if you cannot even get the population element of need corrected. That is the most important one. It is out of line, and there is absolutely nothing in this system that would make it any better.

Professor Holtham: I do not think we are disagreeing. I agree. It seems to me that there ought to be a system that determines the entire block grant, not just the increment. It would be perfectly possible to do that on the basis of ignoring differences in relative need and to do it just on the basis of ensuring continuous, constant expenditure per head. I would be in the camp that thinks that would be a shame, that we can go further and that, just as we do when distributing money to local authorities, we can take some coarse account—we will not fine-tune it—of relative need. That can be done, taking things such as dependency ratios.

Page 155 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Lord Turnbull: We have one other variable left, which is the adjustment of the block grant by revenue. Different formulae could squeeze the Scots more than others. Professor Cuthbert told us that the squeeze could be “catastrophic”, or whatever word he used. Of course, he has 20% to play with before the system starts to become unfair. There is a difference between adjusting according to the growth of total revenue in the UK and adjusting according to total revenue per head. Do you have a view as to which one of those we should use?

Professor Holtham: Per head—we should take account of population, of course. One can take different views about distribution. The formulae for distributing to local authorities are not identical in Scotland, Wales and England, so there is obviously scope for political dispute there, but any plausible formula would see quite a large reduction in the expenditure per head in Scotland. We calculated that 105 would be fair; some people would say 109. However, if you are sitting on 120, that is a 10% cut any way you look at it. You would have to phase that in. I do not think it would be reasonable to impose that with a bang. Once you had the formula, you would have to have some smoothing mechanism.

Lord Turnbull: I have one last comment. I just hope that in 30 years’ time people are not going around saying, “That Holtham formula—God, what a mess that was”, and it does not stick around your memory in the way it stuck around Joel Barnett’s.

Professor Holtham: If my name lived as long as Barnett’s, I would be both astonished and gratified.

The Chairman: We will have one last comment on this question, from Lord Forsyth.

Lord Forsyth of Drumlean: I am sorry—I did not mean to intrude on Lord Turnbull’s question, but the point remains unanswered. Perhaps I should declare an interest, as someone who lives in Scotland. If the formula was just population-based, there would be a 20% reduction. That money is currently being spent on free care for the elderly, free tuition for students, no prescription charges and so on. Of course, that goes to the root of the resentments that are being created, particularly in Wales, which, as you have pointed out on numerous occasions, has lost out as a result of this. Where I have a difficulty is with what was said earlier—that we could not have a needs-based system. The money is distributed on a needs-based system. I very much agree with Lord Turnbull that the starting point should be population, but then you should look at other factors: sparsity, demography and all of the things that are dealt with when money is sent out to health authorities, health boards or to local authorities. What is the difficulty with doing that, other than that Wales would suddenly find it had won the lottery?

Professor Holtham: No, it would not make much difference in Wales.

Lord Forsyth of Drumlean: The Barnett Formula Committee of this House concluded that Wales would benefit significantly, but the numbers may have changed. Wales would do better, but Scotland would lose out. Surely, the way to deal with that is to

Page 156 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) have a transitional system, so that you do not have an impact of losing 10% in one year. You might phase it in over five years, at 2% or whatever, and give people the opportunity to adjust. If we do not do something like that, will there not be continual conflict between the territories? Politicians will fight elections on the basis that they have lost out, and it will tear the kingdom apart. Is this not absolutely central to the whole question of effective devolution?

Professor Holtham: I believe it is, and for more reasons than people perhaps realise. At the moment, Scotland is slightly poorer than the UK average, but not by very much. If the oil price, contrary to my expectations, were to go to $200 a barrel, Scotland would be a wealthier part of the country. In any well-ordered system, the Barnett formula would then be negative. If you have a federation, the wealthier parts are supposed to support the poorer parts. At the moment, we have no system in place that could handle a situation where one of the devolved territories became relatively wealthy and needed to pay in. There is just no basis for working out what that payment would be. We have a situation where three or four regions of England are considerably poorer than Scotland, for example, and get much lower expenditure per head. That cannot be good. This is one of those principles that just does not exist. We are having negotiations in vacuum as far as what we are trying to achieve is concerned. If we are trying to lay down a pattern for how a multinational union will continue to work, some set of principles about how we do equalisation has to be there, and then the chips fall where they do. However, we have not got there. We are perpetuating what Lord Turnbull has correctly described as a hopeless system, with no set principles underlying it.

Q82 Lord Monks: I should like to follow this general line of questioning and to shift it slightly towards the “no detriment” principle—that there should be “no detriment” as a result of UK and Scottish Government decisions post-devolution. You have suggested that this is impossible and impracticable unless there is a “dictatorial” element—I think that was the phrase—in this. Who can play that dictatorial role? Is the “no detriment” rule sustainable?

Professor Holtham: I am afraid that I am very sceptical. I do not really think it is. Take the case that somebody puts a tax down and somebody else claims, “You have taken business off me by that tax reduction. I need compensation”. You cannot observe the counterfactual, so there is scope for infinite argument about what compensation is due. I know of no means to resolve that, so it can lead to endless argument. Everything you do could give rise to such a claim. In fact, we are now devolving things where some spill over is inevitable. If, every time you do something, you get hit with a claim for compensation, it will paralyse the system entirely. Either it abolishes devolution, in effect, or it becomes quite unworkable. I really do not think it is an operational principle. It may be something useful to put in legislation to guide the judge, as it were, if he has to deal with a case—to say what was intended—but heaven forbid that you would get the Treasury to apply it as an actual operational principle.

Page 157 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Charlotte Barbour: I would support that. In principle, if you take “no detriment” to its logical conclusion, you do not have any differences. If you do not have any differences, what is the point of devolving it? If you look at landfill tax, for instance, the rates are the same north and south of the border. That is “no detriment”. Part of you might ask, “Why devolve it if the rates are going to stay the same?”. “No detriment” also lends itself to some fantastic arguments, because tax policy is not just raising money. A whole lot of other policies are intertwined with it, whether it is environmental policy, trying to drive behaviours in certain ways or trying to attract inward investment. All of those elements come into play. I say this just for the purposes of illustration, as I do not know whether they will or will not, but if you put up the income tax rates in Scotland you could convert your income into a corporation—a company. Then you not only lose income in Scotland through not having your higher income tax rates, but you end up with UK rates. Is that to different people’s detriment? Corporation tax is lower than income tax. Is that another detriment? You could have lots of lovely arguments about it.

Professor Holtham: One of the difficulties here is that, because people have not wanted to confront differences at an early stage of the negotiation, certain things have been conceded that people would rather not have conceded. They have introduced “no detriment” as a kind of sweeper: “This is our back-stop. This is our insurance policy. If they really try to pull a fast one, we will spring this on them”. My own view is that it would have been much better to have had the hard discussion up front, because then you have to have it only once. If you said, “Look, we are going to limit what you can do with higher rates of income tax, because there is a limit to the tax competition we want to understand”, the Scots would scream bloody murder, but at least you would have the scrap and have the limitation. As you do not want to have the fight, you say, “Yes, do what you like with it”, and then bring in “no detriment” as an attempt to sweep. I just think it is folly; I really do.

Charlotte Barbour: If you were being more generous, you might just say that people have looked at this, certainly from a Scottish perspective, in terms of accountability. They have not really appreciated that, once you have your own taxes and are accountable for them, inevitably you will end up doing something different with them, because otherwise why have them? Then your flip side comes into competition/tax avoidance, which is the other side of competition. You get some very mixed messages from it.

Lord Monks: The Barnett formula, as we know, has become a tablet of stone, and all sorts of commitments have been given. The “no detriment” principle is close to becoming another tablet of stone, brought down from the Highlands or somewhere. I understand that in Scotland people are regarding it as a high-level principle. Navigating your way through these things to have a sensible discussion about technical matters such as population, economic growth and so on is an extremely difficult task—I am not saying it is impossible, but it is extremely difficult—without the rancorous political games that Lord Forsyth was talking about and that people will play, blaming other

Page 158 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) people. Do you have any feel for how we can avoid that kind of disputatious future on these issues?

Charlotte Barbour: Do you not need to draw up parameters around what “no detriment” means? If you go back to the Smith commission, it is very principle-based. He says there will be no detriment and has his first principle and his second principle. However, one could set parameters around that to say what you actually mean by it, because it can get up a head of steam that it does not need to have. The underlying concept is very broad.

Professor Holtham: Where you are devolving taxes on mobile tax bases, where tax competition and mutual detriment become a real risk, you really ought to have some protocols in place as to how far people are expected to use those powers. If Scotland decided to turn itself into the Isle of Man, it could successfully cannibalise the entire British income tax system. I do not think for a minute that it would do it, but basically you want to say up front, “We do not mind you cutting the top rate by 1p, 2p, 3p or 5p, but beyond that, no”. You need some protocols in place in order to avoid having to have recourse to this “no detriment” principle. You have the scrap upfront and do not try to postpone it.

Charlotte Barbour: Perhaps you want to define what might be deemed to be competition, as opposed to “no detriment”. For some people, they might be different things. Of course, you are slightly confined, because the main tax that is being devolved is income tax. Given that income tax is still part of the UK system, there is a limit to how far you can go anywhere with it. If you upped the income tax too much, people would head towards corporation tax or capital gains tax, capital gains-taxing their block on income tax avoidance—is that not the case? I think there is only so far you can go on any of these things. Again, there is only so far you can go in putting up income tax. While it gives a political message, I do not think you will collect any money from it—or not much.

Lord Sharkey: I wonder how there can be competition without detriment.

Charlotte Barbour: It depends on how you define them, does it not?

Lord Sharkey: No. In the common-sense definition of the words, I would have thought it was impossible.

Professor Holtham: I entirely agree. The point is that you have to decide what is the permissible extent of competition and specify that upfront. Then the detriment business does not come into it.

Lord Forsyth of Drumlean: Is it not more complicated still? It is not just about tax. For example, when I was Secretary of State, in England they privatised water. In Scotland, we decided that we were in enough trouble, so we did not privatise water, but we then lost the Barnett consequences of the money that was spent on water—the whole amount. Under the “no detriment” principle, if we had that now, the English, having

Page 159 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) privatised water so that people got their bills, would presumably have to send a cheque to Scotland to compensate them for the fact that they were now having to pay for their water. Is that right?

Professor Holtham: That is just an instance of how difficult it would be to apply a “no detriment” principle.

Lord Forsyth of Drumlean: Yes, because policy that has revenue implications for Barnett—moving things into the private sector or nationalising things—would have consequences. For example, if a Labour Government decided to nationalise industries in England, presumably the reverse would apply. I just do not see how this is workable.

The Chairman: Can we move on?

Q83 Baroness Blackstone: Leaving “no detriment” to one side, do you think the package of taxes that are being devolved is the right one? Is there a rationale for it, or is it just a matter of more political horse-trading without any real rationale to explain the decisions that are being made?

Charlotte Barbour: Do you want me to go first, as a tax person?

Professor Holtham: Please feel free.

Charlotte Barbour: Who knows whether it is the correct one? You could have any kind of different combination, but if you want to make it work, you can make it work and therefore it would be correct. It is for everybody to pull together and make it work. I think it is too soon to judge, because it has taken a while for the 2012 measures to start to come in. Now we will move on to the next Scotland Bill’s measures; we will need to wait and see when they come in. There are sensible reasons for quite a lot of what is being done. If you look at the purely devolved taxes such as land and buildings transaction tax, it is a discrete tax that does not have much knock-on effect on other taxes, so it sits on its own. It is quite sensible to devolve that. Its locus is on property— you cannot really argue about whether or not it is in Scotland. That is a nice, easy thing to devolve. There is a lot of sense around those smaller taxes that are location-based.

On income tax, first, the Scottish rate of income tax was mooted. Now there are the Smith proposals for rates and bands to be devolved. From an operational perspective, there is an awful lot of sense in that, because you will still have the underlying UK tax legislation. You do not have to write a completely new tax system, so that is an advantage. It keeps things intermeshed. We still have HMRC collecting it and, more importantly, if you are talking about employers, we have PAYE, so your main collectors of the tax will not be unduly put out—they just have to work with “S” codes, for a Scottish taxpayer. Those make a lot of sense, yet when you look at income tax, you think it is partially devolved. There are UK levers in it and Scottish levers in it, because it has not been completely devolved. Again, is that correct? Could it lend itself to arguments? It could, but there are a lot of sensible reasons for doing what has been done.

Page 160 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) I am less convinced on VAT. I do not know how you calculate what is a Scottish bit of VAT in the way the VAT system works. If you calculate it properly to reflect the economy, you may have unintended consequences of that becoming a driver of where you target your economic measures—on to VAT-able things, because you would want your VAT up. Of course, financial institutions tend to be exempt. Food industries tend to be zero rated. I think you would have a lot of problems with the VAT, if it works.

Baroness Blackstone: What are you saying about VAT? Should it be based on the point of production or the point of consumption? Which is the right way to do it?

Charlotte Barbour: Take your pick. You could argue the case on any way of divvying up the VAT. I do not think you get the VAT to work properly unless you set up borders, and who would want more borders? It runs completely contrary to the notion of VAT, does it not, where there is a common market? I question the rationale for it.

Baroness Blackstone: You have not mentioned corporation tax.

Charlotte Barbour: No, thank you.

Baroness Blackstone: Where do you all stand on corporation tax?

Professor Holtham: To answer your first question, there are certain principles that you would want to apply. You want to devolve taxes that have few spill overs and are clearly local taxes. Property taxes are quite good, because the tax base does not move around.

Baroness Blackstone: That is the easy one.

Professor Holtham: That is the easy one. Secondly, you want a tax that is paid by a lot of people. If the idea is to introduce accountability for the devolved Government, you want a tax that is paid by a lot of people, is visible and makes a substantial contribution to their budget, which is the argument for income tax. I do not think there is any problem about the basic rate, because there is no tax competition about the basic rate. If you put the basic rate up by a penny, it will not cost anybody more than 300 quid a year. That does not pay for the removal van, so nobody is going anywhere. It is only the top rate of income tax where tax competition comes in. In my opinion, there should just be a protocol saying, “We will agree that we will not change this by more than X”. Then you do not get into problems about “no detriment”.

The problem with corporation tax is that the Treasury refuses to take seriously where the liability is incurred. In this country at the moment, the liability is incurred where you register the company. As far as I can see, “no detriment” came in because there was a political commitment to give the Northern Irish corporation tax. The Treasury was utterly appalled by that, so it did a calculation of how much revenue would be lost if people went and brass-plated their business off to Northern Ireland. It then announced that it was going to have a “no detriment” principle, so the Northern Irish would compensate them for the brass-plating. In an orderly universe, the Treasury

Page 161 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) would just have said, “We are going to have a proper assessment of your corporation tax liability”. They do this in other countries; it is not impossible. It is some combination of turnover, investment and where your payroll is paid. You pay tax at the highest rate unless you, the company, can show via this formula that you are entitled to the discount because some of your business is held in the low tax region—and we do not care where you are registered. If they did that, you could talk about whether it was possible to devolve corporation tax to some extent. While you assess liability on the location of the brass plate, it is absolutely impossible. Maybe you do not want to devolve it, so it does not arise, but if you wanted to do it, you should not be doing it like this.

The Chairman: Where is INEOS’s brass plate, Mr Crotty?

Tom Crotty: We have lots of brass plates in a lot of different countries. As far as our UK business is concerned, including our Grangemouth business, it is actually south of the border. We are registered with the UK for tax. If you look at the driver behind that, we made that change a few years ago because the UK Government were helping enormously with our issues in sorting out Grangemouth and making UK guarantees available for investment in the site. It seemed only sensible that we returned the favour by making sure that we paid our taxes in the UK. That is why we have gone that route. Going back to your original question, Baroness Blackstone, we are free marketeers and the whole thing sends us into a spin. Yes, it does feel like the result of a horse-trade. It is very hard to see the market logic that sits behind this.

The Chairman: By the UK, do you mean England?

Tom Crotty: Yes. Sorry, it is easy to slip into this terminology, is it not?

Q84 Baroness Wheatcroft: Do you think there is emotional impact from devolving income tax in its entirety? Alistair Darling, for instance, has talked about it. He said, “I am paying my income tax in Scotland. What am I getting for it? Where do I buy into foreign policy, defence and so on?”. Is it just driving the union further apart?

Professor Holtham: Forgive me, but I think that depends on how you handle the deduction from the block grant. The sensible thing to do would be to restore that link, because first you would make a deduction for the income tax that the Scots collect in year 1 and then you would say, “That cannot change with their revenue, otherwise we are cancelling out devolution. If they change rates, they get more or less money. However, we are going to index that deduction to tax receipts in England”. That has the following implication. Suppose the British Government decide to go to war in Syria and are going to raise income tax to finance it. Defence is a reserved area, so the Scots are supposed to pay their whack for this war in Syria, or whatever we are doing. If you have indexed the deduction in the block grant to UK income tax, they will do so, because when UK income tax rises, the deduction from their block grant rises, the block grant goes down and they have paid their share of the war.

Baroness Wheatcroft: We are all in it together.

Page 162 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Professor Holtham: Exactly. On the other hand, if there is an Ebola outbreak in England, so we are going to spend a lot more money on the health service and are raising income tax to finance it, that has two implications. Raising expenditure in England on health will increase the block grant to Scotland via the Barnett formula. If you have indexed the deduction to English revenue, the deduction from the block grant goes up as well, and it is very nearly awash. In other words, the Scottish grant is net not affected, or not affected very much, which is exactly what you want. If the British Government are raising taxes to spend on devolved items, the Scottish block grant should not be affected. If they are raising income tax to spend on reserved items, the Scottish block grant is supposed to be affected. There is a way through this. You may think it is slightly round the houses, but there is a way through this to a sensible outcome, if you handle the deduction from the block grant in the appropriate way. If you do not, you are in exactly the situation that you describe, where we go to war and the Scots do not pay for it. The devil is in the detail.

That has another implication, of course. If you do that, changes to English taxes affect the Scottish block grant, which I think is appropriate. However, if that is the case, you cannot possibly tell Scottish MPs that they are not allowed to vote on English income taxes, because there is no such thing as an English income tax that does not affect the Scottish block grant. We are all in it together, both in terms of voting in the House of Commons and on the implications of changing English income tax. However, for that to work, you must have that indexation mechanism. I am not clear that they are thinking in those terms.

Lord Forsyth of Drumlean: I absolutely agree with what you say about having to link the block grant to the thing, but hang on a second here. If it is linked to tax revenue in England, suppose you have an English Government pursuing what I would say are sensible policies. Suppose they have cut the top rate of tax and the revenue has gone up, and in Scotland you have a not very sensible Government who have put up the top rate of tax and the revenue has gone down. Perhaps I have not thought this through properly, because you have just put it into my head, but would your formula not result in the Scots being rewarded by getting more revenue because in England, where they were pursuing sensible tax policies, the revenue will have gone up, whereas north of the border they are pursuing non-sensible tax policies that have reduced revenue? Would that not create a degree of resentment among the English that they were sending more money to Scotland because they had pursued a daft tax policy?

Professor Holtham: I will try to answer that. What you are trying to achieve is that Scottish revenue depends on the actions of the Scottish Government but is not affected by actions of the English Government—at least, not very much.

Lord Forsyth of Drumlean: Agreed.

Professor Holtham: If the deduction is indexed to English taxes, anything the Scots do that affects their taxes stays in Scotland—they shoulder those implications—so the second bit of your point is handled.

Page 163 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Lord Forsyth of Drumlean: I was making a political point.

Professor Holtham: However, it is the case that, if the UK Government reduced taxes, the immediate impact of lower revenue would mean a lower deduction and a higher Scottish block grant.

Lord Forsyth of Drumlean: I am making a leap.

Professor Holtham: If they go up still further because of secondary effects—

Lord Forsyth of Drumlean: I think that if you cut the top rate of tax you will get more revenue, but that is a tendentious point. If they changed their tax policy in a way that the Scottish Government were opposed to but that resulted in their getting more money, is that not rather difficult to explain?

Professor Holtham: It may be difficult to explain, but there are rather few instances where it is a perverse outcome. It is generally what is supposed to happen. If you think through why people are doing it, what they are spending the money on and the implications, it is generally appropriate that that indexation takes place.

Lord Forsyth of Drumlean: I have another example. This is a real example. Suppose in England they introduce a graduate tax to pay for students who have gone to university. That would result in more revenue, while in Scotland they maintain free tuition.

Professor Holtham: No. You are indexing it just to income tax revenues, not the total tax revenues in the UK.

Lord Forsyth of Drumlean: All right. The principle is the same.

The Chairman: Baroness Wheatcroft, do you want to add anything?

Baroness Wheatcroft: It is just a supplementary, if I may, particularly to Charlotte Barbour. Although income tax is going to be devolved, it will not include tax on savings and dividends. Do you see any problems with that? Is it just a practical issue? Is there a logic in it that we ought to be able to overcome?

Charlotte Barbour: I suppose the logic is that savings are a longer-term thing. It is tied into your longer-term savings—it is not income year upon year. There is an operational sense to it, in that lots of people have £5.50 in their bank accounts, so do you really want to diddle about with getting a different rate of income tax on that? Until next April, income tax has always been withheld at source at one rate. In pure operational terms, it makes a lot of sense. For those who have higher amounts of business dividend income and interest income, especially with the changes that come in after next April, it is more complicated, because you have some income liable to the Scottish rate and some income liable to UK rates. For the majority, it works well.

Baroness Wheatcroft: Mr Crotty, do you have any views on that?

Page 164 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Tom Crotty: No, not really. I would agree with what Charlotte has just said. It is not an issue.

Lord Forsyth of Drumlean: Could I come back to Professor Holtham? Surely a graduate tax would be income tax.

Professor Holtham: It depends on how you classify it.

The Chairman: As we dive deeper, there are more areas of potential confusion and argument. That seems to be the—

Professor Holtham: Yes. As Poul Anderson said, there is no problem, however complicated, that when looked at in the right way does not become still more complicated.

The Chairman: We may quote you.

Q85 Lord Griffiths of Fforestfach: I would like to address this question in the first instance to Mr Crotty. If I were a Scottish businessman, as a result of this afternoon’s discussion I would be confused and would feel I had a major uncertainty in planning what I am trying to do and so on because there is so much uncertainty. Can you tell us what the feeling is in Scottish business about the competition there may be between different countries in the UK and the possibility of people and companies moving— even moving offshore, if that gave greater certainty? Secondly—coming back to Professor Holtham—if you want to introduce some certainty into it, you need principles and some sort of structure and foundation to it. What would business want there to be?

Tom Crotty: Coming back to your opening question, there is confusion and therefore uncertainty. Whether that uncertainty is sufficient to cause people to take action to try to eliminate it—let us say by moving south of the border or even moving offshore entirely—will depend on your business. It would not apply to a business like ours, where the investment in Scotland is so enormous. It is not something you walk away from or pick up and move. We are wedded to a huge operation in Scotland. We are in the process of spending another £300 million on that site as we speak, so we are there, come hell or high water, almost regardless of the fiscal regime and the governance. That applies to a lot of the bigger manufacturing industry. In the service industry—we talked about Standard Life earlier—it is obviously much easier to take those decisions. There is a risk that, if uncertainty is high, service industries will choose to try to reduce that uncertainty by physically relocating. That would be my view.

Lord Griffiths of Fforestfach: What about the second question? If you wanted to have more certainty going forward, what sort of arrangement commitments would you want from the Governments together to give you that certainty?

Tom Crotty: For our type of industry—large-scale manufacturing—the issue is usually around investment and certainty of investment. We are investing in an asset base that

Page 165 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) probably needs at least 10 years of certainty before we make an investment—probably longer. Earlier, I mentioned the investment of £300 million that is going in at Grangemouth. We need a runway ahead of 10 or 15 years of certainty to make that sort of investment, to get it back. At the moment, we would do that through a dialogue with both the Scottish Government and the UK Government, because we need to do it that way, and some assurances that we will not see significant fiscal changes that would impact on our investment. That works at the moment for us. We are big enough to have those conversations at a high enough level of government to give us the assurance. A lot of other companies would not be big enough to have that type of access or assurance.

Lord Teverson: I want to follow that up with Charlotte Barbour. Are her members tooling up to take advantage of all these different tax differentials? Do they see this as a great opportunity to get more business from clients?

Charlotte Barbour: I am not sure that it is a great business opportunity, perhaps for a couple of reasons. If you look at the purely devolved taxes such as land and buildings transaction tax, it is quite a niche tax and is run by the lawyers, as it is about purchasing property. We can park that to one side. Accountants would be involved only in reorganisations and group restructures—that kind of area. If we look at the income tax, one of the strengths of what is being proposed is that it will operate through PAYE. At the moment, employers and some of our members are slightly nervous about it, because we are still waiting for HMRC to roll out the general information programme. That is not to be done until the rate is set, understandably, but once it is in place I think employers will find that it is very little different from what they do today with PAYE. You will simply get a separate tax code for any Scottish taxpayer—an “S” code. Just stick it through a different bit of the machine, because the rates are different, and that is it.

Q86 Lord Teverson: Could I move on to the other area of fiscal policy, which is borrowing? Following the Smith commission’s proposals, what additional borrowing powers should Scotland receive? I am particularly interested to understand whether you think Scotland is of a size where it has to have borrowing powers. Some of our witnesses in the past have said that that is absolutely essential, but local authorities in the UK and individual government departments in the UK with grant in aid have to balance their budgets. Even the EU, with a budget of €148 billion, has to balance. Is it necessary, or what should happen?

Charlotte Barbour: ICAS has more interest in the mechanics of the tax side. However, when it comes to tax and the fiscal framework, you must have borrowing to make your tax work. Obviously you want prudent, sensible borrowing that is balanced between this generation and the next, but you need something to make your tax work. Beyond that, it is a much more political decision as to how much you want to—

Page 166 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Lord Teverson: What do you think about the sort of limits we have at the moment? I think it is £200 million, and loans have to be repaid within four years. Does that have to be increased or larger for things to work?

Charlotte Barbour: I do not have particular views on that.

Professor Holtham: There is a need for borrowing for capital investment. Just to take an example, the Welsh budget is about £15 billion a year, of which £1.5 billion or something is capital. If they want to build this chunk of the M4 around Newport, that is going to cost £1 billion. If we did it over three years, you are wiping out nearly 30% of your capital budget on one project. Why would you not want to spread that over 10 years or whatever, especially at these interest rates? I think it is perfectly reasonable, in terms of capital budgeting and management, that you have the ability to spread those very lumpy expenditures.

I do not have strong views on exactly how much they should be allowed, but it would be good if there were a principle that said, “All right. There is a certain debt you can carry relative to your income. We can assess your income. You should not be carrying debt of more than X% of your annual income, which would give you this amount”. I do not think anybody should complain about that. At the moment, though, we are just told that it is £200 million. Why not £201 million? It is completely arbitrary. Again, it would be useful to have some principles. As you have remarked, you need to borrow for budgetary management, if you have tax receipts coming in and they are variable, but there is also a case for spreading capital investment for very lumpy items. It is not impossible to derive sensible limits. If you just look at the fluctuation of revenue, that should tell you what your requirements are likely to be, worst case, for short-term borrowing and so on. I have no objection to limits. I do not think it is appropriate to say, “Borrow what you like”—certainly not—but there are certain principles that you could use to derive those limits within—

Lord Teverson: A bit like the mortgage industry or whatever.

Professor Holtham: Yes.

Lord Teverson: I am particularly interested in your infrastructure example in Wales and the M4. You are saying as a principle, as an area of real potential difficulty, that this problem is really going to be in devolved areas where there is major infrastructure expenditure. I do not quite understand, therefore, why in Scotland, with these sorts of paltry amounts, it is not a problem already, given the sort of rail investment that is taking place on a number of lines.

Professor Holtham: But they have had a number of fixes. They have been allowed to borrow. For the Forth Bridge, there was a one-off deal. The Scots are very good in the back room. The Welsh are lousy at it, but the Scots are very good at it. They work that back corridor much better than the Welsh do. There have been a few fixes for things like that.

Page 167 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) The Chairman: Can you point us to any examples of devolved financial arrangements that have a formula in them for borrowing by a devolved part of the country?

Professor Holtham: I am sure I can, Chairman, but I cannot do it off the top of my head. I can send you something afterwards.

The Chairman: So this number has just been picked out of the air, has it?

Professor Holtham: Yes, as far as I am aware. If there has been thinking behind it, it has not been made public.

The Chairman: Over five years, it will be £1 billion of borrowings. Under the rules, could Scotland decide to bring that forward to accelerate an infrastructure programme? Is that permitted?

Professor Holtham: No. In fact, it is much worse than that. Not only have you not been able to borrow, you have not been able to save either. There were very limited rules in place—end-year flexibility rules. We argued for them to be loosened so that countries could underspend deliberately in order to accumulate reserves or capital, and they were actually tightened. If you do not spend the money, it is gone. Essentially, you cannot borrow very much and you cannot save at all, which makes capital budgeting more difficult than it need be.

Q87 Lord Sharkey: If Scotland had a modern equivalent of the Darien expedition and it became necessary for the UK Government to consider bailing it out, do you think that we should be able to do that or that, as some people have proposed, we should legislate so that in theory we cannot do it? I accept the obvious observation that it is very odd for a sovereign country to declare that it will not bail out a constituent part of the country, but what do you think? Should we legislate so that we do not bail out Scotland?

Professor Holtham: The federal Government do not bail out states in the United States, at least not formally. The difficulty is that the market would not believe it. The British Government would say, “We are not going to bail them out”, and the response would be, “Oh yeah, that is what they say”. There is what economists call the time inconsistency problem. You are supposed to say that you will not beforehand and then do it when it happens. That is a difficulty. I do not see any reason why you should not say, “There is no bail-out”. The point then is that you can protect essential services in the country, but you are not going to bail out the lender. It is the lender’s risk—be aware of the risk you are running. That will be reflected in interest rates. I see no reason why you should not do that.

Lord Sharkey: What would the implications of that be for the conditions of the people who were living in Scotland at that point?

Professor Holtham: Their Government would be slightly more prudent in their borrowing and would have to pay slightly higher interest rates.

Page 168 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Lord Sharkey: After the event, of course. I am talking about the implications if this Government refused to bail out Scotland. Surely the effect on the people north of the border would be disastrous.

Professor Holtham: I am not clear why. You certainly would protect the provision of essential services. You would not let the creditors come in and distrain the Government of all their assets. They could not take over the hospital and sell it for housing or something. You would have to protect that. It would be a case of “Let the lender beware. This is not guaranteed. It is not guaranteed either by the assets of the borrowing Government or by the revenue of the British Government”.

Lord Teverson: Do you not then start in the real world to have all the issues that Argentina has had with assets worldwide? The Scottish Government could own something that is going to be repossessed. Do you not get into all of that legal vulture fund stuff, or whatever the—

Professor Holtham: I do not see why you cannot write the bond contract that says, “This is payable on the faith and credit of the Scottish Government. You have no claim on public assets in Scotland”. You can just do that. It would have consequences for the interest rate, but that is the way it is.

Lord Forsyth of Drumlean: We did have the modern version of the Darien scheme—it was called the Royal Bank of Scotland.

I think this is crucially important. I have not been the greatest fan of devolution, because I could never quite work out how it would work, but now that we have got to the point where people believe they can have a Scottish Government who are made accountable and raise their own revenue, surely borrowing is crucial. If you do not have borrowing, effectively you have a Government who must always have a balanced budget and cannot adjust for the economic cycle. In thinking about this, I am a little confused, but surely the amount that the Scottish Government would be allowed to borrow would really depend on the arrangements that are reached—going back to where we started—on how the grant would be affected by revenues and how they would operate towards the normal business cycle. Does this not all have to be pulled together?

I am really asking the same question I asked at the beginning. Is it not essential that you work out this so-called fiscal framework—the rules and principles—and have it on the table before you start to consider what powers you are going to give? You cannot just say, “You will have some borrowing powers and you will have some of that”. I am very concerned that in a few weeks’ time the Scotland Act—the next one, before the other one has even been implemented—will come. Of course, if it is a negotiation, the Scottish Government will always say, “That is not enough”, which is what has been taking place all summer. What would your advice be to the Government as to how to bring this to a conclusion and ensure that we get legislation that reflects that fiscal framework?

Page 169 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) Professor Holtham: I entirely agree with your position. Of course there ought to be some architecture around this. You are quite right. Once you have decided what taxes are devolved, you know—you can work out—what the worst-case fluctuation in revenue might be. If you have income tax but you do not have business taxes, there will be a certain volatility in your tax receipts. If you have business taxes, there will be a much bigger volatility in your tax receipts. So yes, you have to know what you have in order to be able to say what the borrowing requirement might be.

Let me take a worst case. If we get a recession half as bad again as 2008, what will happen to your revenue, because that is how much you can borrow for two, three or four years? You just have to take a view on what might be required, and that would be the outer limit for short-term borrowing. For long-term borrowing, I would do it just on a debt ratio. The British Government are running 80% of GDP, so the Scottish Government can run 20% of their GDP or something. I would do it something like that. However, for the short-term stuff, you have to know what you have in order to know how much borrowing you need to buffer for fluctuation.

Q88 The Chairman: The arrangements that are being proposed seem to me to be a recipe for confusion and argument. Given that we are where we are in this process, what particular recommendations could each of you offer that might help to clarify the rules and principles, so that at least some of the areas for dispute are potentially reduced?

Charlotte Barbour: Let me start by going back to the “no detriment” discussion. There are some parameters needed around that, just to make it sensible. It is there and you will have to make it work, so you need some kind of parameters about what it means and to what extent you can take it.

In my specialist area, which is taxation, there is a great deal of confusion. People do not really appreciate what is coming. I do not think that is the fault of HMRC, because it is there to do the operational side of it. Of course, if most of it is collected by PAYE, PAYE was never designed to maximise the profile of income tax, was it? It is plucking the goose with as little hissing as possible. On the tax side, there need to be messages from outwith HMRC on a more accountable, political level, so that people know what is coming, why it is coming and what it will give them. Coming back to your question, will it lead to hypothecation—that income tax equals health and education? I do not know, but it needs to be talked about more broadly, so that people know what is coming. Those are the areas I would focus on from my specialisms.

Professor Holtham: One of the difficulties is that it is the Scottish situation that is driving this. That is a negotiation with, on the one side, a Government who are not particularly interested in arriving at stable, workable, federal relations. In fact, if they are unstable and there are lots of grits in the oyster that might give rise to the pearl of independence, they are happy. That is one of the difficulties—you are not negotiating with the same end in mind. I am afraid I do not have a solution for that one.

Page 170 of 420 Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) It seems to me that it would have been better if the British Government had stated some principles about what they think are essential features of the architecture of a federal state. We do not mind going to federation, but even a federation requires certain things. It requires a certain readiness to accept a sensible scheme of income equalisation, for example, whether it is just revenue equalisation or needs-based— something based on the principle that when your time comes you will pay as well as receive, and we know what it is. That would be a first thing, which really precludes so- called fiscal autonomy. Fiscal autonomy is independence. Fine, go independent, but we cannot do fiscal autonomy in a federal state—it is just kidding ourselves. You have to state these principles and then try to stick to them in negotiation, otherwise you get in a terrible mess.

You could also flesh out some of the details such as how we are going to compensate the block grant for the tax devolution, whether we do it in the way I have suggested or in some other way. At the moment, we do not know how they are going to do it. I do not think they know, so no wonder there is confusion in business ranks. We do not know what is going on. You have to have a certain set of principles, you have to state them and you have to stick to them. I do not think you can save the situation by reverse Danegeld and just saying, “Yes, yes, yes”, to whatever is being asked for, because the other lot do not want this to work. That is the point. You have to say, “We are not going any further than that. That is it”. There are quid pro quos. That means that we are not going to try to chuck you out of Parliament and tell you that you cannot vote on things, because everything affects you. We are all in this together. That would be my approach.

Tom Crotty: To go back to the conversation we had earlier, this is a confused position. It is the result of a horse-trade. There are still huge uncertainties over a number of elements. From a business perspective, we do not like uncertainty, as we said earlier. We need to have those uncertainties resolved as soon as possible and then explained, because they have not really been explained. However, you caveat all that by going back to the point that Professor Holtham made. I personally believe that if we think this is the end of it, think again. Ultimately, there is a desire in the Government in Scotland to go beyond whatever is agreed, so there will never be a situation where both parties say, “Thank goodness we sorted that out. We can all go and relax now”. That is just not going to happen. I do not see the uncertainty disappearing any time soon. However, we need at least to resolve the outstanding issues in what we already have from the Smith commission, to put a line in the sand and say, “That is what we are going to do”, and then to explain the implications of that to business.

The Chairman: Mr Crotty, Ms Barbour and Professor Holtham, thank you very much indeed. It has been a very helpful discussion.

Page 171 of 420 INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007) INEOS; Professor Gerald Holtham, Chair of the Holtham Commission; Charlotte Barbour, Institute of Chartered Accountants of Scotland (ICAS) – Oral evidence (QQ 77-88) (DFPOE0007)

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Institute of Chartered Accountants of Scotland (ICAS) – Written evidence (DPF0010)

House of Lords Select Committee on Economic Affairs

The devolution of public finances in the United Kingdom

Evidence from ICAS

About ICAS

1. The Institute of Chartered Accountants of Scotland (“ICAS”) is the oldest professional body of accountants. We represent around 20,000 members who advise and lead businesses. Around half our members are based in Scotland, the other half work in the rest of the UK and in almost 100 countries around the world. Nearly two thirds of our members work in business, whilst a third work in accountancy practices.

2. ICAS has a public interest remit, a duty to act not solely for its members but for the wider good. Evidence provided by ICAS representatives’ aims to inform in a positive and constructive manner. ICAS is apolitical and will not take a stand for or against a particular political position. From a public interest perspective in relation to tax, our role is to share insights from ICAS members in the many complex issues and decisions involved in tax system design, and to point out operational practicalities. Our representatives also contribute based on the collective experience of decades of work which ICAS members and staff have undertaken with both the UK and Scottish Parliaments and the tax authorities on the shared agenda of a better- balanced outcome for all tax stakeholders.

General comments

3. ICAS welcomes the opportunity to contribute to the call for evidence from the House of Lords Select Committee on Economic Affairs for its inquiry into the devolution of public finances in the United Kingdom, issued in June 2015.

4. Our evidence is restricted to ICAS areas of specific expertise, covering the operational design and administration of taxation arrangements plus commentary on aspects of borrowing powers. Much of our evidence is based on our experience with the introduction of Scottish taxes.

Specific Questions: Fiscal Framework

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Questions: What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

5. Response: we have no comments on these questions.

Questions: Is the correct institutional framework in place for the devolved governments and UK Government to discuss these matters? What processes will need to be in place to make new settlements sustainable and effective? Are there lessons the UK might take from other countries that have devolved spending and revenue raising powers?

6. Response: It will always be difficult to judge whether the correct framework is in place in which to discuss the principles of devolving powers, not least because this is a changing and evolving landscape.

7. There needs to be some form of inter-governmental machinery and this requires a delicate balancing act, which ultimately must rest upon respect, trust and common interests. The machinery needs to be designed in order to facilitate the sharing of powers between different governments, and made strong enough to be effective but without taking on the powers themselves (intentionally or otherwise). It is also the case that joint institutions can be caught in the middle, thereby becoming ineffective. As a result, inter-governmental machinery needs to operate under memorandums of understanding that are principles-based to provide clarity and transparency. They are also best served with appointments who understand both national and devolved governments and who can establish the common interests, aims and objectives.

8. Intergovernmental relations would also be strengthened if there was an Office of the Regions, or similar, so that the devolving of powers, for example to Scotland, Northern Ireland and Wales, could be coordinated and also so that individual devolved authorities may learn from sharing experiences in a formal, coordinated forum.

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9. At present, in relation to the devolution of powers to Scotland it would appear as though a significant number of governmental bodies and parliamentary committees, at both Westminster and Holyrood, are conducting work on aspects of the Smith Commission and Scotland Bill implementation. However, from our perspective it would appear at times their respective workloads are overlapping and some efforts to coordinate this should be considered.

Question: How should block grant funding reflect devolved tax and welfare powers?

10. Response: The Smith recommendations start from the premise that the Barnett formula will remain in place, but adjusted to reflect devolved powers. However we question whether there is currently transparency or understanding by the general public and many policy makers of the principles of the block grant allocation or the Barnett formula. Better information on this starting point would assist understanding of the adjustments to reflect tax devolution.

11. The mechanisms that are required to reflect adjustments will need to find a balance between a broad-based approach and a detailed approach. With a broad, principles-based approach it should be easier to conclude that the result should give the desired outcome. However given the starting point with the current Scotland Bill clauses is at a detailed level, a methodology of working through specific examples and illustrations will be required to ensure proper alignment with the principles-based proposals, and aimed at ensuring the desired ‘no detriment’ outcome. To have effective mechanisms will require analysis, relevant statistics, and resourcing to undertake the work.

Questions: How should future changes to the block grant be decided? How should the Smith Commission proposal of “no detriment” apply over time?

12. Response: Before deciding upon the mechanisms, there needs to be agreement as to what might constitute “no detriment”. In plenty discussions on this topic, there has been a lack of consensus of what might be detrimental and therefore should be taken into account in rebalancing adjustments, and what might simply be tax competition and might be part of the rationale for devolving a particular tax power.

13. Because taxes are used to deliver a wide ranging number of policies, such as to raise money, and to encourage certain behaviours, for example recycling with Scottish Landfill Tax, it may be difficult to disentangle the “no detriment” element that one would expect to analyse and calculate purely in monetary, tax raising terms.

14. This can be further affected by the contradictory policy aims of using potential tax savings, for example in UK taxes offering ISAs or capital allowances to encourage certain behaviours, but which can then be castigated as tax avoidance. Isolating

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what constitutes “no detriment” from such a range of policy aims will require considerable care.

15. Once such points are addressed and agreed, it may then be easier to identify the appropriate mechanisms with which to calculate and give effect to the ‘no detriment’ principle. Agreeing the appropriate adjustments at the outset will be one task, however the subsequent adjustments for later years are likely to be increasingly difficult to determine.

Questions: Should devolved governments receive further borrowing powers? What form of contract between the UK government and the devolved nations will prevent bailouts of governments that do not stick to their borrowing limits?

16. Response: We have considered the issue of borrowing powers in our responses to other inquiries on the devolution of further powers to Scotland. Our focus in those previous responses has been on the need for additional borrowing powers for preventative spend to be considered as part of any negotiations between the UK and Scottish Governments.

17. Our comments have been in the context of our support for a shift from crisis spending towards preventative spending by the public services and we have similarly limited our comments here to this aspect of additional borrowing powers.

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18. We do not comment on the extent to which borrowing powers should be increased to accommodate revenue borrowing for preventative spending as this would be a matter for negotiation between the Scottish and UK Governments nor do we comment on how constitutional arrangements should be revised to accommodate the additional borrowing powers proposed in the Smith Commission Agreement.

19. However, borrowing must be affordable (for the jurisdiction undertaking the borrowing), sustainable and prudent and should be shared proportionately with future generations. Therefore, borrowing powers, in the context of the fiscal framework must be structured with these principles in mind whether these are exercised to fund shortfalls in taxation revenue, investment in assets or for preventative spending.

Borrowing for preventative spending 20. At present Scottish local authorities can borrow to fund capital within the bounds of the Prudential Code and the Scotland Act 2012 gives limited borrowing powers over capital and revenue which are expected to be extended further following the implementation of the Smith Commission Agreement.

21. The draft clauses of the Scotland Bill do not cover the devolution of the additional borrowing powers which are referred to in the Smith Commission Agreement. The omission of any reference to borrowing powers from the draft clauses reflects the detailed work that needs to be undertaken by both the UK and Scottish Governments to agree an overall fiscal framework for Scotland that is acceptable to both parties and both parliaments.

22. In our evidence to the Smith Commission and to the Scottish Parliament’s Finance Committee we recommended that the Scottish Government should have additional revenue borrowing powers to fund preventative spending.

23. We have approached this recommendation from the perspective that additional monies are needed to shift the balance between crisis spending on public services to preventative spending in order to achieve longer term savings.

24. During this extended period of public spending restraint and increasing demand for public services, we support the development and roll out of arrangements which support a preventative spend agenda to achieve better outcomes for communities over the longer term. However, if transformational change is to take place within our public services, we believe that further revenue borrowing powers than have been articulated so far are needed.

25. Neither the Smith Commission report nor HM Government’s ‘Scotland in the United Kingdom: An enduring settlement’ refer to preventative spending in their respective commentaries on borrowing powers. Therefore, in our view, the reports could not be interpreted as permitting revenue borrowing to fund the revenue aspects of preventative spend.

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26. Borrowing for capital projects has always been viewed as preferable to borrowing to fund revenue expenditure on public services due to the benefits accrued from capital expenditure being spread over more than one financial year. A key overarching objective of preventative spending initiatives is to reduce demand for public services and create future savings. Therefore, preventative spending, like capital spending, is about investing in the future. We believe this provides clear justification for the extension of the Scottish Government’s revenue borrowing powers to fund preventative spend initiatives within prescribed limits.

27. Charities are major providers of public services and we believe that there is knowledge and experience within this sector which is vital to the success of preventative spending approaches. While there are a number of barriers to taking forward preventative spend initiatives, some of which could be overcome within the existing devolved arrangements, we believe that further revenue borrowing powers need to be devolved to support a shift away from crisis spend.

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28. The debt financing of charities by government is a potential model for providing working capital to charities for preventative spend initiatives. However, debt financing, where interest is charged below commercial rates, has the potential to be caught by the EU State Aid rules. The State Aid rules were created to promote competition and control state subsidy levels so as to maintain a level playing field across Europe. In practice, this means that government funding such as grants to a small enterprise, the creation of targeted tax reliefs to stimulate economic growth or investing in a framework to facilitate a move towards more preventative spending could be classed as ‘State Aid’ if certain criteria and tests are met.

29. Preventative spending does not guarantee success and therefore there are risks attached to it. Nevertheless, we believe that it is appropriate for the Scottish Government to be able to borrow to fund the revenue aspects of preventative spend initiatives, within an overall cash limit, where there is a realistic prospect of achieving savings. The resultant savings could reduce public spending in the long- term or free up resources which could be re-deployed elsewhere in the public services.

30. In addition to placing an overall cash limit (or introducing a mechanism to establish and overall limit) on the amount the Scottish Government can borrow for preventative spending initiatives, we would envisage that borrowings would need to be repaid within a specified period of time and that governance arrangements would include measures to ensure that borrowings could not be used to fund recurrent revenue expenditure.

Questions: What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?

31. Response: we have no comments on these questions.

What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland?

32. Response: we have no comments on this question.

Specific questions: Tax powers

Question: What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill?

33. Response: The Scotland Act 2012 has already led to the devolution of some taxes and the Scotland Bill builds on this, with the overall result of devolving taxes further being three different levels and/or types of devolved taxes:

a. Full devolution - Land and Buildings Transaction Tax, Scottish Landfill Tax, Aggregates Levy and Air Passenger Duty. These taxes are, or will be, the

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political responsibility of the Scottish Parliament and the administrative duties rest with the new tax authority, Revenue Scotland. The nature of the taxes, the legislation, and the associated collection and management duties are fully devolved and completely the responsibility of those in Scotland.

b. Partial devolution - Income Tax rates and bands. Partially devolved taxes involve joint responsibilities. Political responsibility will be split between the UK and Scottish Parliaments. The UK Parliament will be responsible for the tax base (what is considered to be income, and how it is measured) and the Scottish Parliament is responsible for the rates and the bands (how much is assessed for collection). Administrative responsibility will remain with HMRC, for which the Scottish Government will pay any additional costs of collection.

The Scottish income tax rates will be applied to earned income, pensions and rental income, but will not be charged on savings income and dividend income (to ease administrative pressures and to avoid distortions of the UK savings market).

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c. Assignment – a proportion of VAT receipts. VAT remains the responsibility of the EU (in terms of defining the tax base), and the UK Parliament (in setting the tax rates), with administration and collection by HMRC. A proportion of VAT collected is to be assigned to Scotland.

34. We understand that from an operational, procedural basis the rationale for the different types of devolved tax powers includes the following:

a. Fully devolved taxes are standalone taxes that do not have significant interaction with other taxes so they lend themselves to being devolved. Also, they have their locus in Scotland and are unlikely therefore to give rise to jurisdictional issues.

b. Partial devolution of income tax. Income tax is one of the major sources of government revenue and therefore the devolution of it should provide accountability for tax raising with the Scottish Parliament. Both the Scotland Act 2012 Scottish Rate of Income Tax and, in future, the proposed Smith recommendations combine a pragmatic way of devolving elements of income tax whilst retaining the UK infrastructure of tax collection with HMRC and employers, thereby avoiding the costs and efforts of whole-scale change.

c. Assigned VAT. The purpose of the assignment of VAT is to align tax income with the Scottish economy. How accountability to the Scottish Parliament is arrived at through assignment has yet to be decided, and is not determined or directed in the draft tax clauses in the Scotland Bill. Considerable analytical and statistical work will be required if there is to be an amount that can be identified which truly reflects the VAT attributable to Scotland and will in future reflect any changes in the Scottish economy.

35. ICAS recommended that the following key principles should be used to determine the decision basis for the devolution of new powers:

a. Achieve clear objectives, such as the speed of delivery of devolved powers to meet voters expectations whilst accepting trade-offs are likely to be necessary.

b. Be transparent to voters, whether delivery is in the short term or managing expectations for the longer term.

c. Avoid complex outcomes, by devolving powers whilst avoiding potentially problematic interactions with non-devolved powers.

d. Minimise burdens on employers and businesses, because many taxes are collected at source and significant costs of administration could fall on those unpaid collectors.

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e. Maximise benefits in relation to costs for taxpayers, including assessments of HMRC’s/Revenue Scotland’s capacity and capability to deliver and the likely net revenue impact on Scotland’s finances.

36. The rationale for devolving certain taxes may not be easy to put forward to the public and there is great scope for confusion in public understanding. In public usage most commentators tend to use the phrases “Scottish taxes” or “devolved taxes” but these encompass different types of devolution and varying amounts of responsibilities, and can lack precision. The rationale for, and the nature of, the powers over income tax are fundamentally different from those devolved by, for example, Land and Buildings Transaction Tax. Hence, fairness and transparency may take time in being achieved for the public at large.

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37. We note too that aspects of devolving taxes are beginning to impact on UK taxes. In the UK Spring Budget it was announced that a new Personal Savings Allowance is to be introduced with effect from 6 April 2016. This will apply across the UK and is estimated by HMRC to remove 95% of taxpayers from the charge to income tax on savings. Alongside the announcement in the Summer Budget about dividend income, this should ease the administration of tax for those higher rate Scottish taxpayers who receive savings and/or dividend income and would otherwise have had to account for further UK income tax through a tax return. Scottish taxpayers with significant levels of savings and/or dividend income will, however, have the additional complication and expense of reporting these to the UK tax authorities and ensuring that the right rates of tax are applied to their income.

Question: What is the rationale behind the choice of taxes devolved by the Wales Act 2014?

38. Response: we have no comments on this question.

Questions: What are the implications of devolving corporation tax to Northern Ireland? Will it have an effect on business in the rest of the UK?

39. Response: the devolving of corporation tax has re-opened some discussion in Scotland as to whether corporation tax should also be devolved to Scotland. ICAS has reservations about the devolution of corporation tax which could lead to tax competition and this is discussed further below.

Questions: With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)?

40. Response: It is too soon to judge whether further powers should be considered and the existing package of tax powers should be given time to be exercised and become fully operational.

41. A key driver to the devolution of tax powers is the accountability of the Scottish Parliament and it is considered that this is more likely to be achieved through taxes other than corporation tax, and particularly those with a closer connection to the electorate. However, reservations have been expressed by some of our members that if income tax is to become ‘Scottish’ this may mean that it will be hypothecated to devolved responsibilities such as health and education. In due course this may influence the manner in which the different taxes do, or do not, provide accountability between the electorate and politicians.

42. We have attached as an appendix an ICAS paper on VAT and the public sector, which was issued in December 2014. It raises a number of issues around VAT recovery by different parts of the public sector. This issue may be aggravated if a

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dispute is seen to be between a devolved part of the public sector and the central HMRC authority.

Question: Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England?

43. Response: The impact of tax competition can be seen with some of the fully devolved taxes and has already happened, for example, when Stamp Duty Land Tax (SDLT) structure and rates were changed in December 2014 and Land and Buildings Transactions Tax (LBTT) rates in Scotland subsequently changed. This resulted in: a. Less tax being raised at a UK level; b. A lower block grant adjustment; c. Greater differences in tax outcomes; leading to a debate on whether a particular outcome is tax competition or might be a part of the ‘no detriment’ analysis; and d. Behavioural impacts by taxpayers, for example, a lower level of sales in the upper end of the property market and possibly more activity at the lower end of the property market.

44. The rates of Scottish Landfill Tax have been kept the same as in the rest of the UK so that there will not be any opportunity for ‘waste tourism’. Competition is seen as unhelpful in this context, but if there is very little difference in the devolved tax it begs the question of whether there is a need to devolve it.

45. There is already tax competition with Air Passenger Duty, as identified in the recent ‘Discussion Paper on options for supporting English regional airports from the impacts of air passenger duty devolution’ published by HMT in July 2015.

46. In the context of Scotland, ICAS has expressed reservations about the devolution of corporation tax as it is likely this would lead to tax competition. This is discussed further in the next response.

Question: Would competition be welcome?

47. Response: A tax system works on a number of complex and interrelated principles and interactions and to date this has been balanced across the UK tax system. In terms of international business, the principle of aiming for stability and certainty in tax matters at a UK level has been greatly welcomed as a means of making the UK more competitive on the international stage.

48. Generally, most people do not like paying tax and, given a legal and legitimate choice, they are likely to opt to pay less tax rather than more. There are extensive provisions in the UK tax legislation to prevent tax leakage both between different UK taxes, and to other jurisdictions. The individual behavioural approaches and responses to the tax environment could reasonably be assumed to continue should devolved taxes differ between different parts of the UK, which may in turn lead to

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reduced tax revenues or require additional legislative provisions to protect the revenue.

49. Tax competition is one element that can be used to attract investment and encourage certain behaviours. However, there can be downsides to tax competition such as:

a. If a tax is devolved to Scotland but its tax base is not clear cut then this can create significant new complexities and administrative burdens. For example, many companies operate across the UK and it may not always be easy to isolate profits from different jurisdictions. Consequently, the devolution of a relatively mobile tax such as corporation tax could lead to disputes between taxpayers and the tax authorities about the correct taxing jurisdiction, transfer pricing, double tax relief etc. Different corporation tax rates between Scotland and other parts of the UK would lead to the same issues that currently exist with international tax and its payment to the appropriate authorities.

b. Tax competition is usually effected by reducing rates or offering attractive reliefs from tax but this can encourage a damaging “race to the bottom” between different jurisdictions which would reduce tax receipts for both the Scottish and UK Governments.

c. Tax competition can also lead to tax avoidance and tax planning. For example, tax can be more competitive in one jurisdiction compared to another in order to attract inward investment or the use of, say, a particular airport. The attraction to the potential taxpayer is a reduction in their tax bill, but it also encourages that taxpayer to avoid a less competitive tax. Equally, tax competition can be between different taxes. For instance, if corporation taxes are lowered there is an incentive for any unincorporated business to seek to convert sources liable to income tax into profits that are liable to corporation tax. In the eyes of some, this is also tax avoidance.

50. There will always be a balance to be struck between the desire for taxes that are specifically designed for local circumstances and local accountability, and which support the economy, but at the same time provide ease of administration for taxpayers, businesses that collect taxes on behalf of the state, and the tax authorities. Ease of administration tends to come from uniformity and certainty.

51. Tax competition can also become tied up with ‘no detriment’ debates if the competition in one part of the UK turns out to be detrimental to another part. At the heart of the ‘no detriment’ principle is the notion that the impact of policy decisions taken in one part of the UK do not impact adversely on the funding of public services in another part. Arguably, the ‘no detriment’ principle runs counter to encouraging tax competition.

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APPENDIX

VAT and the Public Sector

12 December 2014

EXECUTIVE SUMMARY

It is time to take a fresh look at the UK VAT regime for the public sector. Changes to the way in which public services are delivered, together with public spending restrictions, have highlighted the impact of VAT on decision making across the sector. Too often it seems the focus is on HMRC getting the maximum amount of tax from the public sector, rather than efficient delivery of services.

ICAS members consider it is time to review the current VAT regime for the public sector to address the following issues:

 The differing VAT status of parts of the public sector under the UK rules gives a VAT recovery shelter to some organisations but not other organisations delivering the same services to the same end users. There are strong arguments to suggest that the UK VAT system for the public sector is not fiscally neutral.

 The Autumn Statement on 3 December 2014 included five separate announcements to adjust the VAT status of various bodies delivering public services. The need to make this number of changes illustrates the piecemeal way of addressing these concerns and indicates that a broader review of VAT and the public sector is needed. This call is not new - it was also outlined in the Monitor report on “A fair playing field for the benefit of NHS patients” in March 2013.

 The differences in VAT recovery act as a disincentive to implement new and innovative service delivery models across the public sector. Moving activities traditionally delivered by an organisation within a VAT shelter to a new organisation unable to benefit from VAT recovery these will increase the costs of providing that service by 20% before any other changes are contemplated.

 The administration of VAT in the public sector should be carried out by a specialist team within HMRC to harness expertise in dealing with the complex VAT issues involved along with an understanding of the bigger picture. We have outlined below the complexity of the VAT rules applying to the public sector; having a specialist team can help alleviate some of the complexities and help the public sector get its VAT position right more of the time.

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 The public sector procurement rules have raised issues about the planning undertaken by the sector to minimise the impact of taxes on their operations. There are conflicting demands on the sector from the interaction of these rules with the need to get the best possible return for public expenditure. Coherent clarification is needed of the procurement rules, particularly around what are considered “artificial avoidance schemes”. We would suggest looking at the types of planning outlined in this document to illustrate “safe harbour” arrangements that are accepted to allow VAT recovery.

 The money to fund large parts of the public sector comes from tax revenues and disputes between HMRC and the public sector about VAT can give the impression that vital public resources are being used to fund what appear to be internal or trivial issues. It is in the interests of all parties to make the system work effectively and deliver good public services and the intended tax outcomes.

1. BACKGROUND

In April 2014 ICAS responded to a consultation issued by the European Commission on the impact of the current VAT system on public sector organisations19. This project identified a number of areas in the UK's system where the current rules give rise to distortions in the way that different parts of the public sector are subject to VAT on essentially the same transaction. ICAS has been asked by its members to look in more detail at the position and identify areas where the UK Government should focus its attention on ensuring a level playing field across the public sector.

Our focus in this area has also been informed by the public sector procurement rules. These rules were changed from 1 April 2013 for central government contracts of more than £5 million and require bidders for these contracts to self–certify their tax compliance as part of the tender process. The introduction of these rules has had an impact across the public sector and many organisations find themselves in the position of needing to include information on tax compliance on tenders to national governments. This is against a background where there may be strategies adopted by public sector organisations to maximise VAT recovery that appear to be in contravention of this rule, even where these are treated as acceptable tax planning by HMRC.

Definition of public sector

The term “public sector” needs to be clarified. We are using this term in this paper to cover all not for profit organisations as the VAT issues are common across the sector. We have used the term to include:

 Central Government.  Local Government.

19 A copy can be found at http://icas.org.uk/Technical-Knowledge/Tax/Consultations-and-Submissions/

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 The public health sector – the NHS.  The public education sector.  The charitable sector.

2. UK LEGISLATION – CATEGORISATION OF VAT ENTITIES

The UK has applied article 13 of the European Directive20 by implementing specific rules regarding the VAT treatment of public sector organisations which splits these organisations into four types:

 Local Authorities and similar organisations (including the BBC) – section 33 VATA 1994 allows these organisations to recover all VAT incurred on activities related to the non-business functions of the organisation. There can be issues where the organisation receives non-statutory sources of income where these new activities are outside the scope of section 33.

 Government departments and the NHS and associated organisations – Section 41 VATA 1994 allows these organisations to recover input VAT in certain circumstances but they cannot recover VAT on non-business activities. The Treasury lists the services on which these departments are able to receive funding to compensate for irrecoverable VAT in the London, Edinburgh and Belfast Gazette.

20 The text of the Article is as follows:

“States, regional and local government authorities and other bodies governed by public law shall not be regarded as taxable persons in respect of the activities or transactions in which they engage as public authorities, even where they collect dues, fees, contributions or payments in connection with those activities or transactions.

However, when they engage in such activities or transactions, they shall be regarded as taxable persons in respect of those activities or transactions where their treatment as non-taxable persons would lead to significant distortions of competition.

In any event, bodies governed by public law shall be regarded as taxable persons in respect of the activities listed in Annex 1, provided that those activities are not carried out on such a small scale as to be negligible”.

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 Other public sector organisations – these are organisations that do not have any specific provisions that allow them to recover VAT on their activities which are for the public good. These organisations use the standard income method to split their activities between business and non-business, and operate an appropriate partial exemption method to determine what input tax can be recovered. In the UK organisations dealt with under these arrangements are mainly charities, housing associations, universities. In effect, these public sector bodies are not treated under article 13 as they are not “bodies governed by public law” as defined by the Principal VAT Directive.

 Non-Departmental Public Bodies (NDPBs) which are effectively a separate category for VAT purposes. These are organisations which have a role in the processes of government, but are not a Government Department or part of one, and which accordingly operate to a greater or lesser extent at arm’s length from Ministers. As these organisations are separate from central government they do not benefit from the section 41 treatment unless they are Crown NPDBs. An NDPB is only able to register for VAT where it makes taxable supplies and can only recover VAT in connection with those supplies and its residual input tax allocated to those supplies under the partial exemption method adopted. This can be a very complex area as the funding of NDPBs relies on grants from Government and often this funding is calculated on the basis that VAT can be recovered in line with section 41 VAT 1994. It is only once plans to transfer services to the NDPB are advanced that VAT is considered and there can be significant issues to overcome in this area.

3. IMPACT OF UK LEGISLATION ON CATEGORISATION

To demonstrate how these regimes would work in practice, consider the example of an organisation in each category incurs £1,000,000 input tax on implementing a new payroll solution across the organisation where the work was outsourced to an external contractor. The VAT recovery position would be:

 Local authority – would be able to recover the £1,000,000 in full under the terms of section 33.

 Central government, NHS – would be able to recover the £1,000,000 in full under the terms of section 41 provided the services were covered by the Treasury List.

 Other public sector organisations – universities, charities etc – if the organisation was able to be VAT registered the £1,000,000 input VAT would be treated as belonging in the partial exemption “pot”. Partial exemption is the method used to allocate input tax incurred on general activities in proportion to an organisations ratio of taxable supplies to total supplies. These types of organisations will have predominantly exempt supplies so full recovery is not possible. Assuming a recovery rate of 15% (this figure is illustrative of the VAT recovery rate for the sector) would mean that the organisation would only be able to recover £150,000

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of the VAT incurred, leaving it with a balance of £850,000 to cover with funding from other sources.

 NDPBs - if the organisation was able to be VAT registered the £1,000,000 input VAT would be treated as belonging in the partial exemption “pot” with similar issues as above. The partial exemption rules would apply to these organisations but as they carry out government functions which are non-business for VAT, they are unlikely to have very significant levels of taxable supplies. Assuming a recovery rate of 5% (this figure is illustrative of the VAT recovery rate for the sector) would mean that the organisation would only be able to recover £50,000 of the VAT incurred, leaving it with a balance of £950,000 to cover with funding from other sources.

This example demonstrates the wide variation across the public sector and the value to the organisations of the statutory shelters in sections 33 and 41. It also illustrate the issues associated with transferring responsibilities from within government to new organisations – either NDPBs or other types of organisations – and the impact on funding for the new organisations.

The VAT cost is a significant burden, and at the moment these rules act as a disincentive to implementing new strategies for delivering public services. There is not a level playing field across the public sector and we believe it is time to address this issue within the UK.

To try and illustrate how this affects the running of the public sector we have looked at two scenarios where the same transaction carried on by bodies with differing status has a very different tax impact.

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1. Categorisation example 1 – social housing

The first example is the provision of social housing which is exempt from VAT in the UK. Where the housing is provided by a local authority they are able to recover the VAT incurred on repairs and maintenance under the generous partial exemption de minimis rules available to local authorities. If the same housing is provided to the same tenant by a Housing Association they are not able to recover these amounts of VAT. A Housing Association is generally a not-for-profit body which may have charitable status and is likely to receive public money; many evolved from the outsourcing of social housing provision in the UK.

The VAT anomaly can lead to issues when there are transfers of social housing stock from the local authority sector and where the successor landlord does not benefit from the local authorities’ VAT shelter outlined above. This can result in convoluted structures to allow the repair and maintenance obligations to remain with the local authority so that VAT can be recovered as the cost of making a complete transfer of all obligations is the 20% of VAT incurred on repairs and maintenance. There are significant professional and legal costs associated with structuring the transaction in this way. The bulk of these costs are on the initial transaction but there are on-going compliance costs.

To give some idea of the financial impact of the VAT in these cases we have looked at the VAT costs of refurbishment programmes under housing stock transfers from Glasgow City Council. The technical issue concerned the recovery of VAT on future refurbishment costs associated with the social housing. As noted, housing associations do not fall into the section 33 shelter available to local authorities and cannot recover VAT incurred on refurbishment work. The additional cost of this VAT threatened the financial viability of the transfer of social housing stock and the third party funders pushed for action to mitigate this cost so the transfer could proceed. A structure was designed, with HMRC consent, to effectively allow the cost of refurbishment to remain with the local authority.

Glasgow Housing Association acquired the social housing stock of Glasgow City Council in 2003 with an intended budget of £1.47 billion for refurbishment costs. The level of future costs anticipated on refurbishments where Glasgow Housing Association includes both the debtor due from Glasgow City Council and the creditor for future upgrades disclosed at 2012 is £250 million.

As indicated by the example above, it is possible to enter into contractual arrangements which benefit from the VAT recovery position of the local authorities. However, without detailed approval from HMRC this type of tax planning could be seen as falling foul of the guidelines included in the Treasury document “Managing Public Money” issued in April 2013 which states at paragraph 5.6.1:

“Public sector organisations should not engage in, or connive at, tax evasion, tax avoidance or tax planning…… artificial avoidance schemes should normally be rejected”.

Page 191 of 420 The guidance notes that tax advisers can be used for normal compliance activity but it casts doubt on the ability of Government bodies, including NDPBs, to adopt planning strategies which are justifiable in terms of Institute of Chartered Accountants of Scotland (ICAS) – Written evidence (DPF0010)

“Public sector organisations should not engage in, or connive at, tax evasion, tax avoidance or tax planning…… artificial avoidance schemes should normally be rejected”.

The guidance notes that tax advisers can be used for normal compliance activity but it casts doubt on the ability of Government bodies, including NDPBs, to adopt planning strategies which are justifiable in terms of deliverables and governance if one of the aims is also to maximise the VAT recovery on their activities. There is a tension between this requirement and the need to use public money effectively. Paying more tax than is required could be the result of this tension.

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2. Categorisation example 2 – “relevant residential purpose” or “relevant charitable purpose”

The other example to consider is the provision of accommodation for “relevant residential purposes” or “relevant charitable purposes”. Where the developments falls within either of these categories the construction work will be zero-rated with no VAT cost charged on construction costs from the main contractor. This zero-rating covers most work on student accommodation for Universities and work for charities on providing premises to be used for the non-business activities of the charity.

On substantial capital projects of this nature there are normally significant costs from architects, surveyors and other consultants which cannot be treated as part of the construction and are subject to VAT at 20%. If these costs are incurred by either a university or charity the VAT incurred would not be recoverable.

The approach to this that has been used is for the university/charity to set up a separate subsidiary to act as the main contractor on a design and build contract for the organisation. This structure allows the subsidiary to use the composite supply rules to zero-rate the whole supply it makes to the organisation – so it is able to recover all the VAT incurred on associated architects, surveyors’ etc. costs. Using a separate subsidiary is the method used to ring-fence the property activity and make sure that the VAT can be recovered while giving the organisation the control over the appointment of main contractors on the project and apply for funding for the project while under the control of the organisation.

This is a normal planning strategy, and has been accepted by HMRC. HMRC reviewed the position in 2011 as a result of the Talacre case at the European Court of Justice (C-251/05) and after discussion with the Charity Tax Group decided that the treatment as a composite supply would be available for zero-rated construction services in Group 5 Schedule 8 VATA 1994. The Charity Tax Group took Counsel’s opinion on the issue as part of their discussions on the issue and HMRC accepted that the Talacre judgement did not affect the approach in these particular circumstances.

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3. PUBLIC SECTOR PROCUREMENT RULES

As the planning for transfer of housing stock outlined above demonstrates, this is tax planning by the public sector to enhance VAT recovery. The procurement rules across the whole public sector will require organisations to consider whether they can justify the use of this type of planning to eliminate VAT costs on property transactions. To the man in street, the use of a single purpose vehicle property development company can look like part of an avoidance scheme and using this type of structure does not add to overall transparency. There is now a tension between planning for financial viability and the need to be seen to be tax compliant even if this would mean a higher tax bill for the organisation.

4. ADMINISTRATIVE COMPLEXITIES

4.1 Business and non-business activities

There are further layers of complexity in VAT recovery for public sector organisations in dealing with VAT. The first step is that these organisations will be involved in splitting their activities between business activities and non-business activities. This is a complex area in itself and there is a wealth of case law that covers the issue, along with a full manual of guidance for HMRC staff at http://www.hmrc.gov.uk/manuals/vbnbmanual/index.htm .

4.2 Partial exemption

Once this has been calculated the organisation then has to consider its partial exemption position applicable to its business supplies. A large number of public sector organisations are partially exempt – their supplies for VAT purposes include both taxable supplies and exempt supplies – and they are required to agree a formula with HMRC for apportioning the input VAT that is incurred across the business activities of the organisation between its taxable activities and its exempt activities.

This can be a very complex process and involves work to ensure that the accounting system and the staff who operate the system can distinguish between taxable and exempt supplies and purchases. For example, it becomes important that income from car parking activities is allocated to either taxable or exempt for some organisations. The operation of the partial exemption scheme is dependent on this level of detail being available to complete the calculation for all public sector bodies.

5. ADMINISTRATIVE COMPLEXITY PARTICULAR TO THE PUBLIC SECTOR

There are a number of areas where there are particular problems for public sector bodies as a result of the complexity of UK VAT regulations and this paper will now go on to consider these in more detail to give a flavour of the types of issues that these organisations have to deal with in practice. The examples to be covered are:

 Issues around prescribing within the NHS.

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 Issues around cost sharing across the public sector.

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1. Administrative complexity example 1 - prescribing within the NHS

The NHS is treated in a very complex way by the VAT rules and their interpretation by HMRC. We are focusing on the issue of prescribing within the NHS as a discrete issue but in the bigger picture the rules around partial exemption calculations and the interaction with contracted out services cause significant practical issues for the day to day running of the NHS. The HMRC guidance on this issue is here http://www.hmrc.gov.uk/menus/frame-nhs.pdf and gives some flavour of the issues and problems associated with this area

As noted above the NHS is a section 41 organisation and is able to recover input VAT in certain circumstances. For most of the organisations covered by section 41 the supplies they make are outside the scope of VAT or exempt so there is no requirement to account for VAT. Prescription services offered by the NHS are zero-rated for VAT in certain circumstances under Group 12 of Schedule VATA 1994. This means that the VAT incurred in purchasing the medicine can be recovered while there is no VAT to be accounted for on any prescription charges.

The UK legislation in this area applies the zero-rating as follows:

“1) the supply of any qualifying goods dispensed to an individual for that individual’s personal use on the prescription of an appropriate practitioner where the dispensing is:

a) By a registered pharmacist; or b) In accordance with a requirement or other authorisation under a relevant provision”.

There is HMRC guidance which defines the terms used in the legislation so that most prescriptions issued under the NHS prescribing guidelines fall into this zero-rating. It is worth noting that drugs and medicines supplied in hospital are treated as part of a supply of healthcare to the patient which is outside the scope of VAT and the VAT incurred by the hospital on these drugs and medicines cannot be recovered by the NHS.

However, there are developments in the ways that prescriptions are issued by the NHS in line with policies to try and reduce the pressure on general practitioner workloads. One of the areas that is causing difficulties from a VAT perspective is prescribing by local clinics for medicines to be used by non-named individuals, and thus outside condition one. This occurs for many emergency prescriptions such as for drug treatment where the clinic is not able to get a suitable prescription for the individual. If the conditions cannot be met, the supply is treated as standard-rated so that the clinic is required to account for VAT on the cost of the drugs or medicine and this can create significant problems.

There are plans to expand the powers of local clinics in this area, and it is likely that they will be able to issue emergency prescriptions for a wider range of drugs and medicines, including expensive cancer treatment drugs. This additional VAT cost will have significant impact on funding for the NHS and it is vital that HMRC adapt their guidance to ensure that it reflects an up to date approach to prescribing within the NHS. Page 196 of 420 Institute of Chartered Accountants of Scotland (ICAS) – Written evidence (DPF0010)

2. Administrative complexity example 2 - cost sharing across the public sector

In July 2012 legislation was passed that allows an independent group of persons to form cost-sharing groups to provide shared services without charging VAT in line with Article 132.1(F) of the Principal VAT Directive. Until this legislation was introduced, organisations were able to set up cost- sharing groups but the services provided by the cost-sharing group were subject to VAT which is a disincentive where organisations are not able to fully recover VAT. The legislation is intended to combat this position and allows the cost-sharing group to treat its services as exempt from VAT. This VAT exemption gives the group the scope to realise the savings of shared services without the additional VAT costs.

The UK legislation is rules based and is included in Group 16 Schedule 9 VATA 1994. The primary conditions are as follows:

 There must be an independent group of persons supplying services to persons who are its members.  All the members must carry on VAT exempt and non-business activity.

 The services supplied by the cost-sharing group must be directly necessary for a member’s exempt and/or non-business activity.

 The Cost-sharing group must only recover the member’s individual share of the expenses incurred by the cost-sharing group in making supplies to its members.

 The application of the exemption to the supplies made by the cost-sharing group must not likely to cause a distortion of competition.

As with most rules–based tax legislation the terms used are further defined, and these impose additional conditions for organisations who are considering whether a cost-sharing group would be appropriate to their circumstances. The conditions outlined above include a requirement that the services supplied are “directly necessary” to a members exempt and/or non-business. HMRC interpret this as requiring that the organisation has exempt/non-business activity which represents at least 85% of the total activities.

For many Higher Education Institutions and charities, this limit is very problematic as they are actively involved in trying to generate more business income to address funding concerns – through business partnerships, holiday rentals, consultancy work etc. The conflicting demands of funding issues for the organisation may mean that it cannot satisfy this test and it cannot be involved in cost-sharing groups. The 85% threshold is not included in the Principal VAT Directive and was included by HMRC primarily to prevent organisations with higher levels of taxable activity using this as an opportunity to manage their VAT position.

The conditions outlined also illustrate the complexity of the legislation for the public sector. To be able to determine if they are within the conditions the organisation must undertake a number of calculations using accurate and reliable information and understand all the strands of its activities. This ought to be straightforward – but as recent Tribunal cases such as Brockenhurst College TC02569 demonstrate, this is still an area where organisations need to keep up to date with developments.

This rules based interpretation ofPage the 197 Principal of 420 VAT Directive into UK legislation illustrates some of the major issues for the public sector. The UK legislation is driven by rules rather than principles and these particular Institute of Chartered Accountants of Scotland (ICAS) – Written evidence (DPF0010)

CONCLUSION AND CALLS TO ACTION

This paper has examined the distortions in the operation of the UK VAT system and their impact across the public sector. The current situation does not give a level playing field and many of the distortions give rise to financial issues for public sector operations. The real challenge is to find a system for dealing with the VAT affairs of the sector which is less complex for both the taxpayer and HMRC – the examples above illustrate the complexities that face the sector when dealing with VAT issues.

There is a very strong argument for HMRC to treat the public sector as a special sector administratively and have dedicated resources allocated to dealing with the issues from this sector. We are aware of HMRC’s diminishing resources and recognise the need for careful allocation of those resources to the areas which carry most risk. The value of transactions within the public sector is itself a risk and public bodies themselves do not often have internal resource with sufficient knowledge to deal with complex VAT queries. This can result in very difficult decisions when organisational finances are being considered. A dedicated team which is open to discussion with both public bodies and their external advisers would be able make better use of their resources in managing the sector.

A dedicated team would be more aware of the bigger picture for the sector and have an understanding of the wider impact. An example of this in the past was the HMRC dedicated NHS team, which met with external advisers on a quarterly basis and issued newsletters on current VAT issues to NHS Trusts and Boards to ensure consistent compliance across the sector. These newsletters gave the NHS bodies and their advisers clear informed guidance on the VAT treatment of transactions, and allowed HMRC to focus on the exceptional transactions rather than the day to day transactions. We understand from our members that there are concerns that the public sector is now seen as a “soft touch” for HMRC staff.

The UK tax system has not adapted to the changes in the way that public services are delivered in the UK, particularly under single outcome agreements, and often new methods of delivery are not able to use the shelters of section 33 or section 41. The planning to try to allow some of those benefits to remain can mean very significant professional costs and even disputes between the organisation and HMRC.

As noted in the executive summary, there were 5 announcements in the Autumn Statement on 3 December 2014 to adjust the VAT recovery status of various bodies delivering public services. The changes cover:

 Hospices – paragraph 2.20 of the Autumn Statement  UK search and rescue and air ambulance charities – paragraph 2.80 of the Autumn Statement  Highways Agency – paragraph 2.107 of the Autumn Statement  Certain Government departments – paragraph 2.108 of the Autumn Statement

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 London Legacy Development Corporation – paragraph 2.109 of the Autumn Statement

The need to make these changes is driven by the underlying issues in the UK VAT legislation covering the public sector. It is time to consider a full review rather than make occasional changes for certain organisations.

There needs to be recognition of the amount of public money that is devoted to these issues and for a review of the whole system for dealing with VAT and the public sector. The piecemeal approach adopted to date has meant that HMRC do not keep pace with changes in the sector. A new approach that looked at principles rather than rules would benefit this sector and provide a system that is better able to deal with the challenges facing the public sector and its finances.

24 August 2015

Page 199 of 420 Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007) Institute of Chartered Accountants of Scotland (ICAS); Professor Gerald Holtham, Chair of the Holtham Commission; Tom Crotty, INEOS – Oral evidence (QQ 77-88) (DFPOE0007)

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Institute of Economic Affairs – Written evidence (DPF0006)

About the authors

Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary's University, Twickenham. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. Previously, Philip Booth worked for the Bank of England as an advisor on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs and on the editorial boards of various other academic journals. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

Diego Zuluaga joined the IEA as International Outreach Officer in December 2013, becoming International Research Fellow in June 2015. He is also Deputy Director of EPICENTER, the pan-European think tank network, with responsibility for its research activity. Prior to joining the IEA, Diego worked as Development Analyst in Canada for Maryland-based TSL Marketing. During his time in North America, he was also the Economics Editor of online journal Life.Liberty.Economics., and a monetary and trade policy columnist for the Prince Arthur Herald. Originally from Bilbao, Diego holds a BA in Economics and History from McGill University in Montreal, and is fluent in Spanish, German and French.

DISCLAIMER: As part of its educational objectives the IEA facilitates responses to public policy consultations by academics and others. However, the views expressed, whilst generally consistent with the IEA’s mission, are those of the authors and not those of the IEA (which has no corporate view), its managing Trustees, senior staff or Academic Advisory Council. If these views are quoted then we ask they are quoted as the views of the author(s).

Devolution – the background

Page 201 of 420 Institute of Economic Affairs – Written evidence (DPF0006)

The United Kingdom has been characterised by various forms of devolution throughout its history. However, there was a step-change in 1999 when the Scottish Parliament and Welsh Assembly were formed. Just before that, in 1998, devolved government returned to Northern Ireland. The powers that have been devolved to each of the nations are not the same, and the different nations have used them in different ways.

In Scotland, the following matters are devolved21:

 health and social work;

 education and training;

 local government and housing;

 justice and policing;

 agriculture, forestry and fisheries;

 the environment;

 tourism, sport and heritage;

 economic development and internal transport.

Spending decisions, organisational issues and the passing of primary legislation in these areas have all been devolved. The devolved matters cover a large proportion of government activity with the major exception of welfare. By comparison with spending powers, revenue raising powers are limited. The original devolution settlement, and then the Scotland Act 2012, gave the Scottish government the power to vary income tax and also vary some other minor taxes. However, revenue raising is essentially still a matter for the UK government.

Following the referendum on Scottish independence in September 2014 further proposals were made for devolution. The measures that were proposed by the Conservative Party at the 2015 election included requiring that 50 per cent of revenue spent in Scotland was raised in Scotland and also the devolution of welfare and further health and social matters. These proposals were adopted in the Scotland Bill, which is currently going through Parliament, and which will give the Scottish Parliament control over income tax rates and bands, a half share in VAT revenues and a greater say over welfare policy in Scotland. These measures could reduce the extent of fiscal centralisation within the UK, but they are also likely to exacerbate the problems caused by asymmetries in the devolution settlement which are discussed below. It was also proposed in the Conservative manifesto that the Barnet formula was maintained and that a special funding floor for Wales should be introduced.

21 See: https://www.gov.uk/devolution-settlement-scotland

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As far as spending and the delivery of services are concerned, the devolved powers to Wales and Northern Ireland are not significantly different from those in Scotland. However, the powers to enact legislation are less wide-ranging and there is no control of income tax.

The devolution settlements mirror the arrangements within local government in England in that there is far more devolution of spending than of revenue-raising. As will be discussed below, this is probably the worst of all possible combinations.

In July 2015, the government announced a new arrangement that would complement the devolution settlement to try to deal with the ‘West Lothian’ problem discussed below. This would require that any legislation passed by the UK parliament that only affected England (for example, that covering health or education) would also have to obtain a majority of English MPs in order to pass. This may be helpful in some respects, but does not deal with the range of problems discussed below. Furthermore, the system will bring with it its own problems, including the potential for parliamentary deadlock if a party has a majority in the House of Commons but does not have a majority of English MPs.

Page 203 of 420 Institute of Economic Affairs – Written evidence (DPF0006)

Local government and fiscal centralisation in the UK

The UK has something of a ‘patchwork’ system of local government. That is not necessarily a bad thing. Different approaches to local government may well be appropriate in different areas - for example in urban as compared with rural areas. This paper will not propose a reorganisation of the structures of local government. Rather, the focus for discussion is on the extent to which local government should have greater responsibilities devolved from the centre.

In England, there are 55 single-tier authorities which have responsibility for nearly all local government matters. In addition there are 27 ‘non-metropolitan’ counties, which tend to be large areas, with responsibility for education, libraries and a number of other areas of expenditure over which it is believed that more strategic oversight is needed. These counties also contain lower-tier authorities responsible for services such as refuse collection and planning applications. There are additional complexities. For example, there are a number of ‘metropolitan boroughs’ which tend to act as unitary authorities, and the local government arrangements in London are quite different from those which exist in the rest of the country. Furthermore, a few functions are undertaken by parish or town councils, which tend to represent very small areas and have advisory functions as well as some spending powers.

Local authority spending under central government control

Councils have wide-ranging but constrained powers. For example, they are responsible for children’s services (though not free schools and academies); aspects of highways and transport; social care for adults; housing; planning; the environment; and fire and rescue services.22 They also have some role in the provision of other services which are co-ordinated locally but for which they are not directly responsible, such as policing. In many of these areas, local discretion is limited and most local authorities are implementing national government guidelines or plans. An indication of local government’s subservient role is given by the fact that, in 2011, there were over 1,300 local authority statutory duties.23

Local councils received ring-fenced grants for particular purposes, though the extent of these has been reduced in recent years. As far as revenue unrelated to education is concerned, over 70 per cent is now either raised through the main local authority tax (Council Tax) or provided through general government support. The rest involves ring- fenced support. Education is one of the functions funded in this way, insofar as services are provided by local councils rather than through schools that are funded directly by central government.

The provision of services is heavily circumscribed and regulated, as indicated by the number of statutory duties. Local authority schools, for example, must follow the

22 See: http://www.local.gov.uk/c/document_library/get_file?uuid=a5b2c920-8f40-4eae-9852- 8b983724f5bc&groupId=10180 23 See: https://www.gov.uk/government/publications/review-of-local-government-statutory-duties-summary-of- responses--2

Page 204 of 420 Institute of Economic Affairs – Written evidence (DPF0006) national curriculum; and, with regard to libraries, under the 1964 Public Libraries and Museums Act:

it shall be the duty of the Secretary of State to superintend, and promote the improvement of, the public library service provided by local authorities in England and Wales, and to secure the proper discharge by local authorities of the functions in relation to libraries conferred on them as library authorities by or under this Act.

Indeed, the Secretary of State has met with local authorities regarding library closures.

Adult and children care is heavily regulated by the state with local authorities effectively carrying out legislative duties as laid down in acts of parliament. There is even a special government fund to enable local authorities to empty dustbins once a week rather than once a fortnight.

There has been some further devolution of powers on an ad hoc basis to particular local government areas. For example, the Manchester conurbation, which includes a number of local council areas, will be given control of public sector land, health and social care services and is likely to be given control of children’s services. There are currently talks with a number of other areas (including Cornwall, Sheffield and Liverpool) regarding the further localisation of service provision.

The centralisation of revenue-raising

With regard to taxation, or revenue-raising, the extent of central control is even greater than that over spending. Furthermore, the modest decentralisation to areas such as Manchester barely affects revenue-raising.

Even the one tax that is levied and determined by local councils is heavily regulated by central government. The government provided funding of £5.2 billion between 2010 and 2015 to freeze Council Tax24 and councils are unable to update valuations, use alternative taxes or even change the Council Tax banding system within a local area. There is even less local discretion with regard to business rates, the other main tax designed to finance local government which is administered and set by central government.

Measured by the percentage of tax revenue raised locally, the UK has by far the lowest level of tax autonomy for local government amongst comparable countries. According to OECD figures, in 2011, 4.8 per cent of all tax was raised locally. This is on a par with (or slightly higher than) countries such as Slovakia and the Netherlands, which are much smaller than the UK. Other similar countries raise much more locally as a proportion of national income. For example France (13 per cent), Italy (16 per cent),

24 See: https://www.gov.uk/government/publications/2010-to-2015-government-policy-council-tax-reform/2010- to-2015-government-policy-council-tax-reform

Page 205 of 420 Institute of Economic Affairs – Written evidence (DPF0006) the US (37 per cent) and Germany (29 per cent) all raise a significantly greater proportion of total taxes locally than the UK (see table 1).

As can be seen in table 1, which includes all G7 countries except Japan (for which expenditure figures are not available), the figures for expenditure tell a different story. When it comes to the extent of government spending administered at local level, the UK is at the low end of the spectrum, but not an outlier. However, as is discussed below, decentralisation of spending authority coupled with centralisation of revenue raising can be the worst of all worlds.

Country Percentage of tax revenue Percentage of expenditure raised at sub-national at sub-national level level

UK 5 25

France 13 21

Italy 16 28

Japan 25 -

Germany 29 39

US 37 48

Canada 50 67

Tablet 1 Percentage of tax revenue and government spending at sub-national level, 2013 (source OECD Fiscal Decentralisation Database)

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Problems of the UK’s devolution settlement

Big government asymmetrical bias

The current political settlement in the UK is asymmetrical in the sense that some members of parliament have responsibility for determining legislation that does not affect their constituents: in other words, we have “representation without taxation”. This, in itself, is not necessarily a problem as long as there is accountability and proper checks and balances within the system to prevent such biases significantly affecting government decisions. However, in the case of the UK, a form of devolution has evolved which has a built-in bias towards higher levels of government spending than the electorate may desire.

The political bias within the UK system is perhaps best explained with reference to what became known as the ‘West Lothian’ question, i.e. the fact that Scottish members of parliament can vote on matters that only pertain to England and which have no effect on their own constituents. Such MPs are rather like MPs from rotten boroughs or pocket boroughs before the 1832 Reform Act – the members are not accountable to anybody for the decisions they take on a wide range of devolved issues, but they can affect policy in constituencies that do not elect them.

It is difficult to predict the impact of this situation on MPs’ voting behaviour. If MPs do not have vested interests to protect because a given decision does not affect their constituents they might be less likely to vote for interventionist measures. However, as will be discussed below, the areas to which there has been devolution tend to have high levels of government spending relative to taxation. Their MPs would have an incentive to maintain this position. Furthermore, under the party whipping system, Scottish MPs can simply be required to vote with their English colleagues.25 All MPs from devolved nations can in fact vote for more government spending in England (which they do not represent and which may not want more government spending) whilst also being confident that there will be a majority favourable to high levels of government spending in the assemblies or parliaments of their own nations.

The problem is exacerbated by the fact that MPs in devolved nations tend disproportionately to be members of parties that believe in greater levels of government spending. This would seem to reflect voter preferences, given that surveys show that electorates in devolved areas tend to favour greater government intervention. For instance, in a YouGov poll which asked participants for their view on whether the level of spending and taxes should be higher, lower or around the same, voters in Scotland were more likely than those in the UK as a whole to say they would prefer higher spending and taxes and less likely to prefer lower spending and taxes (see Fig. 1).

25 This is less of a problem in the parliament elected in May 2015, where there are only three Scottish MPs who are not members of the Scottish National Party.

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Figure 1: The money the government spends on public services and other things comes mainly from taxation. Do you think…26

The current devolution settlement thus creates an asymmetry whereby devolved nations can always have greater levels of government intervention by electing politicians that suit the preferences of the average voter in those nations, whilst contributing to the dilution of the anti-interventionist tendencies of those parts of the country that do not have devolved government and which are governed by a parliament elected from the whole of the UK. In other words, the current settlement has a built-in bias in favour of greater government intervention and spending which does not necessarily reflect the preferences of the average UK voter.

Over-representation of Scotland, Wales and Northern Ireland

The problem of asymmetry is compounded by over-representation in the UK parliament of those nations which have devolved powers. It might be expected that nations with devolved powers would have fewer members of the UK parliament, but the opposite is the case. Using 2013 figures, the mean and median number of electors per seat is shown in Table 2.

Nation Total number of Total number Mean electors per Median electors electors of seats seat per seat

England 38,587,100 533 72,396 72,400

Scotland 4,027,200 59 68,258 69,000

26 Taken directly from Packer and Sinclair (2015). Total sample size was 1,684 adults. Fieldwork was undertaken 10 - 11 March 2013 by YouGov for the TaxPayers’ Alliance. The survey was carried out online. The figures were weighted and are representative of all GB adults (aged 18+).

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Wales 2,297,300 40 57433 56,800

Northern 1,218,400 18 67,689 66,800 Ireland

Table 2: Electors per seat in UK nations

All the other home nations have higher representation than England. In turn, Wales and Northern Ireland have greater representation than Scotland because their devolution settlements involved the transfer of fewer powers.

Historically, there has been some attempt to alter the number of seats allocated between the four nations to take account of the extent of devolution. For example Northern Ireland had 13 (reduced to 12) seats during the period of devolved power. This was then increased after direct rule was imposed. The number of Scottish seats was also reduced from 72 to 59 before the 2005 general election to reflect its increased devolved powers. Nevertheless, Scotland is still over-represented.

Even if the representation of Scotland, Wales and Northern Ireland is not decisive in determining the government of the UK as a whole, it can still affect the balance of opinion in parliament. There have been times, however, when the election results in the devolved areas was decisive.27

High government spending in Scotland, Wales and Northern Ireland

It has been argued above that the devolution settlement is asymmetrical and favours those parts of the UK which have supported a larger state. This, in turn, means that there will be an artificial bias that will encourage high spending and high levels of regulation. High spending in the nations that have devolution pre-dated the current settlement and it is difficult to argue that devolution is the cause of high spending in Scotland, Wales and Northern Ireland. However, the devolution settlement makes it more likely that this situation will continue into the future.

The level of government spending in 2004-05 in the UK, England, Scotland, Wales and Northern Ireland is given in Table 3 below as a proportion of national income at factor cost (the most appropriate measure of national income for such comparisons). Other figures are given for employment in the public sector and also more recent figures for government spending per head (in absolute terms and as a percentage of the UK average).

27 Though Scotland did not have devolved powers at that time, in October 1974, the Labour Party’s majority in Scotland was far bigger than its majority in the UK as a whole. In 2010, the Conservative Party had a very clear overall majority in England but not in the United Kingdom.

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Government Proportion of Government Government spending as % workforce in spending per spending per GDP (2004-05) the public head (2012-13) head as % of sector (2004- £ UK average 05) (2012-13)

England 46.0 19.5 8,529 97.1

Scotland 58.5 23.8 10,152 115.5

Wales 67.9 23.3 9,709 110.5

Northern 75.8 29.8 10,876 123.8 Ireland

UK 47.2 20.3 8,788 100

Table 3: Government spending in the UK nations (source, Smith, 2006 and Public Expenditure Statistical Analyses, 2014, chapter 9)

Government spending is clearly much higher in the nations with devolved government. One possible explanation is that, from long before devolution, Scottish, Welsh and Northern Irish representatives in parliament comprised well-aligned interest groups28 that could obtain benefits whilst spreading the costs over the whole electorate.29 Having gained such concessions, the devolution settlement gives an incentive to the electorate and their representatives to maintain and enhance them.

This problem is exacerbated because, when it comes to the UK parliament, non-English MPs have interests in a relatively small number of issues – the general fiscal settlement being one of them. This is because most issues of importance have been devolved whilst the raising of finances to fund the devolved spending has not. The interests of the non-English MPs are likely to be closely aligned around the objective of maintaining or improving their fiscal settlement. Even members of the UK parliament who believed in cutting government spending in general might support increases in government spending for their nations given that the cost would be spread across the UK.

28 This is essentially applying the argument of Olson (1965). 29 Very particular examples of this include, in 1979, discussions (which broke down) between Ulster Unionists and the government over the provision of cheap energy in exchange for support in a confidence motion and concessions to Plaid Cymru which, did, in fact, secure their support in that no confidence vote. See: http://www.walesonline.co.uk/news/wales-news/could-worse-gordon-think-callaghan-2120651. In the 1979 general election, both major parties promised a dedicated Welsh language television channel and the leader of Plaid Cymru threatened to go on hunger strike if the promise was not delivered.

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This combination of pre-existing high levels of government spending outside England, very little responsibility for raising the taxes necessary to fund the spending and the closely aligned interests of non-English members of the UK parliament around the maintenance of high spending outside England that is financed by the UK taxpayer, compounds the problems of political asymmetry in the devolution settlement. All of these problems point in the direction of encouraging the growth of the size of government.

Dealing with the ‘English question’: half-baked solutions

The problems with the current devolution settlement are not new to the UK. Precisely the problems described above existed in relation to Northern Ireland until direct rule was established in 1972 and they were anticipated in the discussions surrounding Home Rule for Ireland in the late 19th and early 20th centuries.30 For example, when home rule for Ireland was discussed, proposals included the exclusion of Irish members from the House of Commons, reducing the number of Irish members or preventing them from voting on issues that were decided in Ireland (the equivalent to ‘English votes for English laws’ currently being discussed in parliament). In the event, rather later, when Northern Ireland was given devolved powers, the number of Northern Irish MPs was reduced. Translated into the current conjuncture, however, none of these solutions is satisfactory.

English votes for English laws

If Members of Parliament in the nations with devolved government were excluded from the UK parliament altogether – as was suggested in the case of Irish Home Rule – it would mean that they could not vote on matters to do with the taxes which would be raised in their constituencies to pay for UK-wide or devolved spending. It would also mean that they could not vote on matters which pertained to the UK as a whole. This is clearly unsatisfactory and is not under serious consideration. An alternative to this approach would be to exclude non-English Members of Parliament from votes relating to measures that only affected England. However, there are several problems with this proposal, which has become known as EVEL.

EVEL would, in effect, mean that in some circumstances, depending on the outcome of a general election, a stable government could not be formed which could propose legislation on and administer departments in relation to all issues. For example, there could be a Labour government in the UK as a whole, dealing with matters such as foreign affairs and proposing budgets and the Finance Acts. At the same time, that government might not be able to legislate in areas related to health and education, on which Scottish members would have no vote.

30 See Bowers (2012).

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Packer and Sinclair (2015) also point out that this so-called ‘English votes for English laws’ proposal would weaken accountability. It would mean that some MPs were responsible for two sets of issues and others only one. It would be very difficult to identify the executive that was responsible for English issues. If there were dissatisfaction with the health service, for example, would that be the fault of the relevant ministry, the organisation of the service in England or the financing of the service through the Treasury? The whole system would be very confusing.

This problem could be avoided by creating an entirely separate English parliament, but this would create yet another level of government (also see Packer and Sinclair, 2015). Some English electors are already represented at parish or town, district, county, UK and EU level and this proposal would create a sixth level of representation.31

A federal solution to the ‘English’ problem

The most appropriate system of governance for the UK would be an entirely federal solution. It has none of the faults of the other proposals and many advantages.

For ease of exposition, it will be proposed that the basic governmental units should become Scotland and the Rest of the UK (RUK). However, the federal system could be expanded to give Wales, Northern Ireland (and therefore, by default, England) the same status as Scotland.

At the initial stage, RUK and Scotland would negotiate regarding the powers that would be retained by the federal (UK) government. For the purpose of this discussion, it would be assumed that these would include defence, border control, foreign affairs (including issues related to EU membership) and, possibly, monetary affairs and financial regulation. The existing national debt would also have to be managed jointly. All UK nations would share the same head of state.

Both a Scottish and RUK parliament would be established to deal with all matters that were not UK-wide. In addition, there would be a UK parliament which could be small and meet infrequently except during times of national emergency. It is not the purpose of this paper to discuss exactly how the parliaments would be elected, but there would be a stronger case for fixed terms and a much smaller number of members in the UK- wide parliament. It would not be unreasonable for the smaller nations to be “over- represented” compared with their populations.

Preventing re-centralisation of power

A proper federal solution should put the power in the hands of Scotland and RUK to devolve power upwards to the federal union rather than the authority for determining

31 Though the federal system proposed below would also have an additional level of representation, the delineation of powers would be very clear and the powers of the federal parliament very limited.

Page 212 of 420 Institute of Economic Affairs – Written evidence (DPF0006) which powers lie being at the federal level. Many federal unions or international bodies made up of nation states have seen a centralisation of power at the federal or supranational level. This has happened within the EU and also within the US. Both Bolick (1994) and Vaubel (2009) argue that institutional design is key to preventing centralisation.

In any system that works on the basis of majorities and which has federal institutions that favour centralisation, there tends to be an accretion of powers to the centre and, once they lie with the centre, they are difficult to return to the federal units (or member states in the case of the EU). Constitutional protections are not effective if the constitutional court is at the federal/supra-national level because there are always clauses that are capable of interpretation in favour of authority being moved to the higher level of government. The solution to this (proposed in different ways and in somewhat different contexts by both Bolick and Vaubel) is to require unanimity at the sub-federal level when powers are moved to the higher level of government and also to have involvement of the lower level parliaments when such decisions are made.

This principle – whilst difficult to implement in a 50-state or 28-state union - is much easier to implement in the federal system proposed here. For any competence to be passed to the UK level there would have to be agreement in each of the Scottish, RUK and UK parliaments. There would have to be similar agreement for powers to be passed down from the UK level. Unanimity – essential to prevent the drift to centralisation – would be practical in the UK context.

Centralisation also tends to arise where there are ambiguous clauses in constitutions that are interpreted in a centralising way by federal institutions that hold the ultimate power. Bolick cites the inter-state commerce clause in the US constitution as being important in promoting centralisation. And the same can be argued in relation to the development of the EU single market: the EU single market has evolved from a concept designed to promote trade based on mutual recognition of national regulations to the harmonisation of regulation at EU level (see Booth and Morrison, 2012). The fundamental problem is that, once the federal level is given power to regulate trade (to prevent trade barriers developing within the country), almost any form of regulation at the central level can be justified because of its relevance to promoting trade.

There is no straightforward solution to this problem. However, as long as the UK remains part of the EU, nearly all such trade-related issues will be handled at the EU level and thus the problem might be relatively limited in practice. Indeed, unless the UK leaves the EU, it would not be necessary for powers in relation to trade regulation to be delineated at all.

Ensuring no bail-out

A second problem with federal systems is the treatment of government borrowing at the sub-federal level. This must be dealt with very clearly ex ante and the following

Page 213 of 420 Institute of Economic Affairs – Written evidence (DPF0006) principles would be sustainable and provide the right incentives for sound fiscal management:

 The existing UK-wide debt would remain and be managed by the UK government. Taxes would be levied to service this and/or pay it down as appropriate.

 The UK-wide government could increase its debt level from the level inherited at the outset of the federal structure (measured as a proportion of national income) but only with the agreement of UK, Scottish and RUK parliaments.

 Only UK-wide debt would be acceptable for monetary policy operations of the central bank if the central bank were to operate across the UK.

 There would be strictly no bailout of RUK or Scotland and all debt issued by those governments would be on that understanding.32

It is not the purpose of this paper to lay out in detail how the budgets of the constituent parts of government will look. However, we might expect the federal government to spend about £100bn-£120bn, the biggest portion of which would be debt interest33. The federal budget would also include the EU gross contribution. The amount spent would be roughly equal to the UK VAT yield or the UK national insurance yield or about two-thirds of the UK income tax yield. It is important that there are legal constraints on the approach to taxation that can only be changed by agreement of the Scottish parliament, RUK parliament and the federal parliament to prevent the federal government undertaking redistribution that is not part of its function. The broad principle that should be followed is that taxes can be levied by the federal government with the following constraints:

 A value added tax can be levied at a set maximum rate with no broader exemptions than currently exist in the UK’s Value Added Tax.

 A land value tax or tax on imputed rent, the maximum rate of which is linked to the lower of the basic rates of income tax levied in Scotland and RUK (e.g. a land value tax of one-twentieth of the lowest basic rate of income tax).

 Any property tax levied applies equally to business and domestic property.

32 Unlike in the case of the euro, this provision would be enforceable because the central bank would not be taking Scottish or RUK debt in monetary operations and therefore becoming liable for default through the “back door”. 33 Interestingly, this takes us very close to the position in 1870 when UK government spending was 10 per cent of national income about half of which was debt interest. Indeed, a key reason for a federal approach is that it recognises that, when the welfare state was developed, it could have been developed independently for Scotland and the rest of the UK. Broadly, the proposed federal government will undertake those functions that governments used to undertake for the majority of the period of the union (from 1714 to the development of the welfare state in 1911).

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It is preferable not to levy a federal income tax given the link between income tax and the corporation tax system which would be administered separately in the two countries, but this should not be ruled out on principle.

Objections to a federal solution

Gough and Tyrie (2015) object to a federal solution. They describe it as an “attractive, tidy and apparently logical” solution but argue that it could not be implemented quickly. Further, they suggest that the size of England (or RUK as proposed here) would make the UK an unequal federal partnership for which there is no precedent. The main objection appears to be that the federal government would be a weak and marginal player in domestic affairs and that the solution would not hold.

These are not compelling objections. The whole purpose of the proposed federal arrangement is to ensure that the UK government does become a marginal player in domestic affairs. As has been explained, whilst the UK remains part of the EU, this should be easy to achieve and is desirable. It enables ‘foot voting’ (see below), competition and a better matching of the provision of public goods and regulation to the views and preferences of the citizens of the nations involved. There is some merit in the point regarding the issue of the size of RUK or England relative to Scotland. However, this differential exists in the case of Westminster representation currently – it is simply a matter of population and geography. With regard to issues such as defence and foreign affairs, which are currently issues for the Westminster parliament and will become the responsibility of a federal parliament, Scotland currently holds fewer than 10 per cent of all the votes. Exactly how representation should be determined in the proposed federal parliament is a practical problem beyond the scope of this paper but, no doubt, Scottish representation would be around 10 per cent of the total or perhaps higher.

The main political advantage of a federal solution is the stability that comes from government by consent with an alignment between taxation, representation and decision making. The fact that there will be between two and four countries within the federal arrangement should make decision-making under unanimity relatively easy.

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The costs of fiscal centralisation

The Tiebout effect

One of the main economic roles of government is the responsibility for the provision of public goods that cannot easily be provided privately34. The Tiebout effect (Tiebout, 1956) suggests that there can be considerable advantages of fiscal decentralisation. Decentralisation allows different local government units to offer different packages of public goods which are suited to the different preferences of local residents. Thus, decentralisation allows for differences between preferences – the residents of Buckingham do not necessarily want the same set of public goods as the residents of Liverpool. Localisation also ensures that local knowledge can be exploited by politicians and bureaucrats in determining the right sort of government provision. Furthermore, local governments can be disciplined by residents who can move between local areas, thus putting pressure on localities to provide the right level and combination of public goods (see ‘foot voting’ below). ‘Tax competition’ can also be complemented by ‘public good provision competition’ and both can help keep government more efficient and ensure more appropriate provision of public goods.35

Confused representation and voter ignorance

The problem of ‘rational ignorance’ amongst electorates is widely discussed. In general, voters do not have a strong incentive to acquire economic and political knowledge because there is an infinitesimal probability that their votes will affect an election. However, interest groups that are well organised and which might have an opportunity to change policy have an incentive to campaign and become well informed. This view is challenged by, for example, Bryan Caplan (2007), who argues that, rather than suffering from rational ignorance, voters are irrational and possess several inherent biases that would tend to lead to bad policy (for example, biases towards protectionism).

It seems true that there are straightforward objective issues that voters get wrong or do not understand. These are not just issues in relation to economic policy. Voters do not even understand for which areas of policy the politicians for whom they are voting are responsible. Somin (2013) cites some examples relating to the US:

 In 2006, only 42 per cent of Americans could name the three branches of government.

 In the 2010 election, nearly two-thirds of the US electorate got the wrong answer when asked if the economy had grown in that year.

34 Of course, there is substantial evidence that many goods and services that are often called “public” goods are often “club” goods and can easily be provided privately. However, we do not pursue that debate here. 35 As Tiebout puts it: “Spatial mobility provides the local public-goods counterpart to the private market's shopping trip” (Tiebout, 1956, page 422) and “While the solution may not be perfect because of institutional rigidities, this does not invalidate its importance” (op cit. page 424).

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 In the 2010 election, less than half the electorate knew that the Republicans controlled the House of Representatives but not the Senate.

Basic facts about which party proposes which policies, which layers of government are responsible for different areas of policy and so on, are not widely known. Indeed, voters often give completely wrong answers to questions relating to these issues.

In many senses, it does not matter whether voters are rationally ignorant whilst interest groups are rationally well-informed and therefore unduly influence policy or whether voters are simply irrational, the policy conclusions in the areas we are discussing are the same: we should rely as little as possible on the political system for delivering economic goals. Unfortunately, the UK political system is especially well designed to exacerbate the effects of voter ignorance.

Firstly, our system is complex. It is possible, in England, to vote in elections for the following layers of government, all of which exercise some power: European Union; UK parliament; county council; district council; parish or town council. In some parts of the country, some of these layers do not exist or are replaced with different layers, but in many parts of the country, there are five layers of government – four of which only raise less than 5 per cent of revenue between them. In Scotland, Wales and Northern Ireland, there are also devolved authorities, though the structure of local government is also somewhat different. This complexity compounds the voter ignorance problem: it is simply more difficult to for voters to understand who controls what. On the other hand, it is worth noting that the need to avoid complexity does not mean that different approaches to local government should not be used in different areas. Complexity of the system as a whole matters less than complexity of the arrangements relating to a particular local government area.

The system of government in the UK is also highly centralised, as discussed above. This leads to two further problems related to voter ignorance. The larger the governmental unit, the less is the chance of an individual elector influencing an election. There are various benefits from decentralisation of governmental control, but one advantage is that individuals have a greater incentive to be well informed. In addition to this, as has been noted, the UK is much more highly centralised when it comes to revenue raising than with regard to spending. And there are ad hoc arrangements such as ‘city deals’ which involve some decentralisation. Moreover, spending is often localised in theory but, in practice, dictated by government guidelines and regulation. All of these factors make it much more difficult to ascertain which layer of government is responsible for what functions.

The following approaches could ameliorate the problem of voter ignorance:

 Limiting the functions of government so that individuals and civil society organisations are responsible for a greater number of important economic decisions. This makes it easier to assess the performance of government over the narrower range of activities for which it is responsible.

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 Decentralising power so that smaller units are responsible for a greater number of powers.

 Making much clearer the powers of different levels of government.

Local government elections can be abused

A further problem arising from our centralised system is that voters can use local elections to ‘send messages’ to national government. This can be done at little cost in terms of bad policy at the local level given the relative unimportance of the powers exercised by local government.36

It appears that, in practice, local elections are used to ‘punish’ national governments. For example, in the 199337 County Council elections, the ruling Conservative Party lost every single county except for one (Buckinghamshire). By 200938, the party controlled all but eight counties in England. These results cannot plausibly reflect the independent performance of county council administrations at these times. During the period of Labour government from 1997 to 2010, there were local elections in most years. In these elections, the Labour Party polled between 7 percentage points and 16 percentage points of the vote fewer than they did in the previous general election.39 There is an almost identical pattern in relation to the Conservative Party between 1979 and 1997 and similar patterns exist for elections to the European Parliament.

Overall, this is an extraordinary picture. It suggests not only that voters are confusing UK parliamentary election issues with issues relevant to other layers of government, it would appear that they are using the other layers of government to register what they believe is a costless ‘mid-term’ protest against the Westminster government of the day. If local government has few powers, of course, voters may be correct that their actions are costless. However, this picture also suggests that changes of government at the local level will happen almost randomly, as determined by the performance of government at the national level.

The absence of ‘foot voting’

Whilst voters are relatively uninformed about political issues people who migrate from one political jurisdiction to another have a strong incentive to be highly informed about what they are doing. People do not need sophisticated knowledge when moving from one governmental jurisdiction to another – they only need relevant knowledge about whether one area is better than another from their perspective. What Somin (2013) calls ‘foot voting’ is therefore more effective in disciplining government than ballot box voting. At the very least, foot voting allows individuals to move from an area

36 This does suggest rational behaviour on the part of voters. 37 The mid-term of a Conservative government. 38 Towards the end of a Labour government. 39 See Mellows-Facer (2006): http://researchbriefings.parliament.uk/ResearchBriefing/Summary/RP06- 26#fullreport.

Page 218 of 420 Institute of Economic Affairs – Written evidence (DPF0006) where government is performing badly to an area where it is performing better, even if it does not improve the poorly-performing government.

We can see that foot voting is practical by observing how parents move home to try to obtain better schools for their children. For example, polling research in the UK suggests that nearly one third of parents have moved house in England to be in the catchment area for a good school and 10 per cent are willing to pay in excess of £50,000 for a property in a desirable school catchment area.40 Thus, it is clear that people move to get better services when they are able to do so.

Somin (2013) shows how people have been able to vote with their feet even in the most difficult conditions. However, the structure of the UK government does raise considerable barriers to foot voting being effective. Centralisation leads to greater similarity in service provision throughout local government areas.41 The first of these barriers is the fact that spending decisions are often devolved without tax decisions being devolved. As is explained above, the Scottish government is able to spend more per head, effectively financed by the English taxpayer. This means that English voters have an incentive to move to Scotland to, for example, receive free long-term care for the elderly or free university tuition, financed by the taxpayers of the United Kingdom as a whole. Secondly, centralisation more generally makes foot voting both ineffective and relatively pointless.

Other disadvantages of fiscal centralisation

Other problems with the UK settlement are discussed by Sinclair (2014). If local governments do not raise their own revenue, they have no incentive to grow their own tax base by following policies that are favourable to business and attractive to the local population. Innovation can also be reduced in centralised systems.

Blöchliger (2013, page 8-9) argues that decentralisation leads to two main benefits. It will increase the productivity of all government spending because mobile factors of production (foot voters) can discipline local government. Furthermore, the spending that does take place is likely to be on more important services that are valued by businesses and residents. Local authorities can experiment and other local authorities can copy the things that work.

Tax decentralisation also allows local authorities to choose a tax and charging mix that is more closely aligned to providing appropriate public goods within the relevant area. For example, a tourist tax on hotel occupants, if carefully spent and not set at levels

40 See: http://www.propertywire.com/news/europe/uk-families-move-schools-201409099567.html. 41 Though there is some difference in school performance – see Ofsted (2013): https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/386795/Ofsted_Annual_Report_ 201213_Schools.pdf - and there seem to be differences in healthcare performance between England and the other nations (Propper, 2002).

Page 219 of 420 Institute of Economic Affairs – Written evidence (DPF0006) that are too high, can both offset the costs tourists impose on an area and help pay for public goods related to tourism (maps, tourist information centres, hill paths, clean beaches, and so on) which it might not be feasible to finance through direct charges.

If spending is decentralised without taxation being decentralised, the ability of a local authority to grow its tax base by following good policy is reduced. And if grants are ring-fenced by government and have to be used for specific purposes, there is very limited scope for experimentation. These problems can be exacerbated where central government allocates grants according to complex formulae which may, in fact, benefit local authorities that are in population decline or economic and social decline more generally. Indeed, as we shall suggest below, decentralisation of spending combined with centralised revenue raising may produce the worst results.

The complex system within England leads to other difficulties. Not only is there tight local control of how local authorities spend money and provide services, there are additional costs that arise from ensuring that spending and activities are compliant. Accountability is then further blurred because it is unclear whether national or local government is responsible for the failings (or successes) of particular policies.

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The benefits of fiscal decentralisation – the evidence

There is a significant amount of evidence that fiscal decentralisation increases economic performance over a range of indicators. For example, Blöchliger (2013) finds that fiscal decentralisation is associated with higher national income, better school performance and higher levels of investment (both physical investment and investment in human capital). In particular, he finds, consistent with Ashworth et al (2013) (see below), that the decentralisation of revenue raising powers has a stronger effect on performance than the decentralisation of spending.

The effects of decentralisation are strong. He finds that (page 3): “Doubling sub-central tax or spending shares (e.g. increasing the ratio of sub-central to general government tax revenue from 6 to 12%) is associated with a GDP per capita increase of around 3%.” It should be noted that it cannot be assumed that a huge step change in a particular country would replicate this result. However, UK sub-central tax revenue is less than one half of that in France and only one tenth of that in Canada so this does suggest substantial possibilities for benefits from decentralisation. Overall, taking into account the fact that the relationship is non-linear, Blöchliger suggests that, if the UK raised the same proportion of tax revenue at sub-national level as Sweden, it would increase national income by 4 per cent. However, the most significant gains would come from the initial reductions in the proportion of revenue raised centrally.

The Lyons report into local government financing (Lyons, 2007) found: “Recent work comparing the UK with the USA and Europe has concluded that the lack of devolution and local discretion in the UK is a constraint on economic performance, particularly in the cities.” (Lyons, 2007, Executive Summary 33).

Nevertheless, the picture is not completely straightforward. Ashworth et al (2013) have studied the impact of spending localisation and tax localisation on the size of government. These authors also find that the decentralisation of spending tends to lead to ‘bigger’ government – that is, higher government spending. On the other hand, decentralisation of taxation can lead to ‘smaller’ government.

This conclusion is consistent with other studies. For example, work by the IMF (specifically, Cottarelli, 2009) confirms the above results whilst making the additional point that it is important for fiscal discipline to be maintained in the sub-national government areas (through credible ‘no-bail-out’ mechanisms or fiscal rules). Furthermore, it is also important that local government has the administrative capacity to raise and spend revenue.

A race to the bottom?

But, does fiscal decentralisation lead to a ‘race to the bottom’? There is, in fact, no reason to assume there would be a race to the bottom if local authorities have more revenue raising and spending powers as compared with the centre. They may compete to have lower tax rates and provide fewer services. However, as Tiebout (1956) points out, many of the services that local government provides have ‘public good’

Page 221 of 420 Institute of Economic Affairs – Written evidence (DPF0006) characteristics. It might be the case that such services would be better provided by the private sector but, in so far as this is not the case, businesses and residents are likely to prefer the ‘best’ package of services and revenue raising rather than the smallest package of services. Of course, residents would also prefer a given package of services to be provided at the lowest cost. The incentives are more likely to be aligned with the achievement of this objective if tax raising and service provision take place at a local level. Blochliger and Campos (2011) confirm this result, arguing that ‘a race to the bottom cannot be observed.’

Evidence that suggests decentralisation is bad for performance

Thießen (2003) finds that fiscal decentralisation is growth promoting in common with the studies cited above. However, when fiscal decentralisation reaches high levels, it can reduce growth. Indeed, it is clear that, just as the Tiebout effect and other benefits of decentralisation can lead to better public service provision and lower taxation, there must come a point when some public goods are more efficiently provided on a national scale so this result is not surprising.

The evidence regarding fiscal decentralisation is not all in one direction. It is possible to envisage a detrimental impact of fiscal decentralisation on economic performance in certain circumstances. For example, if a country has weak institutions and high levels of corruption, it might be difficult to envisage such a country having the capacity to govern effectively at local level – though, on the other hand, it may be possible for local government in some areas to bypass the problems caused by weak institutions in the country as a whole. In the UK in the 1970s and 1980s, an extremely narrow tax base might well have contributed to the poor performance of local government in some areas. Also, we might expect small countries to benefit less from fiscal decentralisation given that the optimal scale on which public goods can be provided might then be closer to the population of the country as a whole.

Rodriguez-Pose and Ezcurra (2011) suggest, in fact, that fiscal decentralisation has a negative impact on growth across 21 OECD countries. However, whilst the results of this research are important and certainly should lead us to question whether fiscal decentralisation is always and everywhere a good thing, two shortcomings make it less relevant to the UK case. Firstly, the authors examine the impact of fiscal decentralisation on growth and not national income levels. It is unclear why decentralisation would necessarily affect growth – changes in decentralisation might lead to changes in national income (and therefore growth in the short term) but decentralisation itself is likely to lead to a higher level of income rather than a higher growth path. Secondly, the authors did not adjust for country size (because country size was strongly correlated with the level of fiscal decentralisation).

Fiscal centralisation and the UK

In a sense, the more nuanced results should lead us to be even more emphatic about the conclusions for the UK. The UK is in the worst position possible. The UK has very

Page 222 of 420 Institute of Economic Affairs – Written evidence (DPF0006) low levels of fiscal decentralisation and tax raising is much more centralised than spending. Overall, the evidence suggests that it would not be possible to devise a more damaging combination. Secondly, the UK is a large country in which it would be expected to efficiently provide public goods at a sub-national level. Thirdly, migration within the UK is substantial but migration from the UK to other countries is difficult either because of language difficulties (in the case of EU countries) or immigration restrictions (in the case of English-speaking countries). As such, starting from the current position, with relatively high levels of local spending financed by grants, devolving revenue raising to the local level should lead to much better outcomes.

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Proposals for fiscal decentralisation within RUK – revenue raising

Local authority revenue raising requirements

As has been discussed above, fiscal decentralisation must take place in respect of both taxation and spending. With some possible exceptions discussed below, spending in the local authority area should be entirely met from taxes raised locally. A crucial principle is that local authorities must be able to decide both the level of taxes and which taxes to levy, within some loose limits.

This immediately leads to the question of how much money would have to be raised locally. A trivial increase in the amount that has to be raised does not necessarily lead to important questions about the appropriate tax base, but a significant increase would do so.

Currently, business rates raise around £27bn and Council Tax around £28bn, a total of £55bn.42 Business rates are currently collected and set nationally. Around half of the total is absorbed into general government revenue streams which helps finance central government grants to local authorities, and the other half is retained by local authorities.

It is difficult to define relevant local authority expenditure precisely because some is financed by specific grants and user charges. However, business rates and Council Tax make up roughly half of all local government spending in England. At first sight, in order to maintain spending at current levels, local authorities would need to double their revenue raising to around £100bn even if they had total control of business rates. However, it would be desirable to direct mainstream schools’ funding through parents to schools and so bypassing the local authority financing system altogether. This would reduce total local authority spending by £30bn.43 Although it will be proposed that local authorities should become responsible for working-age welfare, this would be financed through central government (see below). Overall, it would appear that a modest total increase in local government revenue raising would be necessary.

Local authority revenue sources

Local authorities should be free not to use existing taxes if they preferred. However, as Packer and Sinclair (2015) suggest: “The objective for local taxes should be that they align the incentives of sub-national government with the economic interests of the wider community.” This may be achieved by changing the tax base to one which is broader and which also involves levies on natural resource exploitation. A narrow tax base can lead to local authorities attempting to raise taxes on one part of the electorate to finance spending that will benefit other parts of the electorate and thus lead to rent seeking.44 The use of a broad tax base should also ensure that the local

42 See: http://budgetresponsibility.org.uk/pubs/March2015EFO_18-03-webv1.pdf 43 See: https://www.gov.uk/government/statistics/la-and-school-expenditure-financial-year-2012-to-2013 44 However, such rent-seeking should be mitigated by residents’ ability to move to more welcoming jurisdictions in response to poor policy (see “foot voting” section above).

Page 224 of 420 Institute of Economic Affairs – Written evidence (DPF0006) authority has an incentive to provide good conditions for businesses to flourish as well as ensuring that local authorities can reap the benefits of migration rather than just the costs. For the reasons explained by Packer and Sinclair (2015), capital taxes would be very difficult to administer at local level. Arguably the same applies to income tax (though additional local income tax levies could be administered by central government).

Further details are beyond the scope of this paper, but the tentative conclusions are that local authorities should use a combination of a broad-based consumption tax and a property tax. The property tax should not be progressive but should be approximately proportional to the value of the property and it should be paid directly by tenants or explicitly charged by landlords to tenants. This would mean that any increase in spending would necessitate a rise in the taxes paid by the whole resident population, at least to some extent.

As discussed above, a tax specifically on tourists could help finance public goods for tourists and, given that a local authority will have an incentive to not over-tax tourists (because doing so would reduce both revenue from tourists and revenue from business taxes), a tax on tourists such as a levy on hotel occupancy would be an additional tax that could be used.

Overall, the following tax options would be available to local authorities:

 Taxes modelled on the current Council Tax

 Land value taxes

 Taxes on business property

 Natural resource levies

 Consumption taxes

 Income taxes administered by central government

 Tourist taxes.

Realistically, district councils and other lower-level authorities such as parishes would have to finance their spending through a precept or a tax that was easy to vary according to the place of residence of the individual such as one of the property taxes.

Local authorities would also have the power to reduce taxes for groups of residents and businesses that wished to opt out of local services and provide their own services.

Redistribution

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One of the justifications for the centralised system of government in the UK is the need for redistribution. Currently, the government works out the resources each local authority area should need in order to provide a given set of services and then deducts the amount that can be raised locally through similar levels of taxes. The idea of the redistribution system is that each local government area should be able to provide the same level of services with the same level of taxes.

It is worthwhile comparing two local authorities in order to illustrate the level of redistribution as well as the scale of local authority support from central government more generally. Birmingham City Council spends a total of just over £3bn. About two- thirds of this is made up of central government transfers or grants of various kinds (including the uniform business rate).45 Dorset County Council spends around £267m, of which nearly £200m (nearly 75 per cent) is financed by Council Tax.46 There have been various forms of redistribution within the local government finance system since 1929 (see Sandford, 2014).

The degree of redistribution within the local government system has increased as the need for it has decreased. Much welfare and health provision was previously provided at the local level and is now financed and provided nationally. It is also proposed above that education is removed from local government finance with funds effectively being raised by central government and provided directly to parents. In short, if people are poor, then the general provision of income top-ups by government will provide for such needs. Furthermore, finance for health and education would be provided nationally on a basis determined by the RUK government. It is not clear that further redistribution is necessary except in very particular circumstances to a small number of local authorities.47

Following this logic, there is one area of spending for which the relevant taxes should not be raised locally – working-age welfare. A local authority area with high levels of working-age welfare claimants is also likely to have a low tax base. Any minimum income to be received by individuals should be determined by national and not local government and financed from national government taxes48. However, the management of working age welfare would be devolved in order to take advantage of local knowledge and local differences. To set in place the right incentive structures, it is also important to ensure that the cash grant to local authorities to top up the incomes of and provide services to those on working age welfare is fixed in advance so that any gains from successful programmes accrue to local authorities. The details of working- age welfare provision are beyond the scope of this paper, but the principle is that the function should be devolved, that it should be financed nationally, but that it should be financed in such a way that local areas benefit from managing the problem effectively.

Local government borrowing rules

45 See: file:///C:/Users/pbooth/Downloads/8292Council_Tax_Booklet_2015.pdf 46 See: https://www.dorsetforyou.com/article/418043/Dorset-County-Council-Tax-201516 47 This approach follows the reasoning of Packer and Sinclair (2015). 48 The government may wish to vary the minimum income according to the cost of living in different local areas.

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Currently most local authority borrowing is guaranteed by the UK government through the Public Works Loan Board. In return, there are considerable powers of intervention by government in the finances of local authorities. It would be preferable if central government did not guarantee debt and if there was less intervention in its affairs.

The principle should be established that, in general, local authorities can borrow for capital projects but that they must be entirely responsible for that debt. If a local authority could not repay debt, it would find it difficult to raise further money for capital projects but current spending should not be affected. Local authorities could also raise funds by securitising revenues from investment projects (for example, by issuing bonds repaid by road tolls).

As far as current spending is concerned, it is reasonable to expect local authorities to keep reserves to deal with cyclical fluctuations in revenue but some borrowing could be permitted (for example, up to 5 per cent of current spending in any given year with a maximum debt level of 20 per cent of spending). It may be reasonable to have backstop limits on debt for both capital and current expenditure, but the firmly established no-bailout principle is more important than government rules about the level of debt (see Blankart, 2015). The Spanish experience discussed below is illustrative in this regard.

Proposals for fiscal decentralisation within RUK – spending responsibilities

The creation of a federal United Kingdom is only part of the necessary decentralisation agenda. Indeed, for England, without further action, there would hardly be any effective decentralisation as a result of the above proposals.

It would be for the individual nations (again assumed, for the purposes of this discussion, to be RUK and Scotland) to decide how much further to decentralise policy within their own jurisdictions. However, within RUK, local government funding in Wales and Northern Ireland is a devolved matter and it will be assumed that this remains to be the case. In effect, therefore, what follows is a discussion of the decentralisation of government in England, though the author believes that it would be beneficial for Scotland, Wales and Northern Ireland to follow a similar track.

Principles to be followed

The principle that should be followed is that there should be the widest possible decentralisation of both spending and fiscal responsibilities to the lowest level of government that is consistent with the efficient provision of public goods. Given that local authority areas can combine together to provide services and smaller units can contract with bigger units for the latter to provide services, there should be a bias in favour of over-decentralisation.

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The principle that should be followed in essence is the principle of ‘subsidiarity’ which is an aspect of Catholic social teaching much misquoted and misused in relation to the European Union. That principle can be described as follows: “so also it is an injustice and at the same time a grave evil and disturbance of right order to assign to a greater and higher association what lesser and subordinate organizations can do”.49 Note that the principle argues that smaller organisations should be allowed to do what they “can do”, not what they are most efficient at doing – this also implies that the benefit of the doubt should be in the direction of decentralisation.

It is proposed that fiscal decentralisation within RUK broadly follows the proposals of Packer and Sinclair (2015). Substantial additional responsibilities would be passed to county councils, cities with county powers and unitary authorities. However, the basic unit of local government could – indeed should – hand down responsibility to parishes, towns or district council areas.

Consider, for example, the situation of parish councils which currently have tiny budgets. Lindfield, a large parish council area in Sussex has a budget of £200,000, which amounts to £33 per head.50 The vast majority of local authority spending is undertaken at County Council level. The relevant county, West Sussex, has an area of nearly 800 square miles and a population of nearly one million. It is implausible that nearly all goods and services that cannot be provided privately by individuals and families and which need to be provided by some layer of sub-central government need to be provided on such a centralised and large scale by a county council.

The precise method by which there could be further decentralisation is not discussed here. However, there are three potential approaches that could be followed:

 The basic local authority unit could devolve further powers (with agreement) to district and parish council level.

 The lower levels could be given statutory responsibilities and tax raising powers by central government (as happens now) but with these responsibilities being much wider than those currently held.

 Lower levels of local authority could ask for powers to be granted and this could be agreed by the secretary of state.

Decentralisation in practice

The proposed areas to be devolved to local government level would include environmental policy, aspects of welfare, education and health, policing and certain forms of regulation. There are other areas of policy that should also be considered for

49 Quadragesimo anno, 79, see: http://w2.vatican.va/content/pius-xi/en/encyclicals/documents/hf_p- xi_enc_19310515_quadragesimo-anno.html 50 See: http://www.lindfieldparishcouncil.gov.uk/Core/LindfieldPC/UserFiles/Files/FGPMins08.01.15.pdf

Page 228 of 420 Institute of Economic Affairs – Written evidence (DPF0006) decentralisation, for example, road building, ownership and maintenance (see Knipping and Wellings, 2012). The list below should not be considered exhaustive.

There would also be a review of all statutory requirements on local authorities.51 The only ones which would be retained would be those necessary to prevent local authorities shifting burdens onto neighbouring areas and those that involved, for reasons of efficiency, local authorities executing central government functions (for example registrar functions).

(a) Environmental policy

Most areas of environmental policy should be dealt with at local level. Problems such as flood defences, whether to manage problems or prevent them, and so on, are best dealt with at the local level where local preferences about the costs and benefits in the context of different geographies and population densities can be taken into account.

(b) Working age welfare

Working age welfare is a strong candidate for localisation. Whilst it may be desirable for central government to provide a minimum income for those in greatest need, other aspects of working age welfare should be localised. It has been proposed by Niemietz (2012), for example, that working age benefits for those not working a full week should be attached to strong work requirements. Local authorities should manage benefits for these groups and administer training and work requirements. The situation and needs of the unemployed in, for example, Cambridge, are very different from the situation and needs in Doncaster or Cornwall and these needs could be best managed locally with financial responsibility at local level.

In the case of education, there should complementary reform that would promote the maximum degree of autonomy for parents. However, certain residual issues such as ensuring special needs provision – though not necessarily providing it - making sure that schools that are receiving state-funded ‘vouchers’52 fulfil the requirements of the law, and so on would be a local authority function. The general financing of education would be removed entirely from local authority budgets. However, local authorities would have discretion to, for example, finance free school meals, adult education courses, special education and training courses for those not in employment, provide support for higher education institutions, and so on. These would be entirely a matter for the local authority – as would be decisions as to whether to charge those outside the local authority area for such provision.

51 In 2011 there were over 1,300 such statutory duties as discussed above. 52 Assuming that vouchers or some similar system would be the preferred system of giving parental autonomy over education.

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With regard to healthcare, again there should be complementary reforms to promote much greater individual choice,53 but there might be some functions that are currently undertaken nationally that should be undertaken by local government. These might include public health functions, for example.

(d) Natural resource exploitation

Currently all natural resources below ground are assumed to be owned by the Crown. The UK government gives licences to extract such resources and normally takes a royalty in the form of taxes. This system has several disadvantages compared with the system that exists in the US and existed in the UK before the Petroleum Production Act 1934. Historically in the UK – and still today in the US – natural resources were owned by landowners. They then had an incentive to exploit them to the extent it was economic, subject to meeting local planning rules that might try to prevent pollution, unsightly extraction works and so on. This is one reason for the success of the fracking industry in the US and the success of the coal industry in nineteenth and early twentieth century Britain as compared with the relative failure of the UK fracking industry in the last few years.

Central government ownership of resources immediately creates conflict. The central government owns the royalty, raised in the form of taxes, from the exploitation of resources, but it is local people who suffer the cost. If the resources were privately owned, the owner would be able to compensate those affected directly in return for being given planning permission to extract the resources.

The localisation of extraction rights for oil and gas within local councils would achieve many of the benefits of returning rights to the owners of the property below which extraction was taking place. It would then be local residents who would both bear the cost and gain any royalties or taxes from resource extraction and thus economically rational decisions could be made with direct compensation being provided to affected groups if necessary. It is therefore proposed that all onshore gas and oil exploitation rights should lie with local authorities, though local authorities could privatise such rights if they wished.54

(e) Lifestyle regulation

The arguments for decentralisation also apply to regulation. Although the author would prefer to reduce the extent of regulation in general, the power to regulate would clearly still exist within government. However, the national government should divest itself of such powers in relation to a large number of areas. Broadly, these would

53 See Niemietz (2014, 2015a, 2015b). 54 Indeed, localising extraction rights would also diminish the need for the central government to intervene to speed up fracking permissions, as local authorities would see their incentives to delay authorisation reduced.

Page 230 of 420 Institute of Economic Affairs – Written evidence (DPF0006) apply to the provision of non-tradable services and other controls on lifestyles. For example, the following would become the responsibility of local government:

 All alcohol licensing provisions and licensed premise opening times.

 Regulations in relation to smoking in private places (such as pubs and cafes) and public places (such as streets and parks).

 Provisions related to gambling.

 Shop opening hours (including Sunday trading rules).

There has been a great deal of controversy about such issues in recent years. However, there is no reason why decisions about such matters should take place at national level. Taking decisions about such forms of regulation at local level would allow regulations to be better matched to local preferences and allow people to compare outcomes between regulated and deregulated areas. It would allow more experimentation and copying of approaches that worked best. Localisation in these areas would also allow “foot voting” by those who wished to live in more liberal or more conservative local authority areas.

(f) Policing

Currently, policing is the responsibility of directly elected police and crime commissioners covering areas which cross local authority boundaries. This is confusing for the electorate, and the level of turnout (just 15 per cent at the 2012 elections) in the elections for police and crime commissioners would suggest that effective accountability in this crucial government function is low. The structure of policing is broadly determined at national level and this responsibility should be transferred to the local level. This is not only important for improving accountability, it is also important because different areas have very different policing needs.

Although responsibility should be transferred to the local level, it does not follow that there should be a police authority in every local government area. It is important that local governments can form police authorities with neighbouring areas because of mobile nature of crime and because of the awkward geographical shape of some local authorities: Buckinghamshire, for example, is just 10 miles wide at its narrowest point.

However, the principles enunciated above suggest that local authorities should have clear accountability and responsibility for policing. This would not stop local authorities combining together to create regional police forces, but such decisions should be taken by local authorities themselves so that it is clear to electors who should be held responsible for performance. Indeed, Buckinghamshire has a joint fire authority with Milton Keynes, a decision that belongs in the hands of the two local authorities and not the national government – a similar approach could be followed with policing. It is possible that there are some aspects of policing that are best left to a very local level

Page 231 of 420 Institute of Economic Affairs – Written evidence (DPF0006) and others that should involve the creation of an authority of four of five local government units. These should be matters for local government itself.

(g) Housing and planning

Central government could retain a role providing cash support for individuals who cannot afford housing. With regard to the provision of housing, local authorities would be free to build homes, though definitely not encouraged to do so. Furthermore, they would have to do so within the financial constraints suggested below.

However, local authorities should have much greater freedom when it comes to land- use planning systems. If this function were localised, which would involve the repeal of the Town and Country Planning Act 1947, there would be strong incentives for local authorities to introduce market-based planning systems through which residents were compensated for the loss of environmental amenities when development takes place. Such an approach would give local authorities an incentive to grow the tax base, ensure an alignment of the interests of residents and developers and help ensure that development balanced efficiency and environmental costs in a rational way.

Implementing devolution – lessons from Spain

The above discussion has highlighted two key principles which should guide any devolution of powers to sub-national administrations in the UK. They are:

 That devolution of spending powers should be coupled with a proportionate devolution of revenue-raising responsibilities

 That there should be a strict no-bailout principle in the relationship between national and sub-national governments.

The experience of Spain, which has had increasing levels of devolution to regional governments (comunidades autónomas, or “autonomous communities,” hereinafter ACs) since 1978, illustrates the problems that arise when these principles are not followed.

Progressive devolution with asymmetries

For much of the last two centuries, Spain was a heavily centralised country. There were brief yet repeated attempts at decentralisation throughout this period, the latest of which – during the Second Republic between 1931 and 1936 – was cut short by the Civil War of 1936-1939 and then decisively reversed by the Franco dictatorship which lasted until 1975 (Heywood, 2000).

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As part of the constitutional process during Spain’s transition to democracy from the mid-1970s, the framers sought to accommodate the demands for greater autonomy by nationalist sectors in a number of regions. The rationale was that, since these regions – which included the Basque Country, Catalonia and Galicia – had a history of self- government and salient independent identities, they should be granted autonomy over the management of a large number of regional affairs (Ruiz Almendral, 2012). This had to be achieved while retaining the equal treatment of all Spanish citizens.

The solution offered has become known as Spain’s “State of the Autonomies” (Estado de las Autonomías). At the heart of the system is a process of asymmetric decentralisation of powers to the ACs. Such asymmetry takes two forms: 1) it transferred competencies to different regions at different paces between 1979 and 2002, when the process was completed;55 2) it gave two ACs, the Basque Country and Navarre, special tax-raising powers in recognition of their “historical rights” guaranteed by royal charters (fueros) over the centuries (Fernández Llera, 2009). All other 15 ACs were granted much more limited revenue-raising powers.

Progressive devolution of spending over the last four decades has radically transformed the structure of public administration in Spain. As Table 4 illustrates, between 1982 and 2008 the share of total public spending disbursed by ACs grew tenfold, while central government’s share dropped from 85 per cent to half of the total.56

1982 1995 2008 2013

Local government 10.6% 11.1% 13.3% 10.8%

Autonomous Communities 3.6% 21.5% 36.5% 31.6% (ACs)

Central government (incl. Social 85.5% 67.3% 50.2% 57.6% Security)

Table 4: Local, regional and national government spending as a share of total Spanish public expenditure (source: Cuenca, 2009; Intervención General de la Administración del Estado; OECD Fiscal Decentralisation Database, 2015). N.B. Figures are approximate and may not add up to 100 per cent.

55 Power transfers in each AC followed one of three routes prescribed in the 1978 Spanish Constitution. Heywood (2000) explains the process in greater detail. 56 It is also worth noting that ACs’ and municipalities’ shares of public expenditure declined following the 2008 recession, likely due to a drop in revenues from the taxes ceded to or levied by them.

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The growth in ACs’ share of public spending reflects the gradual transfer of responsibility from the central government to the ACs for the management of a large array of government programmes, notably healthcare, education, employment and environmental policy. In many of these areas, the national government has retained prerogatives to set the ‘general framework’ of policy, while ACs are tasked with implementation (Heywood, 2000). At the same time, the central government maintains full control over areas seen as of national importance, not just including defence and foreign relations, but also public works, roads and train networks involving more than one AC, as well as some large ports and airports, and inland revenue.

While spending has been substantially decentralised since 1978, revenue-raising responsibilities have not kept pace. As Table 5 shows, ACs’ share of tax revenue has lagged behind by as much as 13 percentage points when compared to their share of public spending. Even this number overstates AC’s tax autonomy, since much of their revenue comes from so-called ceded taxes – a share of personal income tax and VAT, as well as inheritance and gift tax, wealth tax, gambling taxes, and others – which are, to a large extent, determined by the central government.57 ACs have some limited control over rate-setting and deductions, but they have to follow the general framework set by the national government.

1982 1995 2008 2013

Local government 7.5% 8.5% 9.6% 10.1%

Autonomous Communities 1.5% 4.8% 23.8% 25.4% (ACs)

Central government (incl. Social 91.0% 86.7% 68.4% 64.6% Security)

Table 5: Local, regional and national tax revenue as a percentage of total tax revenue in Spain (source: OECD Fiscal Decentralisation Database, 2015). N.B. Figures are approximate and may not add up to 100 per cent.

This means that, despite enjoying significant powers over the allocation and management of public spending, ACs are heavily dependent on the central government to finance the lion’s share of their outlays (Ruiz Almendral, 2002 and 2004). Their main sources of income are thus revenue from the ceded taxes, as well as

57 This has led some scholars (Ruiz Almendral, 2002; Heywood, 2000) to view ceded taxes more as central government transfers than own sources of AC tax revenue.

Page 234 of 420 Institute of Economic Affairs – Written evidence (DPF0006) conditional and unconditional transfers from the national government.58 Transfers are determined through a complex formula (see de la Fuente, 2012) taking into account expected and real tax revenue from the AC in question, which is then adjusted for factors which may warrant additional funding (e.g. regional languages, low density and scattered populations, etc.). The final figure for each region is arrived at through regular political negotiations between AC governments and the central government, on a bilateral and multilateral basis.

The details of the system are beyond the scope of this section, but it becomes clear that there is an acute imbalance between ACs’ tax and spending powers. Successive reforms were passed in 1997, 2002 and 2009 to try and close the gap (de la Fuente, 2012), and while some progress has been made the tax autonomy of regional governments remains limited.

Problems with Spain’s devolution settlement

The most salient problem with Spain’s current system of devolution is that it lacks incentives for ACs to manage their affairs efficiently. As Ruiz Almendral (2004) has pointed out, the status quo enables regional governments to make spending decisions without having to account for the required tax revenue, and without having to explain to voters why such spending is necessary and worth the cost. What is more, to the extent that increased expenditures can be used as an argument for additional central government transfers in budget negotiations, regional politicians are encouraged to live above their means.

These incentives appear to be borne out by the data. Even in the boom years that preceded the 2008 crash, when the central government was posting budget surpluses of up to two per cent of GDP, ACs had difficulty managing their books (Cuenca, 2009). While there was strong variation across regions, most AC governments – with the notable exception of the Basque Country and Navarre, which operate under a more balanced and decentralised regime – recorded small deficits. Many administrations spent lavishly on items of questionable value, such as regional public broadcasters, remote airports and myriad cultural facilities (The Economist, 2008). It is telling that AC government-owned enterprises saw their debts grow more than fourfold between 1995 and 2007, compared to 50 per cent for all state-owned enterprises (Fernández Llera, 2009).

The economic crisis that gripped Spain between 2008 and 2013 further highlighted the deficiencies of the system. AC budget deficits soared across the board, reaching levels of up to six per cent per year (Cuenca, 2009). Given the acuteness of the downturn, the rapid rise in regional government budget shortfalls cannot solely be blamed on a poor devolution settlement, but it was arguably made worse by it. More importantly, ACs’ lack of own resources to meet their spending commitments pushed the government to

58 There has been a third major source of income for some ACs in the form of EU structural funds since Spain joined the European Community in 1986. Their impact on intergovernmental relations within Spain is beyond the scope of the present discussion.

Page 235 of 420 Institute of Economic Affairs – Written evidence (DPF0006) take increasing responsibility over the design and management of regional budgets. In a process akin to developments taking place in the Eurozone around the same time, central authorities attempted to set strict deficit and debt targets for ACs to follow, with limited success (Cuenca, 2009; Ruiz Almendral and Cuenca, 2014). This undermined a fundamental principle underlying the devolved constitutional settlement in Spain, namely that regional governments enjoy autonomy over the management of their financial affairs. It also decisively hurt the credibility of the no- bailout principle – which had never been explicitly acknowledged – raising concerns about moral hazard and the potential that ACs will expect central government assistance in future budget crises.

Lessons for Spain (and the UK)

Prior to the crisis, the devolution settlement in Spain was widely viewed as broadly successful, if still a work in progress (Heywood, 2000; Ruiz Almendral, 2002). The 2008 downturn exposed the severe weaknesses in the system, which stemmed largely from a persistent lack of revenue-raising responsibilities to match ACs’ spending powers. Reforms aimed at increasing regional governments’ tax autonomy addressed the imbalance only mildly, and they failed to introduce adequate incentives for ACs to take responsibility over their spending commitments. This has not only undermined the principles underlying devolution, but it has also compromised the soundness of Spain’s public finances at all levels of government.

The experience of the crisis, together with renewed pressures for self-government in Catalonia and (to a lesser degree) the Basque Country, have pushed policymakers to recognise the need for substantial reform in the way of genuine fiscal decentralisation. This could follow the model of the Basque Country and Navarre, which due to their foral status have responsibility for raising the vast majority of taxes, including personal income tax, corporation tax and VAT. In turn, they transfer a small amount (cupo) to the central government to pay for nationally provided services.59 This means that they are self-reliant for over 90 per cent of their expenditures and receive less than three per cent of their resources from the central government (Ruiz Almendral, 2004). Extending the arrangements in these two ACs to all other regions would turn Spain into a genuinely federal country, more akin to Germany and Canada.

The Spanish experience offers two key lessons for any future process of devolution in the UK. The first is that any arrangement which does not couple the transfer of spending responsibilities with a concomitant decentralisation of tax-raising powers will make the system fragile and undermine governance. The second is that there must be an explicit no-bailout principle that is stated from the outset. Only in this way can accountability and fiscal responsibility be ensured.

59 There has been some controversy over the specific amount to be transferred to the national government, with some observers claiming it is too low when compared to the services provided in exchange. Nevertheless, it is the arrangement itself rather than the figures which matter for our analysis.

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Conclusion

There is ample room for and much to be gained from extensive devolution of public finances in the United Kingdom. The UK currently lags behind its peers in fiscal decentralisation, particularly with regard to revenue raising. Existing arrangements, whereby some spending powers are devolved to Scotland, Wales and Northern Ireland while revenue-raising responsibilities remain in Westminster, create an artificial bias in favour of big government which is unrepresentative of the views of the average UK voter. This problem is compounded by the over-representation of the home nations in Parliament. Half-baked solutions such as English Votes for English Laws (EVEL) would impair government’s ability to pass legislation in certain circumstances, while also weakening the accountability of English MPs.

Instead, we have proposed a federal solution. Such a reform would see a substantial amount of powers transferred to lower levels of government, with the central government retaining authority over defence, border control and foreign affairs. The principle guiding decentralisation should be that of subsidiarity, i.e. that powers should be handed over to the lowest level of government that is consistent with the efficient provision of public goods. In general, the bias should be in favour of over- decentralisation.

A federal system would bring many benefits. Local governments would be able to offer packages of public goods that were better suited to local conditions and to the preferences of local residents. It would enable citizens to ‘vote with their feet’ in reaction to local government policy, making local authorities more accountable for their decisions. A federal solution would also tackle the complexity of the current system and make local elections less prone to be abused to ‘send a message’ to central government. Additionally, most international evidence suggests fiscal decentralisation as part of a federal solution would have a positive impact on national income.

The main advantage of a federal solution would be to align taxation, representation and decision making on all levels of government. This would be achieved by giving local governments power to levy their own taxes – e.g. property taxes, consumption taxes, natural resource levies, tourist taxes – to pay for locally provided services. A number of functions would be administered by local government but funded by the central government. These would include working-age welfare and housing benefit. Education and healthcare policy, which are currently heavily centralised, could also be partly transferred to local government, though ideally decentralisation should take place alongside wide-ranging reforms to give greater choice to parents and patients, respectively.

In light of the experience of other federal systems which have seen a tendency for powers to flow back to the centre over time, a mechanism would have to be devised to prevent re-centralisation. We suggest that unanimity be required at the sub-national

Page 237 of 420 Institute of Economic Affairs – Written evidence (DPF0006) level whenever it is proposed to transfer powers to a higher level of government, and that sub-national parliaments be involved as well.

Crucially, there should be an explicit understanding between the federal government and sub-national governments that the former will not bail out the latter. This is more important than introducing limits on sub-national borrowing and debt. Articulating the no-bailout principle in advance appears particularly important given the recent experience in Spain. Together with the effective alignment of revenue-raising and spending powers, this principle must be at the heart of any devolution process that aims to ensure stability, accountability and prudent fiscal management on all levels of government.

20 August 2015

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Peter Jones – Written evidence (DPF0020)

Written submission to House of Lords Economic Affairs Committee, Evidence hearing in Edinburgh, 9 September 2015.

Peter Jones, Freelance journalist. (The Economist, The Times, The Scotsman)

This paper is adapted from others written for different purposes around the time that the Smith Commission was sitting. I acknowledge the assistance I received from Dr Angus Armstrong, director of macroeconomics, National Institute for Economic and Social Research. I bear full responsibility for all opinions and any errors and omissions.

Summary.

On any reasonable assessment, the people of Scotland voted in the independence referendum on 18 September 2014 against independence and for Scotland to remain in the UK. They were also promised that a “no” vote would result in substantial further devolution including fiscal devolution. A reasonable conclusion is that the legislative process implementing the recommendations of the Smith Commission for enhancing the legislative and fiscal powers of the Scottish parliament should not weaken the UK, but rather strengthen it. But there is good reason to think that two of the proposals – the near-complete devolution of earned income tax and for greatly increased borrowing powers - could well weaken the UK. This paper proposes remedies for these problems.

Income tax.

The major proposal to have emerged from the Smith Commission and which the UK government intends to take forward into legislation is that there should be near- complete devolution of income tax to the Scottish parliament. Only the setting of the personal allowance and reliefs such as for pension contributions should be retained at Westminster.

This is argued by its supporters to amount to a sharing of income tax responsibilities. It is not, because 100 per cent of the revenues would accrue to the Scottish government and zero to the UK government. National Insurance contributions are argued by some to be an income tax under another name. However, because they are paid both by employers and employees and have a direct effect on the eventual state pension received by an employee, NI contributions are better described as a payroll tax.

In no federal system of government (where there are three layers of government – central, state/regional, local) is there any example of the central government raising no income tax revenue from any state/region/province. This occurs for a very good reason. Personal income tax is one of the three major fiscal tools of any government,

Page 239 of 420 Peter Jones – Written evidence (DPF0020) the others being sales/VAT taxes, and corporate income and payroll taxes. All three of these taxes are by far the most important fiscal tools that any government has at its disposal for macro-economic management. No other taxes provide the same ability to boost or depress demand as do these taxes.

It therefore follows that if the UK government was to cede control of income tax in Scotland, it would have lost some control of a significant fiscal tool. Political pressures would, in all probability, lead to the same tax devolution in Wales and Northern Ireland, and then, under English votes for English laws (EVEL), in England for a government which did not command a majority of English Westminster seats. The UK government can therefore be argued as having embarked, uniquely amongst developed countries, on a process which will eventually deprive itself of its most significant fiscal macro-economic management tool.

This would have serious knock-on effects. The most significant is that because the UK government would have much less fiscal flexibility in macro-economic management, its credit rating is liable to be down-graded, raising borrowing costs not just for government borrowing, but also across the domestic lending spectrum – mortgages, corporate debt, personal lending – exacting a price on Scottish and all UK citizens.

One of the roles of the UK government is to act as insurer of last resort. No one can tell what the next systemic economic risk might be. But when it occurs, the UK government must be able to borrow freely at low cost. The UK has protected this right since Charles II. But if the UK government is no longer in control of its largest single source of tax revenue – income tax – even if there has been a compensating adjustment in the block grant – the UK’s ability to commit to do whatever is necessary to repay creditors is hampered.

Moreover, because under the EVEL principle England would take fiscal policy decisions for 84% of the union, combined with whatever policy response the Bank of England would choose, a large part of macroeconomic management for the UK would be without the inclusion of Scottish MPs in the decision making. And because Scotland is such an open economy, any decisions taken in Scotland with respect to Scotland’s economy will be less effective due to leakages into the rest of the UK. Scottish decision makers might, in fact, end up with less power.

An entirely reasonable conclusion from the September 18th referendum result is that a majority of Scots want to stay in the UK, but for the Scottish parliament to have additional powers, including fiscal powers. It does not follow that a majority of Scots want to see the UK damaged by the near-complete devolution of income tax. If any devolution proposal comes to be seen by the rest of UK citizens as damaging to their interests, this could have serious repercussions in terms of weakening the union.

An alternative fiscal devolution model

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These serious problems could be avoided if there was a genuine sharing of income tax. Models do exist which provide for the required additional tax-raising accountability demanded of this process, which would provide the Scottish government with considerable economic management power and would go further towards paving the way for further fiscal reform than does the near-complete devolution of income tax model.

This latter aspect is perhaps the most important attribute of the proposal presented here. It would allow for similar income tax devolution to Wales and Northern Ireland, even possibly to England, and create a model which could also be applied to other taxes as well. The same cannot be said of the near-complete devolution proposal.

The model presented here is drawn from Canada where in Québec there is a similar political situation of a nationalist party seeking to secede from the union. Canada is one of the world’s most decentralised federations. Provincial governments are responsible for raising 40 per cent of all government taxes, equating to just over 12 per cent of Canadian GDP. In the case of Québec, less than 20 per cent of the provincial government’s budget comes from transfers (block grant) from the federal government.

Personal income tax is shared. All provinces levy an income tax on top of the federal income tax. Taxpayers complete two tax returns but make one tax payment to the Canada Revenue Agency. In Québec the payment is made to the revenue agency of the Québec government which passes on the federal government share. The income tax rates, both federal and provincial, that are applicable in Québec in 2014 are set out in Table 1.

Table 1: Canadian federal and provincial income tax rates and bands in Quebec, 2014.

Québec tax table Federal tax table Income bands ($) Income bands ($) Basic Federal federal rate in % Rate rate Quebec Above Up to applicable Above Up to (%) (%) 0 41,495 15 0 43,953 15 12.53 41,495 82,985 20 43,953 87,907 22 18.37 82,985 100,970 24 87,907 136,270 26 21.71 100,970 25.75 136,270 29 24.22

Source: Québec government, Québec’s personal income tax system, September 2014.

The table needs some explanation. The column headed “Basic federal rate (%)” shows the federal income tax normally applicable in all provinces. The Québec federal income tax is lower because on two occasions, in 1964-65 and 1977-78, the federal government offered provincial governments the opportunity to opt out of certain federal health and social protection programmes in exchange for a reduction in the

Page 241 of 420 Peter Jones – Written evidence (DPF0020) federal income tax rate levied in the province. The provincial governments would then have to finance these programmes from their own tax revenues and would also control the welfare functions. These “tax for welfare” exchanges were made in such a way as to be revenue neutral at the point of change, though thereafter the provinces were free to alter the programmes and bear the consequences in the taxes they levied. The Québec government accepted the offer.

As a result of these changes, and one other, federal income tax rates levied in Québec are now 16.5 percentage points lower than the basic federal rate, ie are 83.5 per cent of the basic federal rate levied in most other provinces.. According to the Québec government, “the special Québec abatement does not engender any financial gain for the Québec government since the 16.5% reduction in federal tax from which Québec taxpayers benefit is subtracted from Québec’s federal transfers for health care, postsecondary education and other social programs (13.5 points) and the fiscal transfer pertaining to the former youth allowance program is reimbursed (3 points) to the federal government.”60 In the UK context, the subtraction would equate to a reduction in the Treasury block grant.

The system looks complex, and to some extent it is. Both the federal government and the provincial governments set their own tax allowances and reliefs. For example, the federal government sets a tax-free personal income allowance of (in 2014) of $11,138 for all Canadian income earners and the Québec government sets a slightly different one of $11,305. Once personal allowances and other federal and provincial reliefs are calculated, the tax bands and rates for the Québec taxpayer look a little simpler. (see Table 2).

Table 2. Combined Canadian federal and Québec provincial income tax bands and rates. Quebec Federal rate rate Combined Taxable income bands ($) (%) (%) rate (%) 0-41,495 15 12.53 27.53 41,495-43,953 20 12.53 32.53 43-953-82,985 20 18.37 38.37 82,985-87,907 24 18.37 42.37 87,907-100,970 24 21.71 45.71 100,970-136,270 25.75 21.71 47.46 Over 136,270 25.74 24.22 49.96

For a UK taxpayer, it looks much more complicated. But since this kind of banding is faced by all Canadians, it obviously works. In Scotland, there is no need to introduce this complexity immediately. It could be phased in, beginning with a straightforward

60 Québec government, Québec’s personal income tax system, September 2014. Page 24.

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50:50 UK/Scotland sharing of income tax. On 2014-15 bands and rates it could look like Table 3.

Table 3: Possible UK and Scotland allocation of income taxes.

UK income tax Scotland income tax Combined Rate Rate UK/Sc rate From To (%) From To (%) (%) Personal allowance 0 10,000 0 0 10,000 0 0 Basic rate 10,001 41,865 10 10,001 41,865 10 20 Upper rate 41,866 150,000 20 41,866 150,000 20 40 Additional rate 150,000+ 22.5 150,000+ 22.5 45

This, on the Scottish government estimates for 2012-13, should raise £5,432 million. The Treasury block grant would be reduced by an equivalent amount by the methods set out in the Scotland Act 2012 for other devolved taxes.

The final column is the one that would matter as far as taxpayers are concerned. Over time the Scottish government could begin to introduce changes to bandings and the personal allowance as it believed was necessary. There are some quite wide variations in income tax between the Canadian provinces. Alberta has the lowest maximum marginal rate (combined federal and provincial) of 39 per cent and Nova Scotia the highest of 50 per cent. The Quebec government notes: “High-income taxpayers in Québec are taxed at a marginal tax rate comparable to the one in Ontario (49.53%). However, the maximum rate in Québec is reached on an income of roughly $135 000, as against $220 000 in Ontario. As for Nova Scotia, which has the highest maximum marginal tax rate, the rate is reached on income of $150 000.”61

Compared to the proposal for near-complete devolution of income tax to Scotland, adoption of the Canadian model has two disadvantages. First, it is potentially more complex, although there is no means of knowing how complex a near-completely devolved income tax might become. Second, it would make the Scottish parliament responsible for raising about half the revenue that the near-complete devolution proposal would raise..

However, it many more several advantages.

1. It retains the direct link and accountability between individual Scottish taxpayers and the UK government which otherwise would be at risk of being severed. 2. It does not impair the UK government’s ability to raise income tax in Scotland and therefore does not impair its macro-economic management ability. 3. Because of (2), it does not pose a risk of increased borrowing costs.

61 Ibid. Page 25.

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4. As a tool of regional economic management, it offers exactly the same capabilities as near-complete income tax devolution. 5. It is flexible – the UK/Scotland division proposed here is 50:50, but it could easily be some other ratio. 6. Experience of how it works can be used to extend the sharing model to other taxes. This would create a basket of taxes and tax-raising powers so increasing the Scottish government’s economic management ability. 7. It can also be applied to other devolved parts of the UK without impairing UK macro-economic management capacity. In time, if the UK evolves towards a federal model of government, Scotland would have led the way. 8. It is a proven model that works in Canada, which would provide lessons for both the UK and Scottish governments in how tax-sharing can be made to work for the benefit of both Scottish and UK taxpayers. 9. Because it is a proven model, the capital markets would be much less uncertain about its effects than if there was the unknown model of near-complete income tax devolution. 10. The Canadian experience of reducing federal income taxes in certain provinces in exchange for provinces taking on additional welfare responsibilities can be used as an alternative to reductions in the block grant as a means of effecting such power transfers.

It would, of course, lead to cross-border differentials in income tax, both in administrative costs to the government and employers. But the same would apply to other income tax proposals. Politicians would be responsible for minimising these costs and any damaging economic effects such differentials would have.

Relying on individuals’ incomes for the bulk of fully devolved taxes does pose two risks for the Scottish government and its taxpayers. In any external economic shock such as a global downturn, employment is liable to be affected, cutting the revenue stream. Raising income tax to compensate merely worsens the problem which may be exacerbated further if the Scottish parliament gains control of certain welfare functions, expenditure on which will rise in a recession.

It also exposes Scottish public finances to the long-term demographic risk of the population of income earners declining relative to the elderly dependent population. This is a problem faced by all developed nations but current demographic projections suggest it is a more acute problem in Scotland than in the UK. Expenditure will have to rise to meet it, but the spending issue is less acute than in the UK because it is expected that pensions will remain a reserved responsibility

In summary, the proposal presented here maintains the integrity of the UK which it otherwise threatened by near-complete devolution of income tax, minimises potential macro-economic costs which the other proposal maximises, provides the Scottish government with the same economic capabilities and accountability, and introduces a flexible model which is capable of being extended, both to further tax devolution to Scotland and within the rest of the UK.

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For illustration purposes the sums involved in the above proposal are set out below. The table assumes that existing devolved taxes including those devolved under the Scotland Act 2012 (with the Act’s plans for income tax replaced by the 50:50 sharing plan) plus air passenger duty are fully devolved to the Scottish parliament.

Table 4: Taxes devolved with full Scottish Government control Under 50:50 Sc/UK sharing Tax Amount Amount raising Tax sums raised raised Amount fully for which (GERS by raised devolved Scotland 2012- Scottish by UK to would be Tax 13) Govt. Govt. Scotland responsible Council tax 2006 2,006 2,006 Non domestic rates 1981 1,981 1,981 Landfill tax 100 100 100 Stamp duty land tax 288 288 288 Air Passenger duties 234 234 234 Income Tax 10,865 5,432 5,432 5,432 TOTAL 10,041 SG expenditure 2012-13 38,546 SG taxes as % of SG expenditure 26.0 Note: HB – Housing Benefit, AA - Attendance Allowance

To this range of devolved taxes can be added a further range of taxes which can also be shared on a 50:50 assigned basis with a view to developing this further, where possible, to make the Scotland half-share a fully devolved tax. This would cover corporation tax, VAT, inheritance tax, vehicle excise duties, fuel duties, alcohol duties, and tobacco duties.

The rationale for so doing is that this set of taxes can be argued to conform to the recent advice announced as coming from the Scottish government’s Council of Economic Advisers that devolution of a “suite” of taxes would be preferable to a “small basket” of taxes.62 “Suite” can be interpreted to mean a complete range of taxes levied on all forms of economic activities giving a government a more complete kit of fiscal tools for economic management which also minimise the risks of being too narrowly reliant on one or two revenue streams. “Basket”, on the other hand, may mean an assortment of taxes which do not fulfil that function.

62 Scottish Government, News Release, November 12, 2014. “FM: Experts provide advice to inform devolution proposals” Available at: http://news.scotland.gov.uk/News/Council-of-Economic-Advisers- 124a.aspx

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The Council is right that it is better to have a range of taxes so that if one revenue stream is affected by an external shock, the effect is less painful because other revenue streams are not so affected. Such a shock is most obviously evident now because of the fall in crude oil prices which, if offshore revenues were completely devolved, would result in a slump in Scottish government revenues. This would be offset to some extent by an improvement in onshore income and consumption taxes that would be expected from lower energy prices causing an economic boost.

VAT, fuel, alcohol, and tobacco duties are consumption taxes. VAT, however, is subject to EU regulation which prohibits variation of this within a member state. There are also difficulties caused by EU regulations inhibiting the exercise of full variation power of a 50 per cent of alcohol, tobacco, and fuel duties by the Scottish government. If so, the revenues could be devolved initially on an assigned basis, with both the UK and Scottish governments agreeing to working jointly to persuade the EU to permit Scottish variation of the Scottish half of the taxes.

Problems of internet sales across the border of alcohol and tobacco and illicit cross- border trafficking may make complete devolution unworkable even if a way through EU regulations could be found. Vehicle excise duties may be more amenable to complete devolution (not just on a 50:50 sharing basis but also under 100 per cent devolution) although there are issues about where owners of vehicle fleets such as rental and trucking firms may register the vehicles to take advantage of any difference in duties.

EU regulation is also an issue with corporation tax because a reduction of corporation tax in one part of a member state may also be judged by the EU to be a state aid to benefitting companies. The criteria here appears to be that the sub-national jurisdiction in which the tax reduction takes place has to show with considerable transparency that it is not receiving any additional transfers from the central government to compensate for any lost corporation tax revenue. The proposed transferral of corporation tax to Northern Ireland indicates however that this problem is not insoluble. A 50:50 revenue sharing scheme does not raise the issues of profit- shifting or distorting locational behaviour to avoid paying tax that are commonly argued to be disadvantages of devolving control of corporation tax. In time it might be possible to replace it with the scheme proposed by the Holtham commission in Wales. It suggested a Welsh corporation tax under Welsh assembly control which could be applied to profits generated in Wales. For a cross-border company with profits generated outside Wales, it could apply to a percentage of profits determined by the proportion of its employees working in Wales. Such a scheme might well work in Scotland.

Inheritance tax is a wealth transfer tax not subject to EU regulation, but it may create legal issues relating to the domicile of the deceased which are difficult to resolve.

The fiscal effects of devolving these taxes on a 50:50 shared basis are set out in the table below which adds in the fully devolved taxes.

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Table 5: Tax revenues assigned to Scottish Government plus devolved taxes Under 50:50 Sc/UK sharing Tax raising Amount Amount devolved Tax sums raised accruing Amount and for which (GERS to accruing accruing Scotland 2012- Scottish to UK to would be Tax 13) Govt. Govt. Scotland responsible Vehicle excise duties 481 240 240 240 Fuel duties 2258 1129 1129 1,129 Alcohol duties 980 490 490 490 Tobacco duties 1128 564 564 564 Betting and gaming and duties 120 60 60 60 VAT 9347 4673 4673 4,673 Corporation Tax (onshore) 2872 1436 1436 1,436 Inheritance Tax 243 171 171 171 Total assigned revenues 8,763

SG expenditure 2012-13 38,546 SG assigned revenues as % of expenditure 22.7 SG exp. + HB and AA 40,775 SG taxes as % exp. + HB and AA 21.5

Total devolved Scottish taxes 10,041 Total assigned Scottish revenues 8,763 Total all Scottish revenues 18,804

All revenues as % exp. 48.8 All revenues as % exp. +HB & AA 46.1

Under this proposal, Scotland would be raising nearly 50 per cent of what the Scottish government spends, roughly half from taxes under its own control and half from assigned revenues. The Treasury block grant would be reduced accordingly

Assigned revenues are normally regarded scornfully by the politically-interested who believe that only fully Scottish-controlled taxes can deliver the necessary degree of fiscal responsibility to politicians and give the kind of incentive needed to encourage political interest in efficient allocation of public resources and economic growth. That

Page 247 of 420 Peter Jones – Written evidence (DPF0020) is not entirely true. It would be a peculiar government which was uninterested in growing the tax base of companies and retailers for growth in corporation tax and VAT revenues in order to get half of the revenues whilst also providing more employment to generate more income tax.

It is true that there is a certain amount of exposure to the risk that revenues might be cut by UK government decisions to reduce tax rates. But such decisions are usually argued as being expected to stimulate economic activity and therefore to be revenue- generating.

An important feature of what is set out here is that this is not intended to be the final end product. In other words, the Smith commission recommendations should not be regarded as leading to a one-off legislative event turning the proposals into action. While there should be that event, it should also be the start of a process whereby all the taxes which are assigned (with the exception of the shared income tax) should be examined for their suitability for devolution to the Scottish parliament, either for power to vary the 50 per cent assigned share or for complete devolution in their entirety.

This is because all of the taxes subject to assignation have complexities which need to be thoroughly worked through by both the UK and Scottish governments and with extensive public and expert consultation. The public consultation conducted by the Smith commission threw up some interesting suggestions for devolution, such as tax incentives for business research and development. These are subjects and a process which could not be given the attention they deserve in the compressed timescale given to the Smith commission. But it can be provided for in the legislation which implements the agreements on what tax and other powers should be fully devolved.

A possibility is that there should be a standing committee of both parliaments which is charged with conducting such an examination, with the aim of producing proposals which can be legislated before the end of this parliament.

Enhanced devolution and borrowing.

If the Scottish parliament’s fiscal powers are to be enhanced beyond the increased tax devolution set down in the Scotland Act 2012, then it follows that devolved borrowing powers should also be similarly enhanced. The ability to tax without a commensurate ability to borrow means that the Scottish government would be constrained at least into having to run a balanced budget or, more prudently, a surplus in case external economic shocks caused an unexpected revenue shortfall or required the introduction of counter-cyclical policies. But maintaining a surplus can also be an inefficient use of resources.

The borrowing limits set out in the Scotland Act 2012 – capital borrowing of 10 per cent of capital departmental expenditure limit in any one year up to a cumulative limit of £2.2 billion, revenue borrowing up to a limit of £200m in any one year, cumulating

Page 248 of 420 Peter Jones – Written evidence (DPF0020) to an overall limit of £500 million, plus the ability to hold cash reserves of £125 million – seem arbitrary.

How the UK government has arrived at the limits decreed in the Act is not at all clear. They should have some relationship to the amount of taxes for which the Scottish government is responsible since the revenue borrowing is intended to smooth any lumpiness in the payment of taxes and to cover what increasingly appear to be random shortfalls. On one set of calculations based on 2012-13 spending (Campaign for Scottish Home Rule), the Act increases the revenue the Scottish parliament is responsible for raising from £4 billion to £8.7 billion, or from 10.3 per cent to 22.5 per cent of total spending within Scottish parliamentary control of £38.5 billion. The revenue borrowing power amounts to just 2.2 per cent of tax revenues, or 3.7 per cent if it is assumed a full cash reserve is also available. This comes close to imposing a balanced budget constraint.

Having to run a balanced budget often looks to most people to be a good thing. Governments are compelled to spend only what they can raise in taxation. Since electorates are usually reluctant to endorse tax increases, politicians are pushed more towards making public services efficient in order to improve them rather than simply spending more on providing them. Conversely, it can also lead to governments having bad fiscal policies intended to raise more revenue that is actually needed in order to give themselves wriggle room for election bribes. A balanced budget rule also assumes that governments are incapable of being prudent.

Balanced budgets run into trouble when an external shock such as a global economic downturn depresses an otherwise fully functioning economy, causing unemployment to rise. Under a balanced budget constraint, a government has no choice but to cut public spending. These cuts become magnified because not only does a government face a reduction in its revenues, it also, assuming a state-funded social security system, faces an increase in its spending on unemployment and associated reliefs. Being able to borrow to finance that spending and to invest in order to take best advantage of the eventual upturn is therefore an essential tool.

Sovereign borrowing is essentially a promise to pay a lender interest and to repay the principal sum from future taxation revenues. Lenders therefore take a keen interest in the ability of the sovereign borrower to raise those revenues. Factors such as political stability, economic strength, volatility of the tax base, taxation levers available to central government, currency arrangements and ability to print money if necessary, contingent liabilities etc., are taken into account to assess the risks associated with lending money to a government. These risks are most commonly expressed by the credit ratings attached to sovereign borrowers by the ratings agencies.

Assessing how much borrowing power the Scottish government should have under a new devolution settlement presents particular difficulties. It would be possible to simply expand or uprate the borrowing limits set under the Scotland Act 2012 in line with any increase in tax-raising and/or spending responsibility. The arbitrary nature of

Page 249 of 420 Peter Jones – Written evidence (DPF0020) these limits, however, suggests that in times of economic stress when there might be high political demand to exceed these limits, there would be renewed political stress on the union with the rest of the UK. Moreover, in times of economic stress the cost of borrowing from capital markets may be at its highest and the ability to do so at its lowest.

While it is unlikely that the potential for this stress can be entirely extinguished, it could be greatly reduced if Scottish borrowing powers were seen to have been decided on objective criteria and were seen to be in tune with the overall macro-economic management framework of the UK. Indeed, it might be possible to design a relatively simple formula to determine borrowing capacity. The Barnett formula for distributing public spending to Scotland, Wales and Northern Ireland, even though it was intended to be temporary, has endured for nearly four decades largely because it is based on the simple and fair-sounding concept of aiming to ensure that every £1 per head increase or decrease that UK government decides should be spent on public services in England should also be available to be spent on public services in Scotland, Wales and Northern Ireland.

Designing such a formula for borrowing, however, is extremely difficult. There is no existing sub-national model available in the world which can be drawn on as a template. The UK is not a federation in which each state or provincial government has broadly equivalent powers. Nor does it seem likely that it will become one in the near future.

Following the independence referendum, it seems to be envisaged that Scotland will accrue greater taxation and spending responsibility than other semi-autonomous parts of the UK, while remaining within the sterling monetary union. These taxation powers, however, will fall well short of the normal range of tax powers available to sovereign borrowers.

It was also stressed during the referendum by No vote advocates that one of the advantages of the union was that Scotland had access to the relatively favourable borrowing terms enjoyed by the UK government. The No vote therefore should mean that this access via the National Loans Fund should continue as should the ability of the Scottish government to borrow on the capital markets which was inserted into the Scotland Act 2012 during 2014. It also means that Scottish borrowing powers will have to nest inside UK borrowing needs and policy in a way that allows reasonable freedom of action to the Scottish government without disrupting UK macroeconomic management.

The proposed increase in taxation powers raises, however, the question of who should pay the costs of Scottish borrowing. In principle, and in practice because of the UK’s present deficit, all of Scotland’s capital spending and some revenue spending is financed by borrowing. The costs of this are borne by all UK taxpayers. This is acceptable because Scottish-controlled tax revenues (council tax and non-domestic

Page 250 of 420 Peter Jones – Written evidence (DPF0020) rates) are only 0.7 per cent of UK tax revenues under the current devolution settlement, therefore Scots are also paying their fair share of borrowing costs.

This will change, both when the Scotland Act 2012 and any or all of the Smith Commission recommendations come into force. The Scottish government calculated that the Scotland Act 2012 will see the Scottish parliament become responsible for raising 16.3 per cent of all taxes raised in Scotland (on 2012-13 estimates), including a geographic share of offshore revenues. Under Smith, it estimated this proportion will rise to 29.1 per cent. Using figures compiled by The Institute for Fiscal Studies this proportion could be higher at 36.5 per cent. These proportions represent between 1.4- 3 per cent of all UK tax revenues.

These latter percentages sound small but there is nonetheless an important principle involved here. Currently, 92.5 per cent of taxes raised in Scotland (ie excluding council tax and non-domestic rates) are among those revenues which go towards paying borrowing costs. This would drop to 83.7 per cent under the Scotland Act 2012, and to as low as 63.5 per cent under Smith. It means that between 16.3 per cent and 36.5 per cent of taxes raised in Scotland would not be available to the UK government to pay the costs of borrowing. It also means that all other UK taxpayers would have to shoulder some borrowing costs that would otherwise have been paid by Scottish taxpayers. In other words, this would be a subsidy to Scotland and therefore a new imbalance or unfairness in UK territorial public finances.

This cannot be adjusted by changing the Barnett Formula adjustments to the Scottish block grant as borrowing costs are not devolved. Neither can it be resolved by making Scotland responsible for all Scottish capital and revenue borrowing and its costs as that would significantly drive up costs.

A possible solution would be to make Scottish taxpayers partly responsible for the costs of borrowing under the National Loans Fund for Scottish spending purposes. This could be set at the same percentage of all UK taxes (which have an equivalent in the rest of the UK) raised in Scotland but under the Scottish parliament’s control, less the percentage raised by council tax and non-domestic rates (which have devolved equivalents in the other home nations).

For example, under Smith and assuming the IFS calculations are correct, this percentage would be 36.5 per cent less 7.5 per cent, equalling 29 per cent. So for all capital and revenue borrowing notionally incurred under the National Loans Fund via capital Departmental Expenditure Limits and to finance Scotland’s revenue deficit, Scotland would pay 29 per cent of the cost. For all other borrowing on the capital markets, Scotland would pay the full cost.

There are two other problems. Within the current union state, Scotland benefits from low UK borrowing costs because of the UK’s record of never having defaulted on a debt and having the ability to print money. Scotland has no such record and no such ability, but it will remain in the union and benefit from that ability. This could be

Page 251 of 420 Peter Jones – Written evidence (DPF0020) regarded as the UK extending its credit rating to Scotland , therefore taking on the credit risk of Scotland and extending an implicit subsidy to Scotland. Arguably, however, this is a two-way deal – Scotland benefits from the union and the rest of the union benefits from having Scotland in it, cancelling out the costs.

This does not deal with the second problem, the potential new risk within the union that Scotland might default on its debts, either on the borrowing costs incurred under the National Loan Fund or on capital market borrowing. In a macro-economic context, the UK would be regarded, whether it liked it or not, as the lender of last resort and potentially liable for a bail-out of a bankrupt or defaulting Scotland. Just the potential of this could reduce the UK’s credit rating, imposing a cost on all UK taxpayers.

This argues strongly for the imposition of a no bail-out rule. Only Scottish taxpayers should be responsible for any imprudent fiscal behaviour of their government. Experience, however, suggests that this is extremely hard to enforce.

One way of avoiding the problem would be to set limits on Scottish borrowing, as in the Scotland Act 2012. Recent limits on capital investment set by the UK government, however, have led to loud complaints from the Scottish government that its ability to run a counter-cyclical investment programme during the recent recession was severely curtailed to the detriment of the Scottish economy. In its view, the UK government’s policy was mistaken, a disagreement which is mirrored in economists’ divergent views on how to combat the downturn.

The contrasting view is that if Scotland had had complete freedom over borrowing, excessive use of it might have endangered UK economic stability. For example, excessive borrowing by Spain’s autonomous communities (regional governments) was a factor in the credit ratings downgrades applied to Spanish sovereign debt during the European sovereign debt crisis by the ratings agencies because it was seen to be an increase in debt which was not adequately controlled by the central government.

On the other hand, sub-national governments in, for example Canada and Australia, have shown commendable self-discipline. Scotland, also, will not be exposed to the cost risks of a financial crisis, except as UK taxpayers, because that will remain a UK responsibility. Still, at this stage, there is no means of knowing whether future Scottish governments will be self- or ill-disciplined. This argues strongly for the writing of a stringent no bail-out rule.

It should be made very explicit, both to Scottish taxpayers and the markets, that no- one should have any expectation that the costs of imprudent borrowing in order to, say, sustain revenue spending, will be paid by other UK taxpayers.

One way of doing this would be to increase the transparency and political salience of borrowing. At the moment, much of the mechanics of UK borrowing take place away from immediate attention. Market information about the success or failure of bond

Page 252 of 420 Peter Jones – Written evidence (DPF0020) auctions is available more or less immediately, as is monthly statistical information about borrowing. This, however, happens after the fact.

Forecasts of future UK borrowing needs are also made twice-yearly in the budget and autumn financial statement and otherwise occasionally by the Treasury, usually when borrowing needs look to be less than forecast.

The Scottish finance secretary should similarly be required to give twice-yearly and long-term borrowing forecasts to parliament which should also be subject to independent OBR-type scrutiny by the Scottish Fiscal Commission set up by the Scottish government.

The finance secretary could also be required to give the Scottish parliament’s finance committee quarterly or even monthly forecasts of immediate intended borrowing in the quarter/month ahead covering not just the quantum of expected borrowing, but what the purpose and expected costs of it are, and whether it would be from the National Loans Fund or from capital markets. These could also be required to be discussed at the UK/Scotland joint exchequer committee. The finance and the joint exchequer committees could both have powers to refer the borrowing proposal for debate and a vote in the Scottish parliament.

In the quarterly/monthly reports, the finance secretary should also be required to disclose the terms secured for borrowing in the previous month, so judgements can be made about the accuracy of his forecasts. These monthly reports would be an innovative way of providing sufficient transparency, political salience and leverage to discourage imprudent behaviour.

To deter the worst case scenario of a UK bail-out, the costs of this should be made an explicit and severe penalty on Scottish taxpayers. In the event of a Scottish public finance crisis, the Scottish government should be required to submit its budgetary plans to UK government inspection and amendment, much as the EU now invigilates the budgets of Greece, Ireland, and Cyprus. The UK government could also be empowered to recover the costs of any bail-out from Scottish-controlled tax revenues, which would have the effect of imposing spending cuts and/or tax increases on Scottish taxpayers.

This would also create the political risk that Scotland’s hard-fought for degree of independence might be permanently lost, an outcome which no Scottish political party and few Scots would want.

Scotland would have no choice but to accept this loss of independence as breaking away from the UK would not be an option. A defaulting government which had refused to accept pre-determined and well-known costs of default would be an international pariah, closed out not just from capital markets but also from institutions such as the EU.

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A final additional safeguard would be requiring the Scottish government to establish a reserve, set as a percentage of total borrowing, which would only be drawn upon in the event of a funding crisis causing borrowing repayment problems. This would be similar to the capital ratios that banks are required to meet.

There remains the question of whether any limit should be put on overall borrowing. Limits should be put on National Loan Fund borrowing, both for revenue and capital purposes and whether notional through DEL spending or real, in order not to breach UK macro-economic policy. As the degree of tax devolution is being matched by devolution of some borrowing costs which will have to be borne by Scottish taxpayers, there should be no increase in risk incurred by the UK.

Borrowing on the capital markets could in theory be unlimited. In practice, it is likely to be limited by the extra cost of so doing, especially if this extra cost is subject to pre- auction political debate and vote. Politicians and the public would be aware that the borrowing cost would reduce the amount of money available for spending on public services, risking tax increases. Capital markets would also be aware of the fiscal and economic background determining Scotland’s ability to repay and would charge accordingly, useful signal to the electorate as to the robustness of the government’s plans. The risk to the UK would be mostly, though not entirely, extinguished by the draconian no bail-out rule conditions described above.

A final consideration is of what borrowing should be authorised in the event of an asymmetric shock which is more damaging to Scotland’s public finances than to the rest of the UK. Such a shock might demand more spending than is available from existing revenues and borrowing. There should be flexibility available, perhaps through discussion in the Joint Exchequer Committee to allow additional borrowing in the event of this happening. But Scotland should have to bear part of the costs of this as described for forecasted borrowing above. With the freedom to control taxes comes the responsibility of dealing with unexpected costs.

At this stage, it becomes possible to set out some principles which can guide the design of Scottish borrowing abilities. The main design issue is how to minimise and preferably remove risk shifting arising when the Scottish government makes the borrowing decision but does not bear the consequences of failure. The design will also have to distinguish between two types of borrowing, one for revenue spending purposes and the other for capital investment. Both capital and revenue borrowing power should be: (i) related to the Scottish government’s ability to raise taxes to repay loans; (ii) related to the proportion of tax-raising power within the UK for which Scotland is responsible; (iii) related to overall revenue and capital borrowing carried out by the UK government in any one year; (iv) cognisant that borrowing costs and the attendant risks will have to be borne by Scottish taxpayers;

Page 254 of 420 Peter Jones – Written evidence (DPF0020)

(v) cognisant that the risks to the UK have to be minimised and preferably extinguished.

Two additional principles dealing with the differing circumstances of revenue and capital borrowing powers need to be set out.

(vi) Revenue borrowing power should have provision for contingency spending needs such as economic shocks depressing tax revenues and requiring an increase in any welfare spending for which Scotland may be responsible.

Because the Scottish government is responsible for all public infrastructure investment in Scotland and the UK government has very little responsibility except mainly for the provision of defence installations, capital borrowing should be:

(vii) related to the proportion of the onshore economy in GDP terms represented by Scotland within the UK, assuming that offshore revenues are not devolved.

With these principles in mind, two possible rules for the limits on the Scottish government’s use of UK government borrowing facilities can be set out:

A. Revenue borrowing in a financial year ahead should be limited to a percentage of forecast UK revenue borrowing equivalent to the percentage of all UK tax revenues that the Scottish government has been responsible for raising in the financial year previous to that in which the year ahead revenue borrowing is being considered. B. Capital borrowing in a financial year ahead should be limited to a percentage of forecast UK capital borrowing equivalent to the percentage of all UK GDP represented by the Scottish economy in the financial year previous to that in which the year ahead capital borrowing is being considered.

The general intention of these rules is that Scottish borrowing conducted under UK auspices should be defined by UK borrowing needs as set by the UK Chancellor. The Chancellor would have to split forecast borrowing into two parts – a forecast for revenue needs (X1) and a forecast for capital needs (X2). For each element, the UK Treasury would then borrow X-Y% for UK needs where Y% is borrowing to be done by the Scottish government.

The Scottish government could choose whether it conducted some or all of this borrowing, and whether it did so via the National Loans Fund or the capital markets. It could borrow above the limit defined by UK borrowing needs, but only via the capital markets. The cost of this and the political salience it would have should be a practical limit on the use of this borrowing route. The existence of a capital reserve should also protect the UK (and the Scottish taxpayer) from the risks involved with this.

A capital reserve could also be used as a tool to manage the development of borrowing capacity. It would be realistic to imagine that the reserve would be built up gradually.

Page 255 of 420 Peter Jones – Written evidence (DPF0020)

Borrowing power could initially come with limitations which could be gradually relaxed as the reserve accumulated.

These are starting points rather than the finished article. Two major cautionary notes have to be made here.

First, as has been hinted at throughout the discussion, a full prospectus for borrowing powers cannot be developed until the precise nature of the tax and welfare powers to be devolved is known. For example, if the new devolution settlement leaves most welfare provision in the hands of Westminster, then Scotland’s borrowing needs in order to finance increased welfare provision in the event of an economic shock will be less than if considerable welfare powers are devolved to Scotland.

The type of taxes to be devolved also matter. If oil and gas taxes were to be devolved, greater borrowing capacity would be needed because of the extreme volatility of these revenues. Until the murkiness surrounding the proposed devolution settlement turns to clarity, the principles set out above cannot be turned into practical proposals.

Second, the discussion around how borrowing should be paid for highlights a significant wider issue which will have to be resolved. The issue is that further tax devolution erodes UK tax capacity and reduces the UK’s ability to raise taxes in Scotland. Under the Scotland Act 2012, this is not significant. A basket of smaller taxes in Scottish hands plus the ability to levy and vary 10p of the income tax rates leaves the main control of all the major taxes at Westminster.

Going further than this raises issues of fairness and macroeconomic management. The major proposal raised so far is that all income tax, save for the setting of the personal allowance and reliefs for such things as pension contributions, should be devolved. For all practical purposes, this takes income tax away from Westminster’s control.

The difficulty is that income tax is a major tax, raising about a quarter of all UK government revenues. Consider what might happen if there was a major shock. It might be a new military threat to all of the UK requiring a rapid increase in defence spending, or an epidemic requiring significant spending on civil emergency equipment and personnel, or an extreme weather event requiring substantial and expensive infrastructure reconstruction.

In non-devolved circumstances, the UK could use income tax to raise extra revenue to pay for these events. But under the income tax devolution proposal as it stands, it could only do this in England, Wales, and Northern Ireland. If it did so, then any benefit Scots derived from the expenditure would come free to Scottish taxpayers and would constitute free-riding by Scotland.

The only income tax tools affecting all UK taxpayers the UK government would have would be to reduce the personal income allowance, a highly regressive move, or to

Page 256 of 420 Peter Jones – Written evidence (DPF0020) restrict reliefs which could also have other adverse effects. As a means of financing all UK functions, such as defence or overseas aid, income tax would be ruled out, otherwise a Scottish free-riding problem is created which, because of its unfairness, would weaken the union.

This problem would become much more acute if income tax devolution to Scotland was extended to Wales and Northern Ireland. If it turned out to be good for Scotland, why should it not also be good for the other devolved nations? This means that income tax (under the EVEL principle) would also become devolved in England. A situation in which Scotland, Wales, and Northern Ireland could decide their own income tax and also decide income tax in England but England has no say on income tax in any other part of the UK would be politically unstable and could not endure.

It creates two main problems. First, because England is 84 per cent of the union, any tax decisions it takes directly affects the other union partners. This leads on to many consequences affecting regional economic policy within the UK which are concerning, but which are not relevant to this discussion of borrowing.

But the second problem is highly relevant. If the consequence of near-complete devolution of income tax to Scotland is similar devolution to the rest of the home nations (and it is hard to see how political pressure to achieve that could be resisted), then the UK government would have effectively lost control of income tax.

This would have serious consequences for borrowing. Income tax in 2012-13 was the single biggest revenue earner for the UK government, yielding £147.7 billion (25.2 per cent) out of total tax revenues of £586.9 billion, It would not escape the notice of the capital markets that the UK government had lost control of a quarter of its revenues. Sovereign debt generates relatively low but reliable returns for investors who use them as safe havens during turbulent times but more generally as long-term investments for assets such as pension funds. Because of the long-term nature of this market, investors are acutely attentive to risks even if they may only materialise in the medium- to long-term. This means that the markets would react not only if the UK reached the point of near-complete devolution of income tax UK-wide, but also to the possibility of that eventually occurring as a consequence of near-complete income tax devolution to Scotland.

If this measure was to be implemented, there is therefore the possibility that it would lead to the UK’s credit ratings being down-graded and consequential increased borrowing costs for the whole UK, adversely affecting Scottish as well as other UK taxpayers. This possibility would increase if the same measure was applied to Wales and/or Northern Ireland and become a certainty if it was to apply to the whole UK.

In conclusion, tax devolution and increased borrowing power are intimately linked. Some forms of tax devolution have greater impact on borrowing than others. It is possible for devolved borrowing powers to be less circumscribed than in the Scotland Act 2012, to ensure that the interests of both Scottish and rest of UK taxpayers are

Page 257 of 420 Peter Jones – Written evidence (DPF0020) properly protected, and for the provisions to permit greater Scottish borrowing freedom to be innovative. But it is also possible that if the tax and borrowing scheme is poorly designed that there could be adverse consequences for Scottish and rest of UK taxpayers.

8 September 2015

Page 258 of 420 Peter Jones and Lesley Riddoch– Oral evidence (QQ 47-55) (DPF0005)

Peter Jones and Lesley Riddoch– Oral evidence (QQ 47-55) (DPF0005)

Submission to be found under Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005).

Page 259 of 420 Professor John Kay, London School of Economics (LSE); The Weir Group PLC; Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) Professor John Kay, London School of Economics (LSE); The Weir Group PLC; Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98- 107) (DPFOE0008)

Submission to be found under The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008).

Page 260 of 420 Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013) Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013)

The devolution of public finances in the UK: A response to the House of Lords Economic Affairs Committee inquiry

1. We are pleased to submit this response to the House of Lords Committee Enquiry. We write as economists with direct experience of this subject: Dan Corry as a former Chair of the Council of Economic Advisers in the Treasury and Head of the Number 10 Policy Unit 2007 to 2010 and Peter Kenway as special adviser to the 2009 House of Lords Select Committee on the Barnett Formula.

2. Our response is short and addresses three of the questions the Committee is asking about the fiscal framework, namely:

 the principles that should govern the way devolved nations are funded;

 the institutional framework for the devolved and UK governments to discuss these matters; and

 how block grant funding should reflect devolved tax and welfare powers, including how the Smith Commission’s concept of “no detriment” might apply over time.

Principles

3. In our view, the first principle that must govern the way in which devolved nations are funded in future is that the resulting pattern of funding should be capable of both explanation and justification to the public. This justification must also be one that stands a chance of being accepted whichever side of whichever border the public happens to be.

4. With few exceptions, the arrangements for funding countries (and within England, local authorities) have conceded little to openness. The Barnett formula itself does provide a clear rule about how annual increments of public expenditure in each devolved nation are set. But as we explain below, Barnett’s “clarity at the margin” yields an overall funding pattern that cannot be explained but only accounted for (as the working out of a formula over time) – and so cannot be justified in its own terms.

5. As the political tide ebbs away from Westminster, with nationalist, localist and various shades of populist sentiment growing in strength, this old way of reaching funding decisions may no longer be able produce a settlement strong enough to bridge the fault lines that are opening up. This old way is marked by obscurity. Only a handful of experts (Grade 7s, academics, amateur enthusiasts) get the big picture. Without the big picture, it is too easy to fasten onto particular details to nurse a grievance, undermining confidence in the whole.

Page 261 of 420 Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013) Institutional framework

6. What institutional framework could deliver the necessary clarity and consent? The Committee’s question was about a framework for a discussion among governments. Our first point here is that if this is taken literally, it is too narrowly drawn. Instead, we suggest that the Committee should examine the institutional framework for a discussion of this matter among parliaments as well as governments. This is the best guarantee of the clarity we believe is essential.

7. Two elements are required for parliaments to be fully informed:

 A set of values in plain English describing what a just outcome would be.

 Arrangements which allow the politicians (and therefore others) to scrutinise and understand fully the resulting funding and spending.

8. A natural starting point for a just outcome would be uniform spending per head modified in the light of country-specific decisions on tax. But uniform spending per head is only the starting point: for example, as public spending varies by age (being higher for children and older or frailer pensioners), higher spending per head could be justified in countries with above average proportions of these groups. Another value question is whether uniformity should apply to spending or to the services resulting from the spending (that is, if costs are lower should spending be lower?). These are political choices and should be made as such.

9. The job of applying these values to produce financial outcomes could be done by the UK government, the governments working together, or an independent commission. Whichever the answer, we believe the experience of the OBR demonstrates the value of an independent scrutiny body, separate from the civil servants responsible for the decisions. Such a body, with an unfettered interest in openness, is invaluable for parliamentary oversight and approval.

Block grant funding, Barnett and the “no detriment” concept

10. The obstacle that stands in the way of the argument we have set out so far is the real world starting point, namely, a distribution of grant funding which is the product of 35 years of the Barnett formula. Given the continuing commitment to this formula, it is worth looking at how it works and why it has led where it has led.

11. The subject of the Barnett formula is the annual increment to the grant going to each of Wales, Scotland and Northern Ireland. The formula calculates each country’s increment on a uniform per capita basis relative to the increase in spending in England. In other words, if Scotland’s population were 10% of England’s, the increase in its grant would be 10% of the increase in spending in England. This is a sensible short term rule which can easily be explained and justified.

Page 262 of 420 Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013) 12. But left as it has been to run for many years, Barnett produces quite a different outcome, delivering the highest per capita grant in total to the country with the lowest rate of population growth – and vice versa. Over the 30 years to 2011, the population of England grew by 12%, the population of Wales by 7% and the population of Scotland by nothing at all. The reason why Scotland has a higher level of grant per capita than England or Wales is because it has had the lowest rate of population growth. Unlike the short term effect, the long term effect is a numerical bi-product without any internal justification.

13. Barnett is set to continue to run for many years more. Over the next 25 years, the central ONS population projection is for the population of England to grow by 0.6% a year, twice the rate for each of the other three countries. What would this do to spending per head? Two other factors enter into the equation: one is the starting point and the other is the rate of growth of nominal government spending. The table shows how this would play out under three different rates of nominal spending growth, namely 2%, 5% and 10% per annum.

Spending per head relative to England: mid 2010s and mid 2030s

“Scotland” “Wales”

Mid 2010s: (2013/14) 1.20 1.10

Mid 2030s: 2% p.a. spending growth 1.19 1.13

Mid 2030s: 5% p.a. spending growth 1.11 1.08

Mid 2030s: 10% p.a. spending growth 1.05 1.04

14. With high spending growth, the table shows that the per capita differences between the three countries shrink substantially although do not disappear. With low growth, they remain almost unchanged. On the most likely middle growth rate, the imbalances shrink but come nowhere near to disappearing. Whether these imbalances are justified externally is beside the point. If you have any view on what these relative per capita figures ought to be – whether they should be lower than they are now, higher, or about the same – Barnett is unsatisfactory since it produces the figures it does as an accidental arithmetical bi-product.

15. Onto this uncertain and unintuitive basis, the Smith Commission grafted the concept of “no detriment”. Smith explained this as meaning that “the Scottish and UK Governments’ budgets should be no larger or smaller simply as a result of the initial transfer of tax and/or spending powers, before considering how these are used”. In asking how this should apply “over time”, the Committee has put its finger on a key question. “No detriment” is easy to judge at the point when a tax is first devolved but as the Holtham Commission showed, it soon ceases to be so. Beyond year one, assumptions have to be made about what would have happened

Page 263 of 420 Dr Peter Kenway (Director, New Policy Institute) and Dan Corry (Chief Executive, New Philanthropy Capital) – Written evidence (DPF0013) had the particular tax not been devolved. As time passes, so the assumptions about this imaginary counter-factual world become ever more uncertain and ever more important.

16. If Barnett can be criticised for its obscurity, leading to unintended and unexpected outcomes, “no detriment” is a fine sounding phrase that could mean almost anything. In their different ways, both store up trouble for the future. In answer to the Committee’s key question about how to apply the Smith concept over time, our answer is that we don’t think it could possibly be done in a way that would command the necessary broad support.

Conclusion

17. We began with a modest proposal for clarity about what could reasonably be seen as “fair”, whichever side of whichever border one stood on. We then argued for institutional arrangements which promoted openness to, and scrutiny by, parliaments and through them the public. The reason why we have put forward such simple ideas is that they seem to us the best antidote to the mess that devolved funding long ago became – and which threatens now to get worse. Open the whole thing up: we don’t’ know where it will lead but if deep disputes are unavoidable, at least make sure that they are informed by the facts and anchored by a sense of what would be right.

21 August 2015

Page 264 of 420 Professor Noel Lloyd CBE, Silk Commission; The Weir Group PLC; Professor John Kay, London School of Economics (LSE) – Oral evidence (QQ 98-107) (DPFOE0008) Professor Noel Lloyd CBE, Silk Commission; The Weir Group PLC; Professor John Kay, London School of Economics (LSE) – Oral evidence (QQ 98-107) (DPFOE0008)

Submission to be found under The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008).

Page 265 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

Written submission for the House of Lords Select Committee on Economic Affairs inquiry on ‘The Devolution of Public Finances in the United Kingdom’

Professor Ronald MacDonald OBE University of Glasgow

My response to the Committee’s questions is as an Economist with a special interest in the devolution of fiscal powers to the Scottish Parliament.

 What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

The basic principle from the traditional fiscal federalism literature (i.e. Tiebout (1956) and Oates 1996) is that sub-central governments should be able to provide goods and services that match the particular preferences and circumstances of their constituents. This traditional literature also focuses on the appropriate revenue collection system at this level of government and indicates taxes should be devolved, especially if there are important cost differences across regions, although the extent of devolution is modified depending on the underpinning assumptions. In so-called second generation models the focus more on accountability issues and the hardness of the budget constraint which would push the fiscal devolution settlement in the limit to full fiscal autonomy, although there has to be a trade off between the hardness of the budget constraint and risk pooling / equity. This in turn implies that there has to be a block grant element in any fiscal settlement.

In defining a block grant it is important that the grant is not related to the size of a country’s fiscal imbalance. If the grant is not independent of the fiscal balance moral hazard issues can arise. Short of full fiscal autonomy (see below), every devolved system has a block grant element. Simplicity and transparency should be at the heart of a formula that allows for changes to the block grant. In the past I have favoured a growth based measure perhaps using GDP per capita in which the GDP is for the whole area and the population is for the region in question.

As is now widely accepted, reliance purely on the Barnett formula for funding does devolved does not provide a hard enough budget constraint or, to put this differently, it does not provide the necessary accountability nor does it provide the devolved politic the necessary incentives to grow the economy (although it has advantages such as providing a stable and predictable source of income). Even as part of a devolved settlement in which a substantial component of taxes have been devolved, Barnett

Page 266 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

does not appear to be a good method for determining the block grant. For many it is seen as inequitable and the promised convergence of Barnett does not seem to have occurred and if the no detriment clause is cast more widely than it was originally intended it could produce anomalies.

In principle, a needs assessment exercise would seem to be a good starting point for a revised block grant mechanism and certainly in a Scottish context such an assessment would presumably focus on the West of Scotland’s chronic health record/ deprivation and the sparsity of the population relative to the land mass outside central belt as justifying greater ‘needs’. In practice it is probably going to be difficult to implement such an assessment and although, for example, the Australian experience, where the Australian Grants Commission is charged with determining needs, may offer some guidelines, the differences between the Australian system and that in the UK may make this difficult.

If there is to be an on-going needs assessment exercise for determining the bloc grant component of any fiscal settlement, an independent body, perhaps along the lines of the Australian Grants Commission, would need to be set up. If borrowing is to be a central element in the Scottish settlement it is likely a formal stability pact would be needed, which may well need to be modified with experience to ensure any no- bailout arrangement is binding. I believe a process would need to be put in place to monitor relative price/inflation movements within the UK as such movements could have severe unintended consequences for the fiscal system and indeed the stability of any devolved settlement (see below). There is a very rich experience from other country’s experience with devolved fiscal systems (see Hallwood and MacDonald (2009)) and the lessons from this experience are well worth factoring into the design of fiscal mechanisms in the UK.

Short of full fiscal autonomy (see below), every devolved fiscal system has a block grant element. As noted above, there can be a moral hazard issue associated with having a block grant if the block grant is in any sense related to the size of a country’s fiscal imbalance so it should be clearly independent of this. Given there are a number of issues relating to Barnett, not least its failure to converge and its perceived lack of equity, a simpler form of block grant should be introduced. A simple formula could be used to update the block grant and I have argued elsewhere for a growth based formula that relies on the growth of GDP per capita, where the GDP is for the whole

Page 267 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

area and the population is for the region in question.

The ‘no detriment’ proposal of Smith is clearly a political fix and not a concept from the economics literature and especially the fiscal devolution literature. As I understand it, the no detriment idea arises because the tax base is the responsibility of the UK government and the bands are the responsibility of the Scottish government. So if the UK government changed the threshold for the payment of income tax they would bear the risks associated with that. Equally if the Scottish Government changed the bands or rates it should bear the risk associated with that. It is unclear that it should be applied to a wider setting although given the way formula Barnett applies it probably has wider applicability which may say more about Barnett than the no detriment clause itself.

One of the anomalies of the initial devolution settlement in Scotland was that local authorities had borrowing powers but the Scottish Government did not. The existing borrowing powers of the 2012 White Paper and the Smith Commission do not seem to me to be enough. But how much borrowing should be allowed? Different country experiences offer different ways of addressing the issue, from a reliance on market- based borrowing (Canada) through to stability pact arrangements (Germany). Some have argued that the borrowing should be unconstrained and it should be undertaken in open financial markets since such markets will discipline government borrowing in terms of the rate of interest they require. However, even with this there is the danger that the Scottish Government would over borrow especially since all debt – both market raised and HMT - would effectively have to be underwritten by HMT. A legally binding settlement may work but in the extreme / limit if SG knows that the debt has to be underwritten by HMT it may still be tempted to renege. So even with market determined debt there would still have to be some legally binding piece of legislation that would prevent a bailout.

 What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?

I think it important to note that there is no country in the world where a sub level of government has full fiscal autonomy as defined in the current discussions, namely the devolution of all revenues and expenditure absent a payment for defence and foreign affairs. The Basque country is often cited as an example of a full fiscal autonomy arrangement, but this is in name only since although there is complete devolution of all taxes, the Basque government is constrained within narrow ranges with respect to how much it can actually change taxes.

I think it is now widely accepted that if Scotland were to adopt full fiscal autonomy,

Page 268 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

and especially in the light of the current low price of oil, it would have a fiscal deficit of upwards of 7% of GDP (including a geographic share of North Sea Oil. One way that this could be financed would be by allowing Scotland to borrow much more than is proposed under the Scotland 2012 Act or Smith, but as noted above it seems unlikely that borrowing of this magnitude would be compatible with any kind of stability pact agreement between Holyrood and Westminster. An alternative would be to grow the economy. But Scotland is a mature and developed economy and it is hard to see how it could generate productivity growth and GDP growth commensurate with an emerging market economy. This therefore means that a move to full fiscal autonomy would in all likelihood have to be closed by an increase in taxes and or a reduction public expenditure.

A further interesting and important aspect of further fiscal autonomy, and one that seems to have largely been ignored in discussions of an appropriate devolved fiscal framework for the UK, is the issue of the significant inflation differentials that exist within all existing monetary unions (what I would call the sustainability issue). It is widely accepted that such differentials can be large and persistent for countries/ regions within monetary unions and have important implications for competitiveness and sectoral imbalances, this being particular so in the case of divergent economic behaviour (for a recent discussion, see Darvas and Wolff (2014)). One important divergence is that caused by productivity differences, usually explained in the context of the Balassa-Samuelson hypothesis.

The effects of such inflation differentials are non-trivial as they can affect the competitiveness of the country and its real interest rate and create significant imbalances which, without a separate exchange rate and monetary policy, may require painful and difficult adjustments. This issue is likely to be exacerbated in a Scottish context if oil revenues are fully devolved since this will introduce an important asymmetric price shock to the Scottish economy. Given the high degree of both labour and capital mobility that exists within the UK, it is hoped that any new fiscal framework for Scotland would recognise the inflation differential effect and its potential importance and implications for the stability of the tax base. Of course a good starting point in this regard would be to a have a good measure of inflation available in the Scottish context.

 What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland?

In my work with Hallwood (i.e. 2009) we have referred to the secessionist threat to explain the path that fiscal devolution for the Scottish Parliament has taken. Broadly put, the idea of a secessionist threat was articulated in a piece Gavin McCrone wrote in 1975 where he suggested, that given the very large oil revenues generated at that time from the North Sea relative to public spending in Scotland, that to head off a nationalist government some form of compensation would have to be offered. There can be little doubt that the current momentum for further devolution in Scotland is driven by increasing swing towards the SNP in Scotland, as seen by their majority on

Page 269 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

the Scottish Parliament, the swing towards a Yes vote in the referendum, and the slew of Scottish votes for the SNP in the 2015 General Election. Past devolution of fiscal powers can also be explained in this way (see Hallwood and MacDonald (2009)). If this is the correct interpretation of the fiscal devolution path in Scotland then it would seem likely that the renegotiation of the fiscal framework in Scotland would only have a limited effect on Wales and Northern Ireland unless the secessionist threat becomes contagious.

Tax powers

 What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill?

The primary focus of further devolution of tax in the Scotland Bill was to close the so- called fiscal gap and align it more closely with the experience in other countries that have fiscally devolved settlements. Of the key major taxes, the main focus is on the devolution of Income tax because it is a highly visible tax and affects a large proportion of the Scottish population and thereby should sharpen the accountability of the Scottish politic. Under European law VAT cannot be devolved and corporation tax was not chosen as a devolved tax presumably because presumably of the familiar race to the bottom argument (although see below).

 What is the rationale behind the choice of taxes devolved by the Wales Act 2014?

 What are the implications of devolving corporation tax to Northern Ireland? Will it have on effect on business in the rest of the UK?

Devolving corporation tax to Northern Ireland sets a clear precedent and gives other devolved jurisdictions a stronger case for arguing for the devolution of this tax. There is empirical work showing that changes in corporation tax can have an effect on a country’s economic growth rate. Specifically, Lee and Gordon (2005) demonstrate that lowering corporation tax rates by 10 per cent can increase growth by between 1 and 2 per cent per year. Given that Northern Ireland is more likely to be competing with the Republic of Ireland, the impact on Business in the rest of the UK is likely to be small although it could well effect other areas of the UK – Scotland, North of England and Wales.

It is unclear that placing all of the emphasis onto income tax is in fact the correct prescription for Scotland. Clearly the Smith proposals have dramatically changed the so-called fiscal gap profile of the UK vis a vis other countries. In my work on fiscal

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devolution I have advocated that the devolution of corporation tax is a possibility and it is the tax that the SNP have often focussed on in their arguments for improving economic growth. Changes in corporation tax are allowed for example within Canada, the US and Spain. The usual argument against this is the idea of a race to the bottom. Given Northern Ireland and Scotland are relatively small parts of the UK this is unlikely to have a big impact on rUK trade although in the Scottish case it could have a significant effect on businesses intending locating to the North of England. Perhaps the fact that UK wide Corporation tax is already relatively low would weaken the effect of such changes in Scotland, although perhaps not in Northern Ireland.

 Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?

Yes, in all likelihood the devolution of tax powers will lead to competition and this is certainly seen as a considerable advantage of the devolution of taxes in the so-called second generation work on fiscal federalism. In this work the state is seen as too big - the Leviathan concept - and tax competition is seen as a key way of controlling the size of the state.

28 August 2015

Page 271 of 420 Professor Ronald MacDonald BA MA (Econ) PhD OBE – Written evidence (DPF0022)

References Darvas, Z. and G.B. Wolff (2014), ‘So far apart and yet so close: should the ECB care about inflation differentials’ Breugel Policy Series.

Hallwood, P. and R. MacDonald (2005), ‘The Economic Case for Fiscal Federalism’, in (Eds) D. Coyle, W. Alexander and B. Ashcroft, New Wealth for Old Nations. Princeton University Press.

Hallwood, P. and R. MacDonald (2009), The Political Economy of Financing Scottish Government. Edward Elgar.

Lee, Y., and Gordon, R.H. (2005), ‘Tax Structure and Economic Growth’. Journal of Public Economics, 89(5-•‐ 6), 1027-•‐ 1043.

Oates, W.E. (1996), ‘Taxation in a Federal System: the Tax Assignment Problem’, Public Economic Review, 1, 35-•‐ 60.

Tiebout, C. (1956), ‘A pure theory of local expenditure’, Journal of Political Economy, 64, 416-24.

Page 272 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002)

Evidence Session No. 2 Heard in Public Questions 14 - 27

WEDNESDAY 9 SEPTEMBER 2015

Members present

Lord Hollick (Chairman) Lord Kerr of Kinlochard Lord Lamont of Lerwick Lord Turnbull ______

Examination of Witnesses

Professor Ronald MacDonald, Research Professor of Macroeconomics and International Finance, University of Glasgow, Professor Adam Tomkins, John Millar Chair of Public Law, University of Glasgow, and Professor Jon McLaren, Honorary Professor of Public Policy at the Business School, Glasgow University

Q89 The Chairman: I welcome you to the hearing and apologise for the late start, which was for reasons I think you know and understand. We have just come from a very interesting discussion with the Finance Committee of the Scottish Parliament with which we have a good rapport, and earlier this year we discussed these issues in some detail so we have a sense of the realpolitik of things. That was very helpful. If we can run through the questions which I know we have shared with you and then we can have a quick discussion of those. Given that there are three of you, in the interests of efficiency, if somebody has already said what you were going to say you do not need to repeat it. The first question is really around awareness of the proposals for devolution. Has there been enough transparency? Do people have a sufficiently good understanding of what is going on and what is happening?

Professor John McLaren: Clearly the answer is no. Given that the Barnett formula is considered by many to be extremely difficult to understand but in fact is one of the simplest things you could possibly use in terms of working out the funding system, it shows that this is a complex area that not just the public but even journalists can

Page 273 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) struggle to comprehend. If you take the Smith commission, when it reported it was taken as that was what it said, but there was not really much debate within Scotland, although they did go round a few meetings, and you did not really feel that people were engaging with it. When the report came out, it was not very well analysed. For example, the fact that Scotland would have the power to change any benefit level upwards is still not very well understood, as well as what the implications of income tax are and the no detriment principle and issues like that. Since Smith, it has still not been discussed very much in any circles as far as I can see, and it is not very well understood across the political world, the media world and certainly among the population as a whole.

The Chairman: Is that a reluctance on the part of politicians to explain things or a lack of interest in the detail?

Professor John McLaren: I would be surprised if the average person would be particularly interested in this. Perhaps with the independence referendum it became a bit more interesting but I still do not think that most people are really going to engage. As soon as you use a word like “fiscal” people immediately say, “I don’t know what that means”, and they switch off. How would you improve that? It is difficult, but at least within political circles, within Parliament and within journalism you would hope that they would improve the quality of the debate and the interest in what would be a very important change. The same applies across the UK and in England, because there is increasing interest in moving to a more regional system in England. I do not know how well devo-Manc, for example, is understood.

Professor Ronald MacDonald: The only thing that I would add is that there is a common misperception that more devolution, and indeed fiscal autonomy, means more spending power and that there will be more to spend in Scotland. I think that that is a big misperception among the Scottish public. That is the thing that has not been got across; that actually, no, it does not mean that, it means that you are going to have to raise some taxes here to pay for the spending. That is the message that needs to be got across to the general public: a better understanding of fiscal autonomy, particularly full fiscal autonomy. I think that a lot of people, particularly supporters of the SNP, are banging the drum that this would allow us to do lots of things that we cannot do at the moment when in fact, if you look at the full fiscal autonomy proposal, it would not—but I do not think the general public understand it. Whether it is because of what John was saying, because they cannot grasp the technicalities, or whether they just do not understand the picture, I am not sure.

Professor Adam Tomkins: I am Adam Tomkins, John Millar Professor of Public Law at the University of Glasgow. I was a member of the Smith commission and after the election I was appointed by the Secretary of State for Scotland to be constitutional adviser to the Scotland Office. I am also a prospective parliamentary candidate for the Scottish Conservatives at the Holyrood election. However, I do not appear before you today with any of those hats on. I am not speaking on behalf of the Government or the party or the University of Glasgow or anybody else, just myself; I want to make that

Page 274 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) clear for the record. I agree with what has been said so far and to it I would add that I think the Scots have fallen out of love with the idea of devolution. If you compare now the arguments about devolution with the arguments last year about independence, there is a very great contrast. If you compare also the arguments now about devolution with the arguments 20 years ago about devolution and the Scottish Constitutional Convention, there is no passion any more for the idea of devolution because it has become a technocratic exercise. Even the word “devolution” itself is a word that we do not use outside this context. I would much rather be talking about home rule, not because I am a Gladstonian but because it is a more emotive phrase and it is more likely to capture something about what it is that Scots crave. It seems to me that what Scots crave is exactly that: a sense of home rule without leaving the United Kingdom and becoming a new independent state. Those of us who are on the unionist side of the argument have to find a way of allowing something of the union and allowing something of the devolutionary idea of a union to re-enter Scots’ hearts as well as their minds, and we have not even really started that, to be honest. I think that is the problem.

I agree with what John said that arguments about the Scotland Act 2012 and arguments about the current Scotland Bill, which is in the Commons and will come to the House of Lords shortly, are arguments which are very technical about which taxes to devolve and when and why and what rates of tax should be set here and there, which are not the sorts of arguments that are going to, as they say, set the heather alight. That is the reality of where we are. We have to deliver Smith. We have to pass the Scotland Bill. We have to get the fiscal framework right and then, once we have done that, I think we will be able to draw something of a line, although that is a dangerous phrase. Where I would like to get to is to reverse Ron Davies’s famous aphorism that devolution is a process and not an event. I would like to get to the point where we can say, at least in Scotland—we will not be able to say it in Wales or perhaps Northern Ireland for a while yet—that this is Scottish devolution; this is home rule for Scotland within the United Kingdom. It has now been delivered; now let’s get on and use it and through the using of it begin to understand its strengths as well as its limitations.

Q90 Lord Turnbull: Is not one of the reasons that politicians do not talk about this that they understand the Barnett formula extremely well and they know that it is pretty generous compared with Wales? The two countries had similar GDP per head four years ago and they have diverged but the funding formulae have not recognised that at all, and they just want to hang on to it, and the best way to hang on to it is just to refuse to discuss it. They just say, “Keep the Barnett formula” and they do not distinguish between a mechanism for updating, which you can defend as quite a good mechanism for updating, with the baseline from which it starts. We are trying to create a new federal settlement amongst the nations and it would be very good if that started with no hard feelings on either side, with both sides recognising that it started off fair. In England that is not accepted at all, in Wales that is not accepted at all and particularly in the north of England they think that it is unfair, and yet they are dealing with a group of people who do not want to discuss it.

Page 275 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Adam Tomkins: I am not an economist, I am a constitutional lawyer, and constitutional reform in the United Kingdom works when it is consensual. At the moment it is very difficult to find any degree of consensus around what we might call the territorial constitution or the future of the union. It is not in the Scottish Government’s interests to make devolution work. It is in the Scottish Government’s interests for devolution to be understood and to be seen in Scotland as inadequate to meet Scotland’s needs so that support for independence goes up. We all know that, despite last year’s defeat, the Scottish National Party has not given up its pursuit of constitutional independence for Scotland. It is going to be very difficult while the SNP is forming a majority Government in Holyrood to have that degree of consensus between the two Governments of the UK and Scotland. There is also now, unfortunately, clear and manifest distrust between the principal unionist parties, the Conservative Party and the Labour Party, over the direction of the territorial constitution. There is no agreement that I can see between the Labour Front Bench, whoever they are this week, and the Treasury Front Bench on English votes for English laws. There is concern in Cardiff about the way in which the St David’s Day process is being delivered through a Wales Bill that we have not yet had sight of. I suppose that this is not much more than a wistful lament that “one would not start from here”. Something that we absolutely need is some degree of stitching a coalition together that is seen as, if not all-party, at least cross-party—that is, designed to revisit and to revise the United Kingdom’s territorial constitution. It might be that in the atmosphere of the House of Lords, which is much less partisan than the lower House, we can begin that quest. I hope so, because we need it.

Q91 Lord Lamont of Lerwick: We have heard various views about the Barnett formula. Some people have advocated a needs-based system and other models have been put forward. I notice that the Smith commission, of which you were a member, said: “Once a revised funding framework has been agreed, its effective operation should not require frequent ongoing negotiation, albeit it should be subject to periodic review”. But the Command Paper made a slightly different observation that the funding model should be mechanical rather than requiring regular negotiations. I know that you have expressed an opinion suggesting that there should be a degree of adaptability and an element of negotiation. It seems to me that it is very, very difficult to find a mechanical formula. To have a system in which there are reviews, followed by reviews, followed by reviews, arguing over what has happened and over where we are is just a recipe, to my mind, for continuing antagonism and tension. However, it is very difficult to know what mechanical formula there could be.

Professor John McLaren: The Barnett formula is a very mechanical formula but even within the Barnett formula—I used to be a civil servant in both the Treasury and the Scottish Office—there used to be negotiation between officials, and I guess that eventually it would go to Ministers.

Lord Lamont of Lerwick: You “guess” that it went to the Ministers?

Professor John McLaren: Usually we would manage to agree among ourselves.

Page 276 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Lord Lamont of Lerwick: That confirms what I always thought.

Professor John McLaren: Yes, Minister. For example, they would say, “There has been a huge amount of investment in the London Underground but there are no consequentials in Scotland because you do not have any underground”, at which point we would say, “Yes, we do, there’s a Glasgow underground”, at which point they would say, “You’re joking, aren’t you?”. Well, it might not be very big but it is still an underground.

Lord Lamont of Lerwick: Then you could negotiate about trams as well.

Professor John McLaren: So then you would have to negotiate through that. When the Barnett formula was set up, it was amended to adjust for population because the English population was rising so much quicker than the Scottish population, and there have been one-off things such as what happens when water becomes private but stays public in Scotland. The IFS recently pointed out the idiosyncrasy with business rates. There would always be a need to change things due to changing circumstances, usually politically led changing circumstances. That is what I meant when I said that you could not just set it once and leave it there.

To go back to the point you made about whether it would be better to start with a needs assessment, I cannot see how you can move from Barnett to something completely different. You cannot do it in terms of the way education, health or local government money is split. All of those are unfair at the minute and not based on needs. The Welsh have tried to do something recently and put a transformation period in and it just has not happened, because the losers scream blue murder and the winners usually do not know who they are. Nobody is going to accept the political pain, especially if you are going to lose £1 or £2 billion, which is what has been put forward for Scotland. So we need to start from where we are and then see if we still want a degree of convergence—which is what Barnett was supposed to do in the first place, but does not largely due to population changes—and how that can best be brought about. The way that income tax is set up at the minute will probably bring about some convergence because income tax in England is likely to grow more quickly than in Scotland, but that could be adjusted.

Lord Lamont of Lerwick: Income tax could be changed.

Professor John McLaren: Yes, because of the growing population, the demographics and more people in the higher band in England than in Scotland, it is likely to grow faster in England, which would mean that Scotland would lose out because of the adjustment process.

Lord Lamont of Lerwick: My question was not about Barnett but about mechanics and the principle of “mechanimity”, if there is such a word.

Professor Ronald MacDonald: In the Australian system it is revisited every five years, which seems to me not too bad a way of dealing with it. You do not want to get into

Page 277 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) the situation, which is perhaps what you are referring to, where you are looking at it every year. You want a period where you revisit it, especially if there is some indexation of the block grant and you are seeing a diminution of the block grant as your tax revenue increases. I think we need a block grant. In any system such as this, which is short of full fiscal autonomy, you have to have a block grant. I think, as we have noted, that for reasons of equity we want to move away from Barnett. I think John is right that if we were to introduce a new needs assessment at the moment it would show that Scotland was being very generously provided for under Barnett: maybe 120 relative to 110 would be the correct figure, so there is a big political economy issue there if you say, “We want to take that money away from you guys” at the starting point. I think that would be difficult and I agree with what John is proposing, that you would have some adjustment mechanism going forward. But I think that that would have to be reviewed in some fashion, perhaps by an independent body.

Lord Turnbull: With convergence, unless you have a needs assessment you do not know what it is you are trying to converge on and you do not know how far you are off track. Therefore, going forward, one of them is slightly marking time and the other one catches up. A needs-based assessment is needed to guide you from review to review on what direction you want to move in, and the gap that is perceived by people in Wales and Northern Ireland is seen as material.

Q92 Lord Kerr of Kinlochard: I would like to challenge the wisdom that Barnett has favoured the Scots. I think that that entirely depends on what you think is the capital cost of providing the services that ought to be provided at a particular level across the United Kingdom, in each of the United Kingdom. It is quite plausible that in the Highlands and Islands it is much more expensive to provide health and education, partly due to the cost of transport and partly because of population geography. We hear that the Smith commission did not discuss it and took it as a given that the Barnett formula was going to survive. Okay, the realpolitik says that it is going to survive; no party is saying that it should go. But during these five years when we are stuck with Barnett, surely we should be devising some better long-term system?

Professor Adam Tomkins: I think that it is fair to say that the Smith commission did take it as a given that Barnett would survive because it was in the Vow, and the Smith Commission was meeting and working in the shadow of the Vow, if I can put it like that, which has become a sort of 21st century Caledonian “Magna McCarta”. That is why you find in paragraph 95.1 the Smith commission saying that the block grant from the UK Government to Scotland will continue to be determined by the operation of the Barnett formula. Of course the size and therefore the importance of the block grant diminishes the more we go down the route of fiscal devolution. Again, the hope is that some of the politics and some of the heat and some of the noise around—

Lord Lamont of Lerwick: Can you give an estimate of how much it will decline proportionately as a result of devolution?

Page 278 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Adam Tomkins: I cannot, because being a lawyer I am not very good with numbers, but I am sure that others around the table can. I would approach this by saying that there are some grand constitutional principles, or you might call them something more mundane than that, that one can bring to bear on the operation of the Barnett formula. Is it fair? Is it manifestly seen to be fair? Is it transparent? It is not transparent. John says that it is easy to understand but from the outside it is also fabulously opaque: it is a black box. There is very little effective parliamentary scrutiny either in the United Kingdom Parliament or in Holyrood of the operation of any aspect of the fiscal framework. There is a lack of effective parliamentary oversight. There is also a trend for certain key economic decisions to be made by independent arm’s- length bodies that are accountable indirectly to Parliament and to Ministers but differentiated from both Parliament and Ministers. Perhaps there is a case for doing something like the Australians have with their Grants Commission, or something like we have with our OBR, which would take us out of the domain of intergovernmental negotiations between the Chancellor and the Cabinet Secretary for Finance. I am not necessarily signed up to that; I would like to hear the arguments for and against.

Lord Lamont of Lerwick: It is rather different to take away a forecast from a department compared to taking away the power to spend money.

Professor Adam Tomkins: You might be right, but if one thinks about this through the lens of fairness, transparency, oversight and independence, it seems to me that is a useful framework of analysis.

Professor John McLaren: I have done some work on needs assessments, again as a civil servant. The idea that they are objective is wrong; they are very subjective. Everybody will put something different forward. We did it back in 1992 when we were fighting the Treasury. For example, we would say that life expectancy is shorter in Scotland, therefore we should get more money for health, and they would say that life expectancy is shorter in Scotland, therefore we do not spend so much time in hospitals, therefore we need less money. You do not need a service because you are dying younger. That is a flippant example but that did come up. There are all sorts of questions about how you weight things. These are pretty subjective elements. Canada and Australia are so huge, and the states within them are so enormous, that they are very different things. We are a small country. Even if you look at Wales, for example, the north of Wales is right beside Liverpool, the south of Wales is right beside Bristol, and the middle is near various parts of the West Midlands, so what is the need of Wales that can be shared with the West Midlands and what is it on its own? To go back to your point about the needs of Scotland, the geographical need from the work that I have seen is about 3% to 5%. It is quite small because of the small population, even with the Highlands and Islands. I think that there is another argument that some people would put forward about the revenue side being from the North Sea, but that is a whole different kettle of fish.

Q93 The Chairman: On the Smith commission, did you see modelling and worked examples of the formula and how the formula would be indexed and how it would

Page 279 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) work when it was discussed? Is that something that you spent a considerable amount of time on?

Professor Adam Tomkins: No, it was not.

The Chairman: So this was waved through?

Professor Adam Tomkins: What was waved through?

The Chairman: The Barnett formula.

Professor Adam Tomkins: A working assumption, as Lord Kerr put it, of the Smith commission was that we were there to try and deliver on what had been said in the Vow. The one thing that was said in the Vow that had not been said by the parties previously in their commitments was a commitment to maintain the Barnett formula. The working assumption throughout, I think I am right in saying, was that Barnett would stay and that we would have to devise a suite of new powers and responsibilities for the Scottish Parliament that would be compatible with the ongoing operation of the Barnett formula.

Lord Kerr of Kinlochard: I agree that deriving objective criteria is a very subjective business but I think one has to try. It seems to me that what Professor Tomkins wanted to achieve, —is a result, a settlement and the end of devolution as a process— will never be achieved while the block grant is based on Barnett because nobody understands Barnett. Not even all the academic strength across this table could teach Barnett to a school class and try to explain the basis of the block grant system in this country; it is impossible. I think that we should be using this Parliament to devise a long-term system. It may be that some do not want to see a long-term system because they like annual controversy because it helps their political aim, but it seems to me that the House of Lords of the United Kingdom should be trying to propose something which would achieve what Professor Tomkins is talking about: some sort of cemented deal.

Professor John McLaren: It is important to distinguish between the block grant system, which is extremely complicated and difficult to understand, and the Barnett formula, which is extremely simple and which is basically just that Scotland gets its population share of any increase in English departments that are comparable to Scotland. It is a one-liner. But what you put that simple amount into is very complicated. If you try to understand it historically, it becomes this very different political thing. That is path- dependent on how we have got here, but the point is how you get off that path on to another path. If you try to adjust it in one year, that might be quite lot of money and that would be difficult; but if you try to adjust it in 10 years, it is 10 years of griping versus one year of doing it all in one. Or you accept what the position is now, which might not be fair but you accept it, and then move on.

At the minute we are just looking at Scotland, Wales and Northern Ireland. England is interesting, because it would be fairer overall if you did this needs assessment for the

Page 280 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) whole of the UK, but then it becomes very complicated to work out whether the data are available and then what is fair within the UK. For example, again you have, say, Lancashire in the north-west on the borders, and where the hospitals should be, and does the south-east not have many hospitals because they use the London hospitals?—all sorts of issues like that. I agree that it is some effort to move in that direction but having at least some background information to which people could refer would be good. I am less certain about how much it would influence the realpolitik of what emerges.

Q94 The Chairman: Against that background, how should the calculation of a block grant affect the devolved powers of taxation?

Professor John McLaren: What do you mean? I am not quite clear.

The Chairman: You have got to calculate the block grant each year and then the taxes that have been devolved are going to move up and down, mainly down, so how do you then reflect that in the calculation?

Lord Lamont of Lerwick: That is the no-detriment principle.

The Chairman: The second stage of no detriment. How do you deal with that over time?

Professor John McLaren: Jim Gallagher said in his paper produced a couple of days ago that it had been settled for the previous Scotland Bill. I am not aware of that. You look at how UK income tax has grown and you adjust that for the Scottish block and then Scotland has to raise its own tax to fill in that gap, more or less; we will give you more or less money. As I said before, you do not necessarily have to pick growth in income tax. If you do pick that, is it income tax growth per head of population, do you adjust for population and do you adjust for demographics? There are elements like that. You could make it a more complicated adjustment. If it starts to look like one country is losing out consistently, which is likely to be Scotland, again a point of grievance could easily arise.

Lord Lamont of Lerwick: Slightly skipping ahead, how does no detriment apply to tax competition?

Professor Ronald MacDonald: Is this getting at the idea that if you are successful in raising or lowering taxes—presumably lowering taxes—that stimulates growth, then you have to adjust the block grant? Is that what lies behind your question?

Lord Lamont of Lerwick: At our previous session one of the members was really rather against tax competition; he called it unhelpful or anti-social tax competition. I think it depends from which side you are looking at it. It just occurred to me that when a country took an initial step to cut its corporation tax in order to attract inward investment, is someone going to say, “The no-detriment principle applies here and we ought to be compensated because this has a direct knock-on effect on us initially”?

Page 281 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Ronald MacDonald: There are a couple of reactions to that. One is that in our submission to the Smith commission, my co-author, Paul Hallwood, and I had something we called the “Holtham interlude”. There should be a period over which you can adjust things but you do it quite gradually, so if you are successful in cutting corporation tax and that boosts your growth, there should be an adjustment but it does not all come in the current period.

Lord Lamont of Lerwick: But it would be rather odd if we had to compensate other people because they had pursued the wrong rate of corporation tax and not maximised revenue.

Professor Ronald MacDonald: Indeed. That is why if you look at the fiscal federalist literature you do not see that concept. It is not there. It is a political concept. Indeed, in the more recent fiscal devolution literature it is all about tax competition controlling the size of the state, and so tax competition is seen as good per se. I am not necessarily saying that I agree with that but that is where the economics of this is taking us essentially.

Q95 The Chairman: Gerry Holtham said that the no-detriment proposal is impractical and cannot be made operational unless it is dictatorial and that a different range is necessary. Do you agree with that?

Professor Ronald MacDonald: I think I would. Probably what he is getting at there is his idea of indexing. This is like the second stage of no detriment. I think I would broadly agree with that, yes.

Lord Turnbull: The example that was given was a very simplified one where the UK Government cut income tax and says that they are funding this by cutting a service, and then you get a different effect on Scotland where the service it cuts is health or defence. However, since you did not know what was actually funded by income tax, how did you know that was why health got slowed down rather than defence?

Professor John McLaren: This is something that I spend quite a lot of time thinking about. It is quite complicated. It does not matter what you change. If the UK changes its income tax rate, it does not matter where it spends it; Scotland’s block would be adjusted. If the rest of the UK used extra revenues and spent it on devolved services, Scotland’s block grant would rise—but the Scots are not paying for it by more tax so it would have to be adjusted down. Equally, if it was spent on defence, Scots are getting that benefit in defence as a reserved asset but are not paying for it. So it does not matter what it is spent on, there would have to be an adjustment, and the same the other way round.

Lord Turnbull: But you would never be able to disentangle cause and effect.

Professor John McLaren: I think it is easier because you do not have to. In each case there is a benefit to Scotland and therefore Scotland has to pay for it, whether it is defence or health. You would get a political argument if it was going on defence and

Page 282 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) then seen to be spent on nuclear weapons or something like that. That might not be very much liked. Otherwise it is a free lunch. I went through this with Treasury officials and they said that it was correct. I think it is slightly different from what Jim Gallagher says in his paper but I am pretty sure that it is correct. Again, it took me quite a lot of time to fully work it out; it is counterintuitive and it has not been debated at all in public. It could lead to people thinking, “Really? We have to give Scotland more money when we cut taxes?”

Professor Ronald MacDonald: Could we not get away from this form of no detriment by moving away from Barnett, because a lot of what we are saying here is to do with Barnett consequentials? If you have a different block grant, presumably these kinds of no-detriment issues would not arise? Others may but not that particular one.

Lord Turnbull: It would seem from our earlier meeting they have largely given up on this second-tier no-detriment principle. They have realised how difficult it is and they are just relying on the fact that the system in a much broader sense will have to be maintained, possibly by this Australian-type body which is starting to diverge from the starting point. Going through measure by measure, if you cut the income tax rate it might actually go up. You cannot even get the first stage of this calculation right. The no-detriment principle is probably dead.

Professor John McLaren: I think that no detriment was probably applying more to benefits in the way that they saw it, in that if you adjust something and it has a knock-on effect on benefits then you have to pay for it yourself. But on taxes it did not really apply. For example, Northern Ireland gets corporation tax. If it gets more business and companies in and Manchester says, “They were going to come here; they only went there because they have lower corporation tax”, the reply is, “Sorry, that’s the way the game goes”. Or if you reduced the higher band of income tax in Scotland and people moved from London to Edinburgh, that is what it is supposed to do. So I do not think that it is supposed to be adjusted for that sort of element.

Lord Turnbull: Indexation was tax to tax, was it not?

Professor John McLaren: There is regional adjustment, and again it is a moot point whether it is a good year or a bad year for you. Then there is the indexation which is adjusted to a certain thing. But once you have behavioural impacts if you have adjusted taxes, I think that is fair play.

The Chairman: So how would this work? If the second part of the no-detriment principle is raised to a principle and there is no mechanism and then you have got the existing Barnett formula, you are then making adjustments on what basis?

Professor John McLaren: If I am reading it right—because it can be difficult to follow— on the basis that if income tax has grown in the rest of the UK, that is assumed to be what would have happened in Scotland, but if Scotland is outgrowing the UK, then it gets its extra money. That is my understanding.

Page 283 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Lord Kerr of Kinlochard: I am assuming that is on a per capita basis.

Professor John McLaren: I would say on a per capita basis. The reason I say that is because if Scotland had been given powers over immigration policy then that is okay because Scotland can say, “We can’t attract more people in, therefore we suffer because we have the wrong policies”. But if they cannot change those policies and more people are coming into England than Scotland, I do not think that is a level playing field and therefore I would adjust it in per capita terms.

The Chairman: It would be adjusted also for the benefits analysis that you gave just now. To the extent that benefits were changed, or not changed and they were changed in the rest of the UK, there would be an adjustment in line with that.

Professor John McLaren: Yes. There is also a complication if you are changing tax rates and starting points and things like that. It is okay if you change one and try and estimate what that impact would be and see no detriment, but 20 years down the line and there have been 10 changes in income tax levels and rates are higher and lower, can you really make a good estimate of that? I guess you just make the best estimate you can as time goes on, but again it opens up room for mischief.

Q96 The Chairman: Did the Smith commission envisage a five-year review? How did you think this would develop over time and reviewing it over time?

Professor Adam Tomkins: I do not know if I recall whether there was a collective view about that. For myself—I am not speaking on behalf of the Smith commission as a whole—I think that we were all conscious that there were loose ends left in the Smith commission agreement that were deliberately left there, or inevitably left there perhaps I should say, because of the constraints of time under which we were working. The Smith commission reported only seven weeks after it was established. That timetable was not set by anybody in the Smith commission. The core work that we had to undertake around the Smith commission table was to agree a package of further powers for the Scottish Parliament. Our terms of reference were actually quite limited. We were not able to talk about devolution within Scotland, for example, even though some of us wanted to. We were only able to talk about devolution to Scotland. Almost all the time in the Smith commission was spent on working out what those currently reserved powers were that could be devolved to the Scottish Parliament consistent with Scotland remaining in the union.

For example, when we were thinking about universal credit, clearly there is a relationship between the design and delivery of that and a single United Kingdom employment market. A single United Kingdom employment market was something that certainly Annabel Goldie and I wanted to preserve because that is what we thought 2 million Scots had just voted for. When you are thinking about the relationship between the devolution of particular welfare powers, such as social security powers or social security entitlements, and this idea of union that we have, which is the pooling and sharing of risk and resources and the single employment

Page 284 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) market, what we spent most of our time trying to scrutinise and think anxiously about was the extent to which you could go further down the devolution path without running the risk that you were just tearing up the fabric of the union itself. If we had had another six months, it might be that we would have been able to spend much more time thinking about the kinds of questions that you are now having to think about, and others are having to think about, in terms of negotiating the fiscal framework. But the fact was that we only had seven weeks or whatever it was, and it is pretty remarkable that we got as far as we did.

Q97 Lord Lamont of Lerwick: Can I ask a question about an issue that was also raised in the Smith commission but I do not think we have touched on so far? We have discussed variously the responsibility of the Scottish Government and their borrowing and what dangers there are in that, but one small answer to that is the Scottish Fiscal Commission. Do you think the right model is being followed with the Fiscal Commission? There seems to have been some doubt as to whether its own forecasts are going to be independent forecasts or whether it is just validating without any real resources of its own what the Scottish Government say that they expect about revenues and expenditure?

Professor Ronald MacDonald: That is the danger. There is a question as to how independent that body is because two of the three members were former members of the Council of Economic Advisers, which one assumes is a very partisan body. There are questions that you alluded to about how well resourced it is. I do not think that it is well resourced to make independent forecasts and certainly to collect separate data, so I think that there are real issues with that body. There is no doubt we need a body like that.

Lord Lamont of Lerwick: Because that would greatly increase the freedom of the Scottish Government to pursue a policy that they wanted to pursue, whether it was responsible or not?

Professor Ronald MacDonald: Indeed, yes. That is an issue that has to be thought through. I gave evidence earlier in the year to the Finance Committee of the Scottish Parliament and made that very point.

The Chairman: They need some sort of OBR-type body?

Professor Ronald MacDonald: Exactly. Perhaps we may tap into the OBR as well, but that perhaps would not be—

Lord Lamont of Lerwick: I think that John Swinney tried to argue that the OBR took the figures from the Treasury, but that was strongly denied by the OBR.

Professor John McLaren: The OBR and the Treasury inevitably work closely together, but I know some of the characters in the OBR and they are pretty independent- minded. One of the issues is what Scottish model you are working from, because there is not a full model of the Scottish economy and if that does not exist it is difficult for

Page 285 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) anybody to be precise about what is going to be happening. That needs to be built up. The finance department in the Scottish Government as a whole needs to be beefed up if it is going to take on more Treasury-like responsibilities. That is concentrating on the good, developed example of Scotland, whereas Wales, Northern Ireland and internally in England are way behind in terms of the quality of the data and having a fiscal commission or having any sort of model, so I think there are some big challenges there.

Q98 The Chairman: There is a small list of taxes that are being devolved and there is a large list of taxes that are not being devolved. If you are seeking to run a balanced tax policy across the economy, does that not present considerable problems? Are there taxes for instance that you think should be devolved?

Professor Ronald MacDonald: Certainly in my own work I have always left open the ability for corporation tax to be devolved because it is devolved in other systems. I am not necessarily convinced that it would make a huge difference but it has to be borne in mind that the SNP has always argued that is the lever it wants to control. It has never, really, in my experience, mentioned income tax. It proposed putting it up. Many years ago John Swinney proposed to put it up by a penny and it has not done that again because the SNP lost a lot of votes as a result of that. Corporation tax is the lever it always mentions. Certainly I would have preferred a better balance between the taxes that were devolved, because then you could think about them having actual trade-offs: “Well, we cut corporation tax; what do we do, cut spending or increase income tax to pay for that?”

Professor Adam Tomkins: I talked earlier about consensus. This is where there is a greater degree of consensus than there is on some of the other aspects of the territorial constitution. This is also where the Smith commission was starting with a rare advantage, because all three of the parties that campaigned for a no vote had prepared their own proposals for devolution during the course of the independence referendum campaign. The IPPR had published a couple of very interesting and authoritative reports on it, authored by Alan Trench, who has already given evidence to your Committee. The devo-max group, with Reform Scotland and Lord Purvis— Jeremy Purvis—have also done a lot of work. We were not starting from a blank piece of paper when it came to fiscal devolution because all of these sources—the party commissions, the think tanks and others—had all focused on tax devolution more than any other aspect of devolution. Why? Because the core problem with Scottish devolution, and a core reason why Scottish devolution has not done what George Robertson claimed it would do, which is kill nationalism stone dead, is because we have created here a Parliament that is responsible for spending £35 billion of somebody else’s money without being responsible for having to go to those people and say, “This is the money we want to take from you and this is what we will do with it”. Closing that fiscal gap was the core political imperative so far as I could see, which is why so much of the focus has been on fiscal devolution. There are limits with what we can do in terms of fiscal devolution while we are a member state of the European

Page 286 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Union. The tax that is devolved in the United States or in Canada and I think in Australia, which you cannot do here, is VAT. It is a significant amount of revenue.

Lord Kerr of Kinlochard: Sorry, why do we not do it here?

Professor Adam Tomkins: Because it is contrary to European Union law to have more than one rate of VAT in any member state. While the United Kingdom continues to be a member state of the European Union we cannot have sales tax devolution.

Lord Lamont of Lerwick: The Greek islands managed to have it.

Professor Adam Tomkins: Maybe that is not an altogether happy precedent.

Lord Kerr of Kinlochard: If that is a serious problem, it could be corrected very easily in Brussels. That is not fundamental to the VAT structure. That was not a problem that was addressed when the original VAT directive was passed.

Lord Turnbull: What it means, John, is that—

Lord Kerr of Kinlochard: Because the VAT structure in Brussels is written in terms of minima, it would be quite easy in fact to accommodate differential rates of VAT. If there is something in the law which says you cannot—

Professor Adam Tomkins: I think you start running up against state aid questions as well.

Lord Kerr of Kinlochard: You might.

Q99 Lord Turnbull: The thing I was struck by in the earlier meeting, and what caused the biggest disagreement, was the phrase in the UK Government Command Paper, “The fiscal framework must require Scotland to contribute proportionately to fiscal consolidation at the pace set out by the UK Government”. In other words, the UK Government are trying to get their debt down from 5% of GDP to 0% in five years; Scotland has to follow the same path. I think they really think, “Why can’t we say we are happy with 5%? We will borrow the money. We will pay the debt on that money”. John Swinney has set a limit on how much debt repayments can be. We have no basis for relating their aspirations on fiscal policy, on borrowing, to the UK. On the other hand, they say that they favour a balanced budget. As long as they follow that, they would actually be following the UK as a whole, but they do not like the idea that the Government say, “We have got to accelerate the process of getting the debt down or we go off track again” and then there is an argument about how quickly you get back on track. They want to say, “No, we don’t want to follow that; we want a different path”.

Lord Lamont of Lerwick: But it could be within a disciplined trajectory while the UK was still reducing its deficit, surely?

Page 287 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Lord Turnbull: If you listen to Scottish politicians, it is almost as though they want an end to austerity: ie “We do not want to be locked into austerity”.

Professor Adam Tomkins: This is of course driven by politics. The current Scottish Government want to be able to say to the people of Scotland that the nation of Scotland and the nation of England are two different nations moving in two different directions. The economy of Scotland and the economy of England are two different economies moving in two different directions. This is all about their pursuit of independence. The SNP is a difficult political party to understand for anybody who has ever experienced British politics. Most British politics is about strategy. SNP politicians are not interested in strategy at all. They are interested in a destination. They are destination politicians. Their destination is independence and everything else is tactics and how you manoeuvre your way towards that goal. This is just a little bit of tactical manoeuvring by the SNP.

Professor John McLaren: Even if both agree a debt level and an annual borrowing limit, it is possible to agree that, but agree it at different paces. You could get some fudge to say that within an economic cycle we will both do the same thing; I would not be surprised if something like that happened. In terms of trying to address these issues, what could be contentious moving forward, if it is kept in the hands of the politicians, is that every time a new Government are brought in for the UK as a whole, they might change what their targets are. They have already changed enormously quite a few times in the last 10 years; even in the last three or four years they have changed quite a lot. It seems to me that Scotland would probably have to go along with what the rest of the UK has done. It may be given a little bit of leeway to catch up more slowly, but I see that as a pretty lopsided arrangement and I just do not think that the UK Government would pay much attention to what the Scottish Government want. I may be wrong but that is the way it currently looks to me. That could lead to tensions. How do you decide how much extra leeway Scotland should have?

Q100 The Chairman: This point about fiscal consolidation is very interesting. The Chancellor appeared before us yesterday. He acknowledged that between March this year and July he actually changed the year in which he was looking for a surplus from 2018-19 to 2019-20. He also made the point that the bargain that he was offering to the corporate sector was, “We will give you a much lower corporation tax but you will have to pay sufficient to your workers to ensure that the state does not have to pay in-work benefits”. That was bluntly the formula that he gave. That is a political judgment, and we could argue the toss about it. But under these arrangements it would follow that that would be imposed upon Scotland, so the room to manoeuvre seems to be relatively narrow.

Professor John McLaren: One way of getting around that would be to give some of these targets and ranges of powers to the OBR, as the Bank of England was given extra powers to set these things, but I do not see politicians wanting to give up that degree of control. Can I make one point going back to the discussion on corporation tax, about which not much is made? I think that there is quite a big issue in terms of corporation

Page 288 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) tax from North Sea oil revenues as a whole. The big difference between Scotland and the rest of the UK in terms of tax is the North Sea. I understand why it was taken out by the Smith commission and why it is not a very good tax to devolve because it is so up and down, but at the same time it is the key difference between the two tax structures. Anywhere else in the world, whether it is Alberta or parts of Norway, you get something by having that in your backyard. In the past, the arrangement has been that you get more through Barnett and that is funded by the North Sea. That is the rough arrangement. Nobody acknowledges it but that is what happens and we are reasonably happy. But as the North Sea moves on or if we move to a different system, we have to address that more fundamentally and say what it is that Scotland gets from the North Sea, or in future what it is that the north-west of England gets from shale oil. I understand why this was passed over in the Smith commission but I think it is something that could well do with being revisited.

Professor Ronald MacDonald: But then you are not really moving away from the sharing and pooling of risks that people voted for by staying in the United Kingdom.

Professor John McLaren: It adds a complication but I think it is such a fundamental difference between the two economies.

Professor Adam Tomkins: In the Smith commission we promised that there would be no running commentary on various different people’s negotiating positions, but it is in the public domain that the Scottish Government would like to see taxes beyond those agreed by Smith added to the Scotland Bill. The focus is on employers’ national insurance contributions, capital gains tax, the personal allowance in income tax and corporation tax. The focus of their attention is not on the North Sea. It was not glossed over by the Smith commission, it was discussed, and the volatility of the issue means that it would be much harder to see stable fiscal settlements in Scotland.

Professor John McLaren: It kind of hides where Scotland gets the benefit from. Scotland at the minute gets the benefit from the Barnett system but it is really coming from the North Sea, which is allowed through the Barnett system to flow in. Because that is not acknowledged definitively, again it makes it more complicated for people to understand the whole funding system and why Scotland potentially gets this extra money.

Professor Ronald MacDonald: I have always thought of the Barnett formula as like an oil fund; it smooths the revenues for Scotland.

Q101 The Chairman: One of the objectives of devolution surely is that it offers the devolved Parliament the opportunity to improve economic performance, and yet we have heard from Professor Trench that there is no comprehensive evidence internationally that devolution has any connection with growth.

Professor Ronald MacDonald: Devolution of tax powers?

The Chairman: Yes.

Page 289 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Ronald MacDonald: I mentioned in my paper—and I know John and I have had a spat about this—that there is some evidence that corporation tax can stimulate economic growth. It is a perfectly respectable paper in a peer-reviewed journal where a lot of the fiscal devolution literature appears. There is evidence that an approximate 10% cut in corporation tax gives you a 1% increase in economic growth; that is a broad-brush figure. I think that it underpins what the SNP has been saying in terms of using that lever to boost growth. I am not convinced that it would be able to do that. I think that there are alternative ways of doing that which you could use your borrowing powers to do, but there certainly is some evidence to suggest that corporation tax can have that effect.

On the borrowing powers there is one footnote I would like to make. It is my understanding that the Scottish Government at the moment have the power to spend about £0.5 billion on infrastructure and capital spending—that was something related to the funding of the Forth road bridge—and they have not exercised that spending. That does contrast with what you were saying earlier about their position that they are against the overall austerity in the UK, but they have this power at the moment which has gone unused so far to spend about £0.5 billion on capital spending.

Lord Turnbull: You have a strange contrast where George Osborne talks a big game on austerity but does not practise it and the SNP rails against austerity but actually practises it.

Professor Ronald MacDonald: That is a good point.

Professor John McLaren: Changing taxes often can be swamped by other effects in terms of trying to grow the economy, so it is difficult to be sure. You might do something good and something bad happens on the other side. American corporation tax is very high. Economists could give you an idea of what things could change that would grow the economy, and most politicians do not do them because they feel that they are too difficult to do. For example, the Mirrlees report from the IFS had some very good suggestions in it, but a lot of them are extremely challenging politically— road charging and things like that—and therefore are not done. There is a list of things that would be top of economists’ lists to do that are not done for challenging political reasons.

Q102 The Chairman: May I ask one final question before we wrap up? We talked about an independent organisation along the lines of the OBR and maybe the OBR itself. There has been some suggestion of a need for an institution to, as it were, mediate between the UK Treasury and the Scottish Government over the block grant and over all the things we were talking about earlier on. Do you think that that is a sensible suggestion and is it necessary?

Professor Ronald MacDonald: I think so. Given all the issues that we have talked about today about the block grant, whether it needs to be revised in terms of needs and so on, we do need an independent body moving forward, particularly one which offers

Page 290 of 420 Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) transparency in the collection of tax data and indeed other data which we do not have at the moment, which I find extraordinary. We do not have a measure of prices in Scotland, for example.

Lord Lamont of Lerwick: Could you not apply that argument to the health service and say that there should be an independent body to decide what money should be given to health?

Professor Ronald MacDonald: The body has to be seen as impartial for deciding the overall block grant for health and everything else. I am not sure that you would need a separate body for health and the individual units of spending.

Lord Lamont of Lerwick: It just seems to me that to take away the right of those who are largely paying the bill not to ignore but to discuss and then decide may be a bit unreal.

Professor Ronald MacDonald: Ultimately, it would be the two Governments who would decide.

Lord Kerr of Kinlochard: Surely it depends whether they are discussing the size of the cake or the size of the slices? It would be for the Government to decide the size of the cake but the slices should be objectively cut, and that would be their job.

Professor Adam Tomkins: I would analogise a little with the Supreme Court. We have various devolution statutes which confer powers on devolved legislatures in different parts of the country and from time to time there will be border disputes. Is this Act of the Scottish Parliament within competence or outwith competence? It is not Governments who negotiate that between them. If there cannot be a political resolution, you go to court and the Supreme Court makes a determination as to what the law is. It seems to me that if we can do that with constitutional law, we can do that with constitutional economics.

Professor John McLaren: Says someone from a legal background! Inevitably it has to be politicians who make the final decision, or perhaps it should be left to the civil servants, and they will do a lot of the work, but ultimately it has to be the politicians who get a deal done.

The Chairman: Gentlemen, thank you very much indeed.

Page 291 of 420 Professor John McLaren – Written evidence (DPF0019)

Professor John McLaren – Written evidence (DPF0019)

House of Lords Inquiry: The devolution of public finances in the UK

Issues where there is a need for greater understanding:

Data and institutional frameworks

The reliability of data on the actual tax revenues raised and expenditures incurred at the sub-UK (regional) level remains a challenge for the UK and Scottish governments.

Achieving a mutually agreed and robust baseline for taxes raised in Scotland is essential for determining, for example, how the Barnett block is to be adjusted.

Who would be the ultimate arbiter and will each nation/region need: a Fiscal Commission; a new, or much enhanced, Finance Department; a model of the economy? Does the data exist at present to allow for such a model?

Indexations and adjustments to the block grant and implementation of the “no detriment” principle?

While agreeing baselines will be difficult, even more so will be agreeing how to make adjustments to the block over time.

For example, if the UK’s population continues to rise faster than Scotland’s then tax revenues are also likely to rise faster and so Scotland would lose out (as against the current system) unless the adjustment process moved in line with changes in UK per capita revenues.

Should this be indexed and adjusted for or should such population growth be seen as part and parcel of relative economic success? A similar issue applies in relation to changing demographics between Scotland and the UK over time.

Also, in relation to Income Tax (IT) Scotland’s revenue share is lower than its population share, due to a low number in the higher tax band. This again means that, based on recent experience, Scottish IT revenues are likely to grow more slowly than the UK’s. (Furthermore, any adjustment to the UK higher tax rate could disproportionately benefit or cost Scotland.)

Complexity over time - Individual taxes and specific benefits will change repeatedly over time, making it very difficult to follow what the ‘correct’ no detriment adjustment is for a change in Scottish or UK policy. How should this be dealt with?

Second round impacts - It is intended that Scotland should keep any ‘above UK trend’ increase in Income Tax revenues. Such an outcome, of higher economic growth, would also result in higher growth in VAT (and other) receipts. At present, Scotland would

Page 292 of 420 Professor John McLaren – Written evidence (DPF0019) receive a share of this increase, but not its full, higher than UK growth, share. Should any attempt be made to incorporate such second round effects into the adjustment process?

A revised Barnett formula will heighten awareness of the existing ‘faults’ within the formula. For example: - with regards to the treatment of business rates income, (as highlighted by the IFS) - convergence will remain a feature of any revised Barnett formula, with no lower limit over how close the spending per head levels can get - differential population growth rates affect the ‘fairness’ of Barnett, as historical spending levels are maintained but new funds are allotted on a current population basis. How, if at all, should these ‘faults’ be addressed?

How should the existence of exceptional tax revenues (such as natural resources) be treated and should regions benefit from them? As well as North Sea revenues this could apply to future shale oil related revenues. At present Scotland receives no direct benefit, unlike, say, Alberta. While Smith accentuated the undesirable aspects of such erratic revenues, an alternative approach might be needed, especially if a new needs assessment based approach is taken.

Fiscal rules

The Smith Commission made clear the need for a fiscal framework within which Scotland’s borrowing powers would operate, but left the detail open to debate.

Inevitably the current UK fiscal rules will change over time in line with the changing UK political discourse but it remains unclear what these future targets might be. It may well be that, due to the relative sizes involved, any such UK changes will take the lead on this, with Scotland being expected to follow suit. This may lead to tension between government’s, in which case an agreed process of consultation may be adviseable, or even for this role to be taken on by an independent body (or bodies) e.g. OBR.

In general terms, and regardless of the actual targets, consistency of fiscal rules across the UK would be beneficial in terms of transparency and coherency and in terms of improving the likelihood of a mood of co-operation over effective management between government’s.

Regional allocations in a more federal model

There is currently very little debate over changes in how the budget is allocated across the English regions. Would (and could) any needs based revisions include assessing the significant intra-regional differences across the UK?

Page 293 of 420 Professor John McLaren – Written evidence (DPF0019)

If the ‘responsibility’ and ‘economic growth’ arguments apply to Scotland Wales and Northern Ireland, then they should also apply to English regions. However, it may be difficult to move towards greater regional fiscal autonomy when little or no political coherence applies to these regions. Is Devo-Manc a one off or a workable model for further change?

7 September 2015

Page 294 of 420 Professor John McLaren, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor John McLaren, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow – Oral evidence (14-27) (DPFOE0002)

Submission to be found under Professor Ronald MacDonald, University of Glasgow; Professor Adam Tomkins, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002).

Page 295 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006)

Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006)

Evidence Session No. 6 Heard in Public Questions 67 - 76

TUESDAY 15 SEPTEMBER 2015

Examination of Witness

Professor Iain McLean, Professor of Politics, University of Oxford

Q67 The Chairman: Professor McLean, thank you very much indeed for joining us for the second session this afternoon. We visited Edinburgh last week and were struck by the political realities of the situation, but one of the observations that we made was that the detailed workings of these arrangements were not very widely understood. Do you feel that there is sufficient awareness among the population of what is at stake here and that there is sufficient transparency around this process? Generally, on transparency, has sufficient information been put into the public domain to allow those like yourself who study this in great detail to be able really to hone your opinions and views as finely as you would wish?

Professor McLean: Thank you, my Lord Chairman. Taking those in reverse order, I believe that there is not sufficient information in the public domain. From that it follows that there is not sufficient transparency. From that, it follows that the public on both sides of the Anglo-Scottish border are unaware of what is at stake. I think that even many otherwise well- informed people are insufficiently aware.

As members will be aware, yours is one of several parliamentary Committees that is looking into this and closely related matters. I suspect you will be getting the same cycle of witnesses going round. I did not have time to do a written memorandum for you but, in the hope that it might be helpful, I sent in the one I wrote for the Scottish Parliament Scotland Bill Committee—the Devolution (Further Powers) Committee—to which I gave evidence last week. As you will be aware, this House’s Constitution Committee is also holding an inquiry. I expect that either personally or corporately, on behalf of the British Academy, I will be giving it evidence, so my apologies to this Committee if there is any repetition in what I say to, possibly, three parliamentary Committees. However, yours was an easy question, Lord Chairman, because my answer is no to all three parts of it.

The Chairman: Perhaps Lord Layard can ask a slightly more difficult question.

Q68 Lord Layard: We had some difficulty in our previous session in grappling with the question of how one thinks about the total grant to Scotland by focusing entirely on

Page 296 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) how to replace the bit that is removed, rather than thinking about the bit that remains. If I may reveal some ignorance, I would like to understand a little more how the Barnett formula itself is calculated and why you say that “contrary to widespread misconception, Barnett does not protect the relatively higher public spending per head in Scotland”, as some people assume, and that “If allowed to run on, it erodes it”. Could you give us a little lesson on that?

Professor McLean: I can do my best. Members will probably be aware that the world’s greatest expert on the operation of Barnett is indeed one of your special advisers, who can no doubt mark my homework and correct any deficiencies in what I am about to say. Barnett operates not on the baseline of public expenditure but on changes in public expenditure year on year. In principle, it gives the three devolved territories a population share of changes in public expenditure on the relevant functions of government in England—or it might be England and Wales, but we will leave that complication aside—in the reference territory. Because Barnett now operates on nominal changes in public expenditure, for all three territories, starting on the baseline of higher per head public spending on functions that are devolved to them, in the long run you should get convergence to equal public spending per head in the four territories of the United Kingdom. That is how the differential equation system, as your adviser has elegantly labelled it, works in the long run.

This has not been happening over the very many years that Barnett has operated. There are a number of reasons for this, but the main reason is relative population change. The relative populations of Scotland and Wales have been declining vis-à-vis England and therefore they are to that degree protected from the convergence effects of Barnett. Nevertheless, if the long run is sufficiently long—and we all know what an eminent economist said about that—it is correct that Barnett does not protect the relatively higher spending in Scotland. I hope that helps.

Lord Layard: Right. Given that we are starting from Barnett, we were discussing in the previous session different ways of thinking about how to calculate the value of the remaining part of Barnett. The two most obvious ways are first to shrink it by the percentage by which it shrinks in the first year and then carry it on thereafter, and secondly—I think this is the Holtham formula—to try to recreate, as it were, what Barnett would have produced had there not been the extra autonomy. What is your position as between those two?

Professor McLean: Neither of them is fully specified, so I find it difficult to state a position. My problem begins further back. How is it that, once a new tax is devolved, whoever calculates the Barnett baseline does the subtraction sum? Is the tax that was formerly reserved and is now devolved to be taken as a proportion of all tax revenue in the UK in the year before devolution? That cannot be right, because some of the tax revenue in the UK continues to be used for reserved public spending. Here we might need some algebra and a whiteboard, but I guess it is the ratio of that to all of the tax revenue in year 0 that was spent on devolved services in England—services in England that are devolved in, say, Scotland. That gives you your subtraction factor, I think.

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Of the two ways that you suggest of operating it in years 2, 3 and 4, my first inclination is to agree with you that the second way would be more wholesome, but I would rather see the algebra worked out before I could be confident in that opinion.

Q69 Baroness Blackstone: Do you think the Barnett formula could be replaced by a needs-based assessment? Were that to happen, how should these needs be assessed? What kind of principles would you introduce to carry through such an assessment?

Professor McLean: Yes, I do. I have written about this in references that I can supply to your clerks. I have argued for quite a number of years now that the model jurisdiction to look at is Australia, where they have what I regard as a robust needs assessment across the eight states and territories—six states, Capital Territory and Northern Territory. The most important point about the Commonwealth Grants Commission, which operates this, is that it is not owned by the commonwealth Government. It is, in principle, owned by the Parliaments of the commonwealth and the eight territories jointly. Because an element of the distribution is zero sum, it follows that it will never be the case that all nine Parliaments agree on a particular direction to give the Commonwealth Grants Commission and therefore the commission has reasonable liberty to operate.

Its assessment of needs has become very sophisticated over the 80-plus years that it has operated because it has always been well aware that all players in this game will play games and that they will, in particular, want to say that what they do not have much of is a need and what they have a lot of is a policy choice. The Australian commission—and, I would recommend, any UK commission—tries as far as possible to derive its needs from objective factors about the age structure and morbidity structure of the relevant populations, being factors that Governments cannot alter in the short term, although they can alter them in the long term. The second thing the grants commission does is apply some time lags. It smooths its grants to avoid a situation whereby, if a Government made a particular tax effort or had a particularly successful policy in year 1, it did not lose all the results of that good practice by having it equalised away from it in year 2.

To summarise, the essential principles of a good needs assessment are, first, to have the needs calculated as near as you can on an objective basis, immune from manipulation from any of the Governments in question, and, secondly, to have a smoothing system such that any gains made by a jurisdiction are not immediately equalised away.

Baroness Blackstone: If we were to introduce a system of this sort here, how do you see it being implemented? What kind of institutional structure would we have to put in place to do it properly and then make it work?

Professor McLean: A hypothetical UK grants commission clearly would have to report to the four Parliaments, let us assume, in the system—the UK Parliament and that of each of the three devolved authorities. I imagine that each Parliament—and I think it should be owned by the Parliaments, not the Governments, of the countries—might

Page 298 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) be invited to name commissioners, but the commissioners should not be delegates of their Parliament. There are constitutional forms from the various bodies that have been invented in the hope of keeping politicians honest; I am thinking of the Statistics Authority, for instance, and the Office for Budget Responsibility. This is not my area of expertise, but one could look at the constitutional structures of bodies such as these and apply the most appropriate one that one thought one had found to the UK grants commission, if we call it that, but with the addition that it should be owned—I suppose a lawyer would say jointly and severally—by the four Parliaments.

Baroness Blackstone: So you would see each of the four Parliaments setting up some kind of Committee, whether it be a special Committee or something slightly different from a special Committee, in order to oversee the work of the grants commission, as you describe it.

Professor McLean: That would be up to each Parliament. I doubt if it would gain very much from doing that. You want to avoid a situation in which each Parliament has a Committee that simply complains that the allocation of the grants commission does not favour that Parliament. You want to try to make the system as consensual as you can. The Australians have succeeded, in my view. Maybe they are the only nation in the world that can, but you would want to try to devise a technocratic and consensual system.

Baroness Blackstone: Would it not be better to try to get nominations from each of the Parliaments to take part in the oversight of the commission, so they would meet together rather than separately? Is that the sort of thing you have in mind?

Professor McLean: My rough model is that the commission is a permanent body— staffed, of course, by public servants—that reports to a Joint Committee of the four Parliaments.

Baroness Blackstone: That is what I am getting at. It is a Joint Committee of the four Parliaments.

Professor McLean: But that Joint Committee would have to have Standing Orders such that it did not vote by majority rule.

Q70 The Chairman: When we were in Edinburgh last week, it became very clear that there was a deep attachment to the Barnett formula. We did not inquire of the level of understanding of the workings of the Barnett formula; of course, it would appear that that is quite obscure anyway. Have there been worked examples? For instance, as far as you know, did the Smith commission see worked examples of the existing Barnett formula and a needs-based assessment, and then factor in some of the changes that are proposed to be made year in, year out to see which offers the most workable and least disadvantaged of those combinations?

Professor McLean: To the best of my knowledge—but I can be corrected by those closer to the process—Smith did not do this because it did not have time. It was under a mandate to report in an immense hurry. The previous Calman commission—or, more

Page 299 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) precisely, the independent expert group for Calman, of which I was a member—did do this exercise to a certain extent. It considered what might be called Australian-style, as I have just outlined, and Canadian-style equalisation rules. A Canadian-style rule would be characterised as one that attempts to compensate for the differential tax bases of the provinces but does not attempt to make a needs assessment. The Calman independent expert group, which heard from both Australian and Canadian witnesses, plumped for something that was closer to the Canadian than the Australian model. That is the last time I am aware of that it has been considered by an expert committee.

Lord Turnbull: I wonder about this point about the Barnett formula supposedly having mechanisms within it that would produce convergence and actually doing the opposite. Am I right in thinking that the population share—the 10 85ths, or whatever it is now—is supposed to be revised census by census? As a matter of fact, do you know how often it has been revised? It seems to me that this number has been around for a very long time.

Professor McLean: I understand that the population relativities are revised at every reissue of the Treasury document—I am blanking on its name—that comes out at each Budget. In principle, I think the population relativities are revised annually, but I do not know whether the relativities that they use are themselves updated annually.

Lord Turnbull: They are revised each time there is a spending review, which used to be annually, but now they are sometimes two years apart or even three.

Professor McLean: Per spending review, then; I apologise. The statement of funding principles is now revised at each spending review—

Lord Turnbull: What I think happens is that the Scottish population grows more slowly than the UK population, or the English population, and therefore this number is always lagging behind the reality. For a number of years, Scotland is being paid for people who are not actually there, based on what the population relativity was five years ago or something like that. It is quite unlike what happens with the taxman. If you put in a tax return and he says, “You didn’t pay enough tax last year”, he will do two things. One is that he will change the coding—that is, the 10 85ths—so that for the next year you are paying the right amount of tax for the income that is expected for that year. Then he will say, “I am going to add a bit more to your coding—actually, to take a bit more off your coding—to correct what you didn’t pay last year”. What happens with Barnett is that that second adjustment never gets made. Each time the base is a bit higher than was really justified, it stays in the base in perpetuity and gets added to. Over 40 years, that turns out to be quite a lot. That is one mechanism.

The other mechanism is that in ’78 the per capita GDP of Wales and Scotland was probably quite similar. Over those 40 years, Scottish GDP has risen—indeed, the Scots boast a lot about how prosperous a nation they are—but that has not affected the spending that they are given, so you end up with not only a higher per capita spending than Wales but even less justification for it. If that is how the thing works, the last

Page 300 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) thing you want to do is to build those defects into a new system and, in effect, to perpetuate them, but that seems to me what we may be doing.

Professor McLean: Right. These are deep waters. On Lord Turnbull’s second point, as the computer scientists might say, is this a bug or a feature? The fact that Barnett is needs blind means precisely what you have just said, Lord Turnbull—that it has not taken any account of the relatively faster increase in prosperity of Scotland compared with Wales and Northern Ireland, so the outcomes now look more anomalous than they did when Lord Barnett was Chief Secretary. That is just a feature of the fact that it is not and does not claim to be a needs-based system.

As to the first point, yes, I agree that the lag is not caught in the way that HMRC attempts to catch the lag in income for taxation. I do not think that that increases divergence, nor do I think that it changes the baseline, because the baseline is the amount spent in England on the relevant service. Its effect is just that as long as the changes in population relativities—we are into second derivatives here—are smaller in Scotland than in England, the convergence is dampened and the long run remains a bit longer.

The only justification that I can see for keeping Barnett is that it was part of the vow made by the unionist parties and therefore it may fairly be said that these were the terms on which the majority of Scottish voters voted no. That, I think, ties the legislature in good faith to continuing to operate Barnett on the reduced proportion of tax that it already covers, after the 2012 Act and Calman, which will be reduced by even more after the current Scotland Bill is enacted.

Lord Turnbull: If that is where we are—and you may well be right on that—that makes it even more important that as we move forward a proper track of this is kept, through the institutional mechanism that you have set out, so that people can understand whether the system is still diverging and not producing convergence. There needs to be some mechanism for regular renegotiation of it. At the moment we do not have a renegotiation—we simply have a recalculation. That seems to me to be an inadequate feature of the system.

Professor McLean: Yes. We can all agree easily that that is inadequate. I entirely agree that having simply an announcement in the periodic statement of funding policy as to how it is going to be operated, with then a little bit of argument between the Governments at the margin as to which expenditures are to be deemed to carry a Barnett consequential and which are not, is an unsatisfactory system. Even if one did not go the full hog of having an equivalent of the Commonwealth Grants Commission, I would like this to be overseen. It could be, I suppose, by one of the existing bodies— just possibly the Statistics Authority or the OBR, which have been created to be at arm’s length from Government—to do the sorts of calculations that you recommend.

Lord Turnbull: The model that seems nearest to me is the Electoral Commission, which is a UK body that operates in Scotland. The Government do not have to do what it

Page 301 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) says—Parliament can change it—but it is a very influential body. That tells us that we can create these kinds of federal bodies.

Professor McLean: It so happens that, of my last two research trips to Australia, one was to study the Commonwealth Grants Commission and one was to study the Australian Electoral Commission. Over there they have set them up on very similar lines. The UK Electoral Commission is quite similar to the Australian Electoral Commission in the way that it was set up, so we possibly have quite a lot of appropriate lessons from Australia to pick up here.

Q71 Lord Monks: Can I switch the line of questioning a little to the issue of taxation and the taxes that were chosen? In your interesting article in Politics in Spires, you are rather complimentary about the Smith recommendations, particularly given the time pressure that they were under. Are you still complimentary? Would you still say that those are probably the right choice of taxes?

Professor McLean: To be honest, I cannot now remember what I wrote in Politics in Spires, but I think that at that time I was commenting on the Scottish Government’s choice of what to do with the taxes that it already had devolved to it pre-Smith, in particular land and property taxation. If I said that the Smith bundle was right in that article, I had probably better revise that and have another look at the article, because what I would now stand by—if it is different, I apologise—is what I told the Scottish Parliament last week: that the tax powers and, even more so, the spending powers that are devolved under Smith are a bit of a rag-bag. Because this applies particularly to the spending powers devolved under Smith, the tax powers devolved under it look less coherent than they otherwise would. In particular, because Smith devolves some spending responsibilities for social protection but does not devolve national insurance—either employers or employees—I would say that it creates a new anomaly.

I would probably not have devolved the whole of income tax. I heard the last five minutes of David Phillips’s evidence and agree with the reasons he gives for saying that it would have been better if income tax had been a shared tax rather than a fully devolved one. As I say in my evidence to the Scottish Parliament, if more or different taxes are to be devolved, principles that go back to Adam Smith and David Ricardo suggest that taxes on stuff that does not move are the most appropriate to devolve— those not already devolved are oil and gas offshore, but also mineral exploitation onshore—and taxes on things that move instantaneously, such as corporations, are the least suitable for devolution.

Q72 Lord May of Oxford: I was very taken with your description of the system in Australia. As I was mentioning to the others earlier, my brother spent his life in the middle of that, beginning with “Nugget” Coombs. My question to you is, given that, quite understandably, the Australian way of doing it is best, what do you think is the chance of the countries, particularly Scotland, going along with that? How hard do you think it would be to implement that system here?

Page 302 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006)

Professor McLean: The obvious difficulty is that turkeys don’t vote for Christmas. People in Scotland who are aware of the present system are aware that they get a relatively favourable deal under the Barnett arrangements, even though they may not be aware of why that is.

Lord May of Oxford: That was the assumption behind the question.

Professor McLean: Yes. I think you will find—you probably already have found—that the Welsh Government would be very keen on a needs assessment. We have spoken to successive First Ministers and their staffs about this and they are on board with that idea. Northern Ireland politicians do not seem to know what they think about this matter because they are always thinking about something else. So it might be difficult to get a consensus on a move to a needs assessment.

If, however, a UK Government were to say that the only fair thing to do is to do a needs assessment, they have the power to do that. It would be rather difficult for the devolved authorities to say that they were against a needs assessment. They might then get into the politics of saying, “What is expensive to operate in this country is a need, and what is expensive to operate somewhere else is a policy choice”. I have accompanied Treasury civil servants when they have gone round in these Barnett consequential negotiations and have heard them use somewhat salty language about, for instance, the maintenance of two school systems in both Scotland and Northern Ireland, namely a Catholic and a non-denominational one. I think that the Treasury view—I am speaking for what I understand to be the views of Treasury officials, not of Treasury Ministers—is that having two parallel education systems is a policy choice and should not be regarded as a need and that, therefore, were we to move to a needs-based funding system, Scotland and Northern Ireland should take the consequences of having made that policy choice.

Q73 Baroness Wheatcroft: Clearly, the driver behind the current moves towards devolution is politics rather than economics. Professor McLean, I wonder whether you have found any evidence that devolution of powers to regions or countries produces per se any economic benefits.

Professor McLean: There is no strong evidence about this. There are contested claims. There was—as some members and, certainly, some advisers may know—a rather spectacular bust-up, if I may call it that, in the previous Scottish Parliament when expert witnesses who claimed that devolution did of itself bring economic benefits were systematically taken apart by the then Chair of the Scotland Bill Committee. I think the case has not been made, but it is perfectly possible that there are such benefits.

Where I would first look for the benefits would be in the area of land and property taxation. I repeat that, since I came in at the tail-end of David Phillips’s evidence, I know that you had a discussion of that matter and I would go along with what I heard him say. Scotland was given the power to replace what all experts in the field regard as the most indefensible of all taxes in the quiver, namely stamp duty land tax. They have

Page 303 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) taken that opportunity, and kudos to them—they have introduced a land and buildings transaction tax. However, one could look at the whole suite of taxes on land and property, which the Scottish Government are currently doing, as members may be aware. They have appointed a property tax commission, to which I have given evidence. There are ways of making the suite of taxes less regressive and more incentive compatible with tax activities that are, in the view of some experts, currently undertaxed. The Scottish Government are at least looking at those options. If I may be slightly cynical, the angry reaction of, in particular, sporting landowners in Scotland suggests to me as a rather cynical political scientist that the Scottish Government may be on to something here.

Q74 The Chairman: Can we look at the arrangements that are being proposed for fiscal autonomy in Scotland, in comparison with what has happened in other countries? We have a useful piece of information here that shows on a graph—the source is the OECD—exactly where it sits in comparison. From a qualitative point of view, it would be helpful to know how you see it in comparison with what has happened elsewhere and whether devolution of fiscal measures—a degree of fiscal autonomy—has worked successfully in other countries, and why.

Professor McLean: I have looked at the OECD numbers in the past, with my co-authors Guy Lodge and Jim Gallagher. I do not have any up-to-date OECD tables in front of me, so I cannot comment on those. What does it mean to say that a devolved tax system works? I suppose a working devolved tax system is one that is able to adapt to local conditions in all the sub-national territories while creating as few perverse incentives to players in the game as possible. If one looks at mature systems such as Germany, Canada, Switzerland and Australia, at an amateur level I can only say that they all seem to bumble along more or less okay. The only two of which I can say something a little more informed than that are Canada and Australia. We went through this in the Calman independent expert group, and I can say again that both of these are systems that work. They do not eliminate the perverse incentives, but those who have designed the system have thought about those incentives and tried to design institutions that suppress them as far as they can.

The Chairman: Have you detected in those systems in other countries some clues as to what needs to be included in the arrangements to give them the best possible chance of success?

Professor McLean: I would say two principles: non-gameability and incentive compatibility, which I illustrated in the Australian case a moment ago. A system should be non-gameable in that it does not give a player, which would be a Government in the system, an incentive to claim poverty by claiming something they have particularly much of as a need. It should also be incentive compatible in the sense that gains from tax effort are not equalised away immediately. Were I designing a system from scratch, I would adopt those two principles.

The Chairman: Is there not a danger in the fact that there is a second principle of no detriment—the ongoing no detriment—which is widely considered to be unworkable

Page 304 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) and has been put on a shelf as a general principle? Nevertheless, the expectations that flow from that are that, indeed, there will be no detriment over time, yet almost by definition there will be detriment over time—or benefit over time—because autonomy seems to me to imply that. That is one of the arguments for a degree of autonomy. Is there not a problem that, right at the heart of this, there is a principle that could undermine the workings of it and, therefore, the reaction of Scotland and the Scottish people to what subsequently emerges?

Professor McLean: I agree that the second Smith “no detriment” principle is very hard even to parse or interpret. It is also very hard to understand why it should be justified. It states—I have it in front of me—“No detriment as a result of UK Government or Scottish Government policy decisions post-devolution”. A strong reading might say that a tax change is a policy decision and therefore one territory must be compensated for any tax change made by the other. That is patently absurd, so if “policy decisions” does not include taxing decisions, what does it include? Maybe it includes decisions to spend more or less or to change the basket of taxes. There are various interpretations of what this could possibly mean. The only way that I have seen in which the second Smith “no detriment” principle could be made workable would be to restrict it very narrowly to decisions about the rates and base of a tax in one territory that would have knock-on effects in the other. You could do that.

If you apply it to spending decisions, you are constraining the very autonomy of the devolved Governments that the whole successive Calman and now Smith processes are supposed to be about. Members may notice that in my evidence to the Scottish Parliament I gave what was intended as a slightly tongue-in-cheek example, but one to alert MSPs to the issues. As I read it, if the Scottish Government use their to-be- acquired powers over the Crown Estate in a way that is suggested by the explanatory notes to this Parliament’s Bill, and that is less commercial, the second Smith “no detriment” principle could lead to a claim from the UK Government for compensation for the Scottish Government making less tax effort in the form of what it gets from the Crown Estate. The example may be fanciful, but it was designed to illustrate to the Scottish Parliament that the second Smith “no detriment” principle is expressed symmetrically.

Since the population of the rest of the UK is 10 times greater than the population of Scotland, were a UK Government to play hard ball over the second Smith “no detriment” principle, it would severely constrain the freedom of the Scottish Parliament to take autonomous decisions. That is clearly not what the parties who negotiated Smith can have wanted, so one has to try to do some rational reinterpretation of what they may have meant by the second Smith “no detriment” principle, and we face the problem that they may have intended them to mean different things. I can only agree that it is very hard to interpret.

Q75 Baroness Blackstone: Could you tell the Committee how feasible you think fiscal autonomy is for Scotland?

Professor McLean: Did you say “political” or “fiscal”?

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Baroness Blackstone: Yes, in a political sense—full fiscal autonomy.

Professor McLean: I differ from a number of people who write about this in thinking that full fiscal autonomy is feasible. It carries heavy consequences, of which an obvious one is, if Scotland has full fiscal autonomy, is there any case for it to be represented in this Parliament? But that is not a fiscal issue. There is a principle that I believe the current Scottish Government would really like. You would have to ask them, and you probably would not get a straight answer if you did, but I think the present Scottish Government would like a regime in which Scotland controlled all the tax rates and bases applicable to Scotland, used whatever proportion it took on devolved services and sent the UK Government an annual cheque to pay for defence, foreign affairs and debt interest. In principle, that was the system devised for Ireland and then Northern Ireland in the 1880s, and again in 1921.

The obvious warning is that it has never worked in Northern Ireland. Northern Ireland always has been a poor territory. It could possibly be made to work in relation to Scotland, given that Scotland is an average-GDP territory, and it would have the merit that it would force the Scottish Parliament as nothing else would, apart from complete independence, to face fiscal reality, which the design of tax and spend in Scotland—in the other two as well, but notably in Scotland—has prevented it from having to do since the Scottish Parliament was recreated.

Baroness Blackstone: Do they want it just as a next step towards independence? Is that really what is behind the drive for full fiscal autonomy?

Professor McLean: It is not for me to guess the motives of the Scottish Government, but I believe that quite a lot of SNP politicians would be quite content with full fiscal autonomy, if only because that is a popular position among the people of Scotland. If you ask the people of Scotland which Government should do what, they say, “We are happy for the UK Government to do defence and foreign affairs, and the Scottish Government should do everything else”. If that is the allocation of spending responsibilities, I think it is right that the allocation of tax responsibilities should follow that.

There is a problem. No less a person than the nationalist Convener of the Committee to which I gave evidence on Thursday said, “Isn’t this transfer of tax powers a poisoned chalice?” He quoted your own adviser, Professor Bell. I said, “Are these Professor Bell’s words or yours?”. The Convener said they were his words. I said, “It is a consequence of any further devolution of tax powers that the Parliament to which they are devolved has to be more serious about matching its taxing and spending”, or words to that effect.

Q76 Lord Turnbull: When we were in Scotland last week, one of the phrases that got a lot of pushback—I cannot remember the exact words, but it is in the UK Government’s document about the way forward—was something like, “We would expect Scotland to make a commensurate move in deficit reduction”. They did not like that. Of course, a lot of the political rhetoric is, “We want an end to austerity”. The UK Government may

Page 306 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) want to reduce their deficit to zero and even go on to make a surplus, which is controversial even here, but they say, “We don’t want to go that far”. They might want to adopt the old Labour Party policy of having a deficit only of the current budget, and they might have a view on the time over which they wanted to reduce the deficit. How do you reconcile the fact that the UK Government have an overall fiscal policy and powers relating to monetary policy, yet one part of the UK is saying, “We want to be able to determine our bit of that ourselves”?

Professor McLean: I would have to say that, for better or for worse, that is a consequence of the way the Scottish people voted last September. The majority of those who voted, voted to remain in the UK. There is no country in the world—nor, I think, could there be—in which determining the overall fiscal balance is the responsibility of anything other than the upper tier of government. It then devolves into the pure politics of it. Given that the vote was no, it is a necessary consequence that the UK Government are entitled to make the sort of statement that you have just quoted. It is also in the nature of politics that a Scottish Government controlled by a nationalist party is always going to object to that.

Lord Turnbull: It follows from that that all of the discussion about borrowing powers is not about this basic trajectory down to a balanced budget that the UK Government want, but about quite minor variations around that trend. It cannot differ fundamentally; it certainly cannot go off in a different direction. In the end, it always has to come back, even if it takes slightly longer over it. Do you think that thinking people in Scotland have recognised that?

Professor McLean: Here is another point where I may differ somewhat from other academics who look at this. I would maintain that a good way to deal with the contradiction we have just agreed on is for the Scottish Government to have relatively wide borrowing powers, with the effect that market discipline would then be applied to Scottish Government debt. Of course, there would be a question of whether Scottish Government debt was impliedly backed by the UK Government. The UK Government would presumably insist that it was not and would have an incentive to put their money where their mouth is. These politics could then get very painful, but it is safe to presume that Scottish Government debt would carry a risk premium over UK Government debt if the Scottish Government had more serious borrowing powers. For my money, that is all to the good from the point of view of fiscal discipline.

Lord Turnbull: Is this not going to replicate the essential fault of the euro? Ireland, Portugal and Spain all had debts, with risk premiums virtually nothing over German debt. However, when it came to it, it turned out that the markets had guessed correctly that there would be a sort of bail-out. The idea is that the UK Government, in a monetary union, would not bail out one of their component parts, but Scotland is too big to fail and we have to build around that.

Professor McLean: Certainly, that analogy was a powerful driver of two famous speeches of which you will all be aware—by Governor Carney, followed by the Chancellor—both in Edinburgh last spring, saying that a currency union with an

Page 307 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006) independent Scotland would not be acceptable to the UK, for the very reason that you have just said. Can you credibly say that the Scottish Parliament bears the risk of Scottish debt within a union? Here might be a very brutal view. Scotland is not too big to fail. Scotland is 8% of the UK population. If they were to fail to make repayments on Scottish debt issued by and on the authority of the Scottish Parliament, that would be between the Scottish Government and their creditors. The UK Government would not intervene. Why should they, especially as their stake in Scotland would be much less than now? Here one is freely hypothesising about events that would be high risk. I cannot be 100% sure that the UK would not bail out Scotland in those circumstances, but if it did it would be on terms.

Lord Turnbull: Who would those creditors be? Would they be UK institutions? You then get into the complication that our No.2 and No.3 banks are headquartered up there.

Professor McLean: It would be whoever bought Scottish Government debt. “Headquartered up there” is a bit tricky, but the Royal Bank, let us say, would have to take a commercial decision as to whether—or on what terms or what yield—it was willing to buy Scottish Government debt.

Lord Turnbull: The UK Government ought not to bank on the fact that they could just let them fail. They should always recognise that they may find, when the time comes— if only because of the risk of contagion—that they have to, and therefore they should be aware of that from the start. That is why I think the proposition would be that we should not be offering a kind of “no bail-out” threat, because we would not know at the time whether we would ever be able to deliver on it—or want to deliver on it.

Professor McLean: That view may be right, but a concomitant of that is that you are not then going to feel free as the UK Government to give the Scottish Government any extensive borrowing powers. Then we are getting back to the political irresponsibility of the regime. That is not meant as an attack on the present Scottish Government. It is just a fact that a Government who are not fully fiscally responsible have every incentive not to behave in a fully fiscally responsible way.

Lord Turnbull: I think you are saying that accountability will come from one source rather than two. It will come through taxpayers, who might pay an extra bill, but it will not come through pressure of creditors, because we will not be allowing them to play a big part in this.

Professor McLean: Yes. That may be the necessary situation, in which case it is a long way short of the aspirations of the Scottish Government.

The Chairman: Professor McLean, thank you very much indeed for your clear and helpful answers this afternoon.

Professor McLean: Thank you for putting me through a considerable challenge.

Page 308 of 420 Professor Iain McLean – Oral evidence (QQ 67-76) (DFPOE0006)

The Chairman: Good luck with your forthcoming appearances before other Committees.

Professor McLean: Thank you.

Page 309 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006)

Evidence Session No. 6 Heard in Public Questions 56 - 66

TUESDAY 15 SEPTEMBER 2015

Members present

Lord Hollick (Chairman) Baroness Blackstone Lord Layard Lord May of Oxford Lord Monks Lord Turnbull Baroness Wheatcroft ______

Examination of Witness

David Phillips, Senior Research Economist, Institute for Fiscal Studies

Q56 The Chairman: Mr Phillips, thank you very much for joining us. I had understood that a colleague of yours was coming with you.

David Phillips: She sent her apologies.

The Chairman: Okay. Thank you very much indeed for joining us. We are part-way through—probably a little over halfway through—our inquiry into devolved Scottish financing, a topic I know you have spent a great deal of time thinking about. Thank you very much for your written submission. Could we start off by getting your views on how the block grant should be calculated to reflect the devolved powers of taxation in Scotland and the framework that was laid down by the Smith commission?

David Phillips: Okay. Clearly, with additional revenues and additional spending being devolved to Scotland, you need to make an adjustment to the block grant. At least in principle, in the first year of operation that is quite straightforward. You add an amount to the block grant equal to the forecast revenues you are devolving to Scotland and you subtract an amount equal to the forecast spending that is now being devolved to Scotland. The issue that is more difficult is what you do in subsequent

Page 310 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) years. The Smith commission said—a little cryptically—that they “should be indexed appropriately”. It did not directly say how that indexation should take place, but the principles it outlines—issues such as the UK bearing the risk of economic shocks that affect the whole of the UK, the “no detriment” principles and the fact that Barnett should remain in place—have some implications for the kind of system that you would want to use to index, because some indexation systems will comply better with those principles than others, although none will comply completely with the principles.

One way of doing things that would have advantages and would be an attractive way of doing the indexation is to take the initial block grant adjustment you make—if, say, in the first year you take £10 billion off the Scottish block grant to account for devolving £10 billion of tax revenues—and to link that to some measure of the change in the tax revenues in the rest of the UK from the equivalent tax. For instance, you could index it to the percentage increase in the equivalent tax in the UK. If revenues went up by 10% in the rest of the UK, the next year you would increase the block grant adjustment by 10%, so up to £11 billion. You can do it in other ways—in per capita terms, rather than in percentage terms—but linking it in some way to what happens to revenues in the rest of the UK is appropriate, I think. For instance, it ensures that the UK bears the risk of shocks affecting the whole of the UK and it comes close, at least, to satisfying the “no detriment” principles, although it cannot do that perfectly.

The Chairman: When you say the detriment principle, you mean the second detriment principle, rather than the first one.

David Phillips: Actually, it satisfies both of them to some extent. You can think of the first “no detriment” principle as operating only in the very first year, but if you devolve a tax in such a way that it will automatically cause detriment in subsequent years, you can think of that as violating the first “no detriment” principle. I think it helps to satisfy both of them.

The Chairman: When we were in Edinburgh last week, we were briefed by the Finance Committee of the Scottish Parliament that it had wrestled long and hard with the second detriment principle but had concluded that in fact it was unworkable and it would just see it as a high-level principle. Do you agree with that approach?

David Phillips: I think that getting that principle to work fully would be completely unworkable. For instance, if there are any knock-on effects on the other Government—for instance, if the Scottish Government were to change income tax rules and that had the knock-on effect that it increased entitlements to, say, universal credit in the UK—one part of the second “no detriment” principle says that some compensation should be paid to compensate the Government for those knock-on effects. In certain circumstances that would be feasible, but in others it would not, so applying it in a rigid way to every single case where there is detriment or there are knock-on effects would be impossible. I agree that it should be used as a high-level principle and that it can be applied where there are particularly large knock-on effects and a common assessment of the effects can be agreed upon.

Page 311 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) The reason I said that indexing to the revenues in the rest of the UK is a good method—and it is pretty consistent with the second “no detriment” principle—is this. Imagine there is a change in the taxes in the rest of the UK and the UK Government decide to put up income tax in the rest of the UK to fund higher spending on health there. That higher spending on health would feed into the Barnett formula and increase the block grant to Scotland. Scotland would therefore be gaining from higher taxes in the rest of the UK without paying any higher taxes itself. However, if you index the block grant adjustment to the revenues from income tax in the rest of the UK, because those revenues have gone up, you take off more from the block grant to account for the fact that income tax is devolved. That would more or less offset the extra money from the Barnett formula, leaving Scotland pretty much unaffected by the higher taxes and higher Barnett-able spending. It would not be perfect, because the tax bases and spending levels are different, and the Barnett formula does not align with the ways in which you can do the block grant adjustments, but it would be pretty close.

Q57 The Chairman: Which of the three methods that you set out when you met the Scottish Finance Committee do you favour as being the fairest and most serviceable method?

David Phillips: By the three methods, I think, you mean a fixed deduction—

The Chairman: Yes—a fixed percentage, an index to percentage change and an index to growth.

David Phillips: Yes. I would say that the least good of those is the fixed percentage, because—as I explain in that evidence to the Scottish Finance Committee—it does not satisfy the principle that the UK Government should bear shocks that affect the whole of the UK. That would mean that the Scottish Government would be exposed to recessions that affect the whole of the UK and would have to borrow a lot to smooth the cycle. I do not think that would necessarily be the most appropriate level of government for that kind of cyclical borrowing to take place at.

That leaves you the choice of a percentage-based indexation or a levels-based indexation—a per capita-based indexation. It depends on which of the “no detriment” principles you want to satisfy, I think. If you index it in percentage terms, it means that if Scottish revenues grow at the same percentage rate as those in the rest of the UK—if revenues go up by 5% in England, they also go up by 5% in Scotland—Scotland does not suffer. It does just as well under devolution of income tax as it would have done under the old-style system. If you were to expect the same percentage-rate growth in revenues, that system would deliver you no detriment to Scotland. There is a question about whether you want to do this as percentage growth in aggregate revenues in the rest of the UK or percentage growth in per capita revenues in the rest of the UK, but, on either of those bases, if you interpret equivalent performance of the Scottish economy as being equivalent percentage growth rates, this method would leave Scotland unaffected by devolution. Scotland would still gain if it grew faster than the rest of the UK, and lose if it grew slower. That is my personal favourite of these

Page 312 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) methods. The other method is where you index it not in percentage growth rates but in pounds-per-person growth rates. The problem with this one is that we start off from the position where revenues per person from income tax are lower in Scotland than they are in England. If revenues in England went up by, say, 10%, in order for Scotland to keep up with that in pounds-per-person terms, revenues in Scotland would need to go up by more than 10%. If they did not—if they grew at only 10%—Scotland would lose out from the devolution of income tax. Scotland’s revenues would need to grow by a faster rate than those in England under this per capita indexation in order to keep up with revenues in the rest of the UK. We did some analysis that said that, over the space of 10 or 20 years, if Scotland’s revenues did not grow faster than the rest of the UK’s in percentage terms, Scotland could lose billions of pounds per year by using the per capita approach to indexing, rather than the percentage approach. Some might say that that is a way you can reduce the high levels of funding that Scotland gets under the Barnett formula; others would say it is a slightly sneaky way of doing that. I think that I am in the latter camp.

Q58 Lord Turnbull: I was rather surprised by this conclusion. I will illustrate it with a simple arithmetic example. Revenues in total in the UK grew by 5%; 3% was the growth in the revenue and 2% was the growth in the population. In Scotland alone, revenues grew by 3% and their population was not growing, so they both have the same growth per capita. Because this is a deduction, if you are indexing on a per capita basis the deduction is smaller. It therefore seemed to me that that would be more favourable to the Scots, whereas you are saying that on a per capita basis that method is more favourable. I think it is because there is another factor that maybe I have not brought in, which is the starting point. There is a baseline—you are indexing on a sum of money. When that sum of money starts in Scotland, per capita the revenues are lower, therefore the effect that you had was dominant. The effect I was thinking of was that, if you take population growth out, you reduce the deduction and hence increase the grant.

David Phillips: Yes. I would distinguish between two things here. Let us take the percentage method first. You can look at the percentage growth in revenues in total. In your example, the percentage growth in revenues in total is 5%. Then you would index the block grant—the block grant adjustment—by 5%. The second option is to take the percentage growth and work out the percentage growth per capita, which is what—

Lord Turnbull: Indexing the block grant or the block grant adjustment?

David Phillips: The block grant adjustment.

Lord Turnbull: Right. One of these has a positive sign in front of it and the other has a negative sign. You actually said you were increasing the block grant—

David Phillips: I mean indexing the block grant adjustment. Sorry—yes.

Lord Turnbull: Right.

Page 313 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) David Phillips: The first way is to do it in percentage terms, for the aggregate percentage change. If revenue has gone up by 5% in total, you change the block grant adjustment by 5%. The second way you mention is to say, “What is this 5% growth in total? What does that work out at in percentage growth per capita?” In your example, it was 3%. You are right that doing that method would be beneficial to Scotland, because what you are doing is taking into account the fact that there is differential population change in the two countries.

Lord Turnbull: Professor Cuthbert showed us that, according to his figures, using the per capita method, the grinding down of Scotland’s position was much slower.

David Phillips: Yes, but I mean per capita in a somewhat different sense to that. Your adviser, Professor David Bell, may be able to explain this in one of your private sessions at some point. I do not mean accounting for the fact that there is differential population growth. Holding the population fixed, 5% growth in revenues in England might mean £500 per person in England. Because revenues per person in Scotland are lower, 5% revenue growth in Scotland per person, holding population fixed, might mean only a £400 increase in revenues in Scotland. In order to get the same £500 revenue increase as in England, revenues would need to grow by something like 6.2%.

Lord Turnbull: But both these factors—my kind of per capita adjustment and yours— are at work, so which is going to outweigh which one?

David Phillips: Exactly. It depends. There are four options, effectively, here.

Lord Turnbull: Not three.

David Phillips: Ignore the first of the three in my paper. I think that is not an option, given the need—

Lord Turnbull: What is the fourth option?

David Phillips: The four options are as follows. There is indexing in percentage terms in aggregate, so this 5% figure you mentioned. Then there is indexing in percentage terms accounting for population change—so the 3% in your example. They are the first two examples of ways of doing things. The next is to say—holding population fixed, first of all—what is the per capita revenue increase in England? In my example, it is £500. Then you take that £500, multiply it by the population of Scotland and say, “We will adjust the block grant by this amount”. The fourth one is to say, “We will do that but also account for the fact that there is population change going on at the same time”. So there is percentage or pounds per person as two options. Then there is accounting for population change or not accounting for population change. They are two independent decisions that you can—

Lord Turnbull: Which do you prefer, now we have four?

David Phillips: Which of those four do I prefer? It depends on the extent to which you think convergence in funding between Scotland and England would be fair or not. If

Page 314 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) you think that the convergence should be as slow as possible, you would want to have the percentage indexation accounting for population growth, because—as Jim Cuthbert would show—that would give you the slowest rate of convergence. If you thought that actually Scotland was getting too much money under the current system and you wanted to remove that via this system, you would do the pounds per capita, not accounting for population growth.

Lord Turnbull: You have two jurisdictions, absolutely head to head. One of them obviously wants the one that is more generous and one of them wants the one that will grind away over the years at what we believe is overprovision. How do you get that resolved?

David Phillips: That is a very difficult question. I think that is a question for politicians, rather than economists. I can give some principles, though, that could guide this. The way the Barnett formula works is that it does not take account of differential population growth, because it does not update the base-level spending to account for the change in population. You might say that, given that the Barnett formula on the spending side does not account for differential population growth, on the revenue side you also should not account for differential population growth, because otherwise you are ignoring differential population growth where that would penalise Scotland and accounting for it where it benefits Scotland. You might say that the two principles—

The Chairman: I think we are in danger of spending too much time on this. Could we move on?

Q59 Lord Layard: It seems to me to be peculiar to be discussing this issue in terms of how you index what is deducted from something, rather than how you index the thing itself. The prima facie way of thinking about this would be, “This grant has been reduced in the first year. How do we index the remainder into the future?” That would lead you naturally to the first approach—that it is just a smaller amount that is being indexed in the same way as the Barnett formula was indexing the original total. Going on from that, what strikes me is that the Barnett formula is irrational and it is pretty extraordinary to be having this elaborate discussion of how to introduce rationality into a deduction from it when the thing itself is not rational. Why not go for the simple thing that the total has been reduced and then just apply the same percentage to the original Barnett formula?

David Phillips: I can see the logic in that approach. The reason that in my discussion and in my recommendations to the Scottish Finance Committee I said that I do not recommend that way of doing things is that, first, in a similar way, it would not meet the principles set out by the Smith commission. In particular, it would not meet the recommendation that the UK Government should bear the risk of shocks that hit the whole of the UK. To see that, consider an example like this. Say there is a recession that hits income tax revenues across the whole of the UK. That causes a fall in the Scottish Government’s tax revenues. Say the UK Government decided just to leave spending unchanged during the recession and to borrow money to fill that gap. Scotland’s block grant would not change but its revenues would have fallen, so a hole

Page 315 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) would open up in its budget. You could say that Scotland should be able to borrow that money on the markets itself. That could be possible, but the Smith commission said that it thought the UK Government should bear these kinds of risks that affect the whole of the UK, perhaps because it thought that, with a deeper capital market and access to cheaper borrowing costs, it might be easier for the UK Government to smooth these kinds of big shocks that affect the whole of the UK.

Secondly, there could be political concerns about how this would operate with the type of borrowing powers you grant to the Scottish Government. If you expect them to be able to manage these potentially big shocks to aggregate revenues, not just the kind of relative shock to Scottish revenues, you need to give them more borrowing powers. There may be concerns that they would use those borrowing powers in ways the UK Government did not think were consistent with their overall fiscal stance. By taking the approach of indexing the block grant adjustment, rather than changing the underlying block grant, you find a way to avoid the issue of Scotland having to bear big cyclical risks and the subsequent effects of Scotland needing to be given very large borrowing powers to do that. I think that is the reason why the commission—

Lord Layard: I do not quite understand why you are focusing on exposure to UK risk. If a part of the country is becoming more autonomous, it is getting less from the rest of the country; therefore it is inherently less exposed to variation in the rest of the country and more exposed to variation in itself. That seems to me absolutely inevitable. That is what devolution is about.

David Phillips: I agree that the change in the fiscal system might mean that there is some divergence in economic cycles across the UK compared with what there is now, but economic cycles in Scotland and the UK are strongly correlated. If you have a shock that affects the rest of the UK and causes revenues to fall there, that shock will tend also to hit Scotland. The Smith commission took the position that it thought the UK Government should bear the risk of these shocks that affect the whole of the UK. If they affect Scotland worse or less badly, Scotland bears the differential risk, but it thought the UK Government should bear the aggregate risk. I guess it is part of the idea that there should still be some degree of risk sharing across the UK. If you are happy for there not to be that risk sharing across the UK and that Scotland borrows to smooth the aggregate cycle, as well as its own idiosyncratic cycle or idiosyncratic secular trends, I agree that the system you describe would be much simpler, but it would expose Scotland to additional fiscal risks.

Q60 Baroness Blackstone: Most people in Scotland, for obvious reasons, want to see the continuation of the Barnett formula. Many people outside Scotland who think about these issues do not think it should continue. Would you like to see a replacement of the Barnett formula with a needs-based assessment? If so, what factors should it cover?

David Phillips: Again, that is a slightly tricky question to answer simply as an economist. One thing that it is worth bearing in mind is that the Barnett formula as it is implies some degree of convergence. The evidence that you will have seen from Jim

Page 316 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) Cuthbert would say that it does not guarantee complete convergence. It depends on relative population growth and the speed at which spending is rising. It could also depend on relative revenue growth and relative levels of revenue under a system of partial revenue. To some extent, if the concern is that Scotland is getting too much money under the current settlement, the Barnett formula would be expected to squeeze that down somewhat over time, although it will not do that when spending is falling and there are some flaws in the way the Barnett formula deals with business rates and certain other things, which mean that that has not been happening over the last 15 years or so. Anyone would say that there is no clear economic rationale for the Barnett formula. It simply takes historical levels of spending and adds an increment to them, based on relative populations and changes in comparable spending in England. There is no assessment of the level of spending in there.

There could be two approaches to a more rational system. Other countries tend to do one of two things. The first is to go for what they call revenue equalisation and account for the fact that there are different capacities to tax in different parts of the country. The system for allocating grants across the country takes into account that there are different levels of tax-raising capacity. That is normally more straightforward to do than a needs assessment because it is easy to agree on what factors affect tax capacity. You can model what a standard tax system would do across the entire country and use that. Needs assessment is more difficult, because of disagreements about what should enter a needs assessment. Here I would defer to the Holtham commission, which showed that actually you can get a pretty good approximation of the needs-based assessment that seems to be going on in England, with a whole plethora of different formulas in education and health. You can approximate that using just five or six factors. My own view is that keeping it simple would have the benefit of avoiding people trying to game the system by adding things and having things taken off that are considered to be beneficial or detrimental within the formula. Whether or not it is politically feasible to have a very simple system if there is pressure to include these other things, I do not know.

Baroness Blackstone: What you are saying is that, in principle, it is possible to move to a needs-based assessment, with a simple formula, without too many complex factors all being introduced. Assuming that could be done, you would not really agree with Alistair Darling, who perhaps was making a political point rather than an economist’s point, when he said that it would not be possible because nobody could ever agree on it.

David Phillips: I agree that it would be difficult, but at some point, if Barnett does lead to convergence, there will be pressure to reform the system. Moving towards a needs- based system or a revenue equalisation-based system would be difficult but would not be an insurmountable challenge.

Q61 Lord Monks: The logic of the Barnett formula was more political, probably, than economic, wasn’t it? It was compensation for the oil revenues in the North Sea coming into Whitehall and Westminster. That is what is bugging me, really, about formulas generally in this devolved world we are embarking on—or greater devolution of tax

Page 317 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) matters, in particular. I wonder whether you could help me to understand how any of the variations on the formula might work in relation to the revenue decisions of the Scottish Government, because the Scottish Government will have extra tax-raising or tax-cutting powers—probably more tax cutting than tax raising, I would guess, given the political atmosphere in Scotland. Supposing that the Scottish Government cut, say, air passenger duty, which is likely to devolved, and so on; how do these mechanisms work in relation to the Scottish Government saying, “Well, look, our needs now to sustain our spending levels are for a greater amount, through the block grant system, from London”? That is likely to cause tremendous resentment, if there is a feeling that they are giving away things and are claiming more off central UK-wide Government. How does the revenue side act in relation to this?

David Phillips: Under the current system as it is, with the Barnett formula in place, the kind of systems we are talking about if you index this block grant adjustment to what happens to revenues in England mean that Scotland has to bear the cost or the gain from any changes to its own taxes. If they were to cut air passenger duty and that led to a loss of revenue, the Scottish Government would just have lower revenues from their own taxes. There would be no change to what they get under the Barnett formula, so they would bear the cost themselves. That is in accordance with fairness and with what the Smith commission says about Scotland bearing the economic consequences of its own policy decisions. What happens under the current system is quite straightforward.

If you move towards some kind of needs-based assessment, it would work similarly to how it has worked with local authorities, I imagine, where you assess the taxable capacity of Scotland—not based on the actual tax rates it imposes but based on a kind of default tax system. As you do with the block grant adjustments, you would probably take the default tax system as being the tax system operating in the rest of the UK. Again, if their needs had not changed but they cut their air passenger duty—if they decided to cut their own taxes—the block grant would not adjust to compensate for that, because they had decided to deviate from this assumed default taxation system and they have to bear the cost of that themselves.

Where it gets more complicated under a needs-based system is if these tax policy changes have dynamic effects on the economy—for instance, if they cut air passenger duty and that leads to more people flying in and out of Scotland. If you based your assessment of taxable capacity on the observed number of flights in Scotland, you would assume that their taxable capacity was higher than it actually is, because the reason there are lots of flights in Scotland is that they have a very low tax rate. If they imposed the standard UK-wide tax, there would be fewer flights in Scotland and they would have a lower taxable capacity. There is an issue that, when you start to move towards a system of assessing revenue capacity and spending need, the dynamic effects you want Scotland to bear the cost of or to get the gains from can start to be cancelled out by these needs assessments and revenue capacity assessments. There is an issue that arises there, but it is to do with the dynamic effects, not the arithmetic effects of changing the tax rates, if that makes sense.

Page 318 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) The Chairman: Lord Turnbull, could you bring us on to question 5, about the institutional structure?

Q62 Lord Turnbull: When we were in Scotland, it was made pretty clear at a political level that the Barnett formula was not negotiable. It had been re-avowed by the vow and they were not at all interested in a needs adjustment, because they suspected that it would probably show what everyone believes—that the thing is overdone. However, it seems to me that, on this second detriment principle, people have recognised that doing it bit by bit is not going to work. What you will have is that, periodically, someone will have to sit down and say, “What has happened since we last set this thing?” It will probably be on a five-year cycle. Is there then a need for some kind of body that is, first, the guardian of the figures—because we can even argue about the figures—and the guardian of the methodology? It does not necessarily go all the way towards the Australian thing of actually taking the decisions, but you would at least get to the point where there is an agreement on how this system works, because no one outside the Treasury and the Finance Ministry knows it. You will need something of that kind if, instead of doing these things continuously year by year, you let them all pile up for five years and then make a correction. You will need to have someone who is able to provide the basis for that kind of review.

David Phillips: I agree with you on the point that there will need to be changes to the institutional arrangements for managing the devolved Government finance. At the moment the Treasury is judge, juror and executioner on this issue. There are some forms of negotiation between the two Governments, but ultimately the Treasury executes and determines the plans. The question is, what form of arrangements is needed here? First, there is a need for much more transparency about the way in which the calculations are done—not just every five years, but year to year—on the operation of the Barnett formula, the block grant adjustments, the revenues and all of these things. Whether this is just the Treasury publishing its workings or whether it is having—preferably—an independent body publishing its workings, so that people can see how the figures are calculated, that is very important. It is something that has not been done under the Barnett formula to date. I think that the House of Lords Select Committee on the Barnett Formula recommended that these kinds of things be published when it looked at it back in 2009.

Lord Turnbull: The Treasury publishing its spreadsheets will not get us very far, because they will be denounced in Edinburgh.

David Phillips: Yes. As I said, a first step would be their publishing it, but it would be better if a body could be set up that could act as an impartial assessor of these things.

Lord Turnbull: Like the IFS.

David Phillips: I am not sure that the IFS would want to enter quite such a minefield. You mentioned the Australian model. As I understand it, the Australian Commonwealth Grants Commission does not actually make the determination. It makes a recommendation to the Australian federal Government, following a technical

Page 319 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) assessment and consultation with the provincial and the federal Governments, and then the federal Government makes an actual decision. That kind of set-up, where you have an independent body that makes a recommendation about how these things are to work but the ultimate decision rests in the hands of the elected Governments, would be the one most likely to work in this regard.

Lord Turnbull: Is it not inevitable that someone starting work in that area will start to work out a needs-based figure, because that will be one of the ways in which they determine their recommendation? Even if the Scottish do not want this needs-based thing at the start, will it not eventually have to go that way?

David Phillips: It depends on the remit that is given to the organisation. If the organisation is given a remit of saying how this could operate in the context of the Barnett formula and the system of block grant adjustments indexed by percentage growth, what it will then do is forecast what these growth rates will be, forecast the impacts of the policies—the knock-on effects—and decide which ones are big enough to require these compensations. If it is given a wider remit, maybe it will innovate and make suggestions about how the overall system can be changed, but that is a question of the remit it is given by the two Governments. The more difficult question is if it is a body that makes a recommendation as opposed to the decision. Which is the actual body that makes the final decision? If it reverts to the UK Government still making the decision, there could still be difficulties at that level, although you would hope that, if those decisions are based on the independent advice and they follow that independent advice, it would make it somewhat less difficult.

Q63 Lord Monks: Can I move on to a different topic? It is one you touched on earlier—borrowing powers and the form that they should take. Starting this year, Scotland has been able to borrow within certain limits, under the 2012 Act. I am interested to know whether or not you think that borrowing powers should be extended and expanded beyond those that were set out in the 2012 Act. Maybe you could tell us a little about how it is proposed that they use any powers. What plans are extant in Edinburgh to deploy the powers that came in in April 2015, for example?

David Phillips: First, I would say that the extent of the further borrowing powers they are given should depend on the extent of fiscal risk they are going to bear. Thinking about the amount of borrowing powers they need depends very much on the wider set of changes—how you are indexing the block grants and so on. If they go down the route of doing it under these methods where there is some indexing to UK revenues, the risk that Scotland bears is the risk that its own revenues move out of line with those in the rest of the UK. It does not bear the whole cyclical risk of recessions. Having said that, that could still be a pretty substantial amount of risk. There can be shocks that affect Scotland differently from shocks that affect the rest of the UK. For instance, the recent declines in oil prices have likely benefited the UK economy as a whole but are likely to have hurt the Scottish economy, particularly the area around Aberdeenshire, so they still need to have borrowing powers to smooth out the effects of these shocks that hit Scotland on its own.

Page 320 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) Under the Scotland Act, the power to borrow for smoothing for current purposes— current borrowing—only allows you to borrow for forecast errors. If you forecast revenues to be £10 billion but they come in at £9.9 billion, you can borrow that £100 million to make up the gap. But if you forecast a recession next year and your revenues to fall, they are not able to borrow to fund that forecast shortfall in revenues—only the unforecast shortfalls in revenues. Now, I do not think that is an appropriate amount of borrowing powers to have when you could be facing these idiosyncratic risks. If you saw the oil price fall coming—of course, people did not see it coming, but if you could—you should be able to borrow to smooth those risks, not just the risks that you do not see coming. They definitely need further borrowing powers on the current side to allow them to smooth forecast as well as unforecast shocks.

How many more of these borrowing powers there should be is an open question at the moment. One of the things that I and colleagues at Stirling University will be looking at is just how big a fiscal risk Scotland will bear—how much you can expect revenues to vary from year to year. That might give you an idea about how much these borrowing powers should be.

Then you have the capital side of borrowing powers. At the moment they have £2.2 billion as the total amount they can borrow for capital spending, with about £300 million per year. I am not sure whether or not that should be increased. It depends on the extent to which you want to allow Scotland the freedom, in effect, to shift resources from current spending to capital spending, because that is in effect what they will be doing with these capital borrowing powers.

One recommendation that has been made, with which I think there are risks involved, is giving the Scottish Government a prudential borrowing regime. CIPFA has suggested that, like local authorities, the Scottish Government should have a prudential borrowing regime, which means that it is up to the Scottish Government to determine what it thinks is an affordable and prudential amount of capital borrowing that it can undertake. The way that works is that they assess an amount of their day-to-day budget—their current budget—that they think they can allocate to capital budget repayment.

That works very well for local authorities, and it might seem strange that you give local authorities more borrowing powers than you give the Scottish Government. However, the political context could be somewhat different with Scotland. In the case of local authorities, if Westminster believed that a certain authority was borrowing too much, it could intervene. Politically, it would have the capital to intervene in that authority’s borrowing and say, “We are going to cap your borrowing power”, or, if it went completely wrong, it could bail out.

In the case of Scotland, the politics are quite different for a prudential borrowing regime. If the UK Government said to Scotland, “You can have this regime”, and then a few years down the line said, “Actually, no. We think you are being imprudent. We are going to stop you borrowing any more”, the political ramifications of that would be pretty big. It would be the same if they were to bail out the Scottish Government, if

Page 321 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) they were to borrow what turned out to be an imprudent amount. While there could be scope for increased borrowing powers, and maybe a move to a prudential regime giving the Scottish Government the same kinds of powers as local government could work, there would be political risks in doing that. They should be thought about, given the quite different politics of local versus Westminster and Scotland versus Westminster politics.

Q64 Lord May of Oxford: I would like to remark at the beginning, first, that I find much of this difficult to understand, and, secondly, that my brother spent his career in the Australian central bank and I can assure you—at least, from the last conversation I had with him and many earlier ones—that things in Australia are not all that harmonious. They have just the same problems we are talking about here.

My question is, do you really think that the “no detriment” principle, which clearly offers all sorts of opportunities for difficulties, will be put into practice in a way that works harmoniously? It seems to me that tax competition, deliberate or not, would be an inevitable consequence of diverging tax rates and so on. I do not see how just chanting mantras about no detriment will cure these sorts of problems.

David Phillips: I agree with you that there is a strong chance of tax competition, particularly on the taxes where there are more mobile bases—income tax for very high earners and corporation tax in the case of Northern Ireland. If you put complete faith in these “no detriment” principles, you might say, “Okay, you have cut your top rates of income tax. People from our jurisdiction have moved to yours. You have caused us detriment. You have to compensate us”. I think that would quickly become unworkable. It would lead to arguments between different Governments and would potentially remove the incentives that Governments have to engage in policies that are of benefit to their own country. In this regard, what George Osborne said—I am not sure whether it was to the Scottish Parliament’s inquiry or to the Treasury Committee’s inquiry on this issue—was that he did not envisage the “no detriment” principle applying for these kinds of tax competition issues. If Scotland were to cut air passenger duty or the top rates of income tax, or Northern Ireland were to cut corporation tax, and that led to losses in the rest of the UK, George Osborne said that that is just the nature of the competition game and you would not seek compensation for it. Whether or not that can be believed is another question—and whether the devolved Governments would also feel the same way is another question. I agree that if it was implemented in these cases it would be very difficult to do.

Q65 Baroness Wheatcroft: First, I have to echo what Lord May said. I almost feel we are in Alice in Wonderland territory, trying to play croquet with flamingos instead of starting from scratch. Mr Phillips, if you put aside the fact that the Smith commission came up with its proposals and you are trying to work within them, I wonder whether you would not think it more sensible to start from scratch. Even Joel Barnett wanted to do away with the Barnett formula.

David Phillips: As an economist, I would want to start from scratch. One of the issues with the Smith commission is that the “no detriment” principle is by definition very

Page 322 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) status quo- oriented. Any change from the status quo counts, potentially, as a detriment to one side or the other. Not only do the principles they have used here reflect a system that has flaws and failings in it; they reinforce it, because the “no detriment” principle becomes something that binds you to keeping the system going.

I would say that there is a strong rationale for taking a more first-principles approach and looking at what should be the degree of risk sharing across the UK, what should be the degree of equalisation, what risks should the Scottish Government bear and what risks and incentives should the UK Government bear. I agree that that approach would be economically more fruitful. Politically, however, the UK comes from a system where there was a huge degree of centralisation. The status quo is therefore in people’s minds. I am not sure whether politically a different approach would have worked. Hoping that they could have avoided something like the “no detriment” principles may have been hoping too much. What we can hope for is that these principles do not become fetishised and that there is some flexibility around them.

Baroness Wheatcroft: I understand your point about the status quo, but the whole issue about these moves to further devolution is to change the status quo. With that in mind, I wonder if you could say how you view the rationale between the different taxes that it is proposed to devolve to Scotland, Wales and Northern Ireland.

David Phillips: I will take one of the taxes that has already been devolved under the Scotland Act—stamp duty. It is a property tax. Property taxes are probably one of the more natural things to devolve. It is a less mobile base. It also reflects the fact that there are already devolved taxes—not transaction taxes, but devolved recurrent taxes—on property: council tax and business rates. What it will mean is that Scotland and Wales have full control over both the annual property taxes and the transactions- based taxes. That gives them the opportunity to design a better system by abolishing stamp duty. Neither has done it so far, but in principle it would give them the power to do that. That is a sensible tax to devolve.

The rationale for income tax seems to be that it is a large and salient tax and therefore that it gives political accountability to the devolved Governments. That is true—it is a large and salient tax. However, there are some difficulties with devolving income tax in its entirety. First, it makes the UK almost unique—if not completely unique—in devolving income tax in its entirety to a devolved level of government. The UK Government are now left unable to raise income tax in Scotland.

Secondly, one of the issues that will arise under this new system is what happens when the UK Government change income tax rates in the rest of the UK. The logic of the system of block grant adjustments that we set up is that if they increase revenues in the rest of the UK and decide to spend that on pensions, say, or defence, the revenues in the rest of the UK have gone up, the revenues in Scotland have not gone up and you are taking more from the Scottish Government’s block grant now. Actually, that is fair, because the Scottish Government are benefiting from the higher pensions and higher defence spending but not paying any extra taxes themselves, so they should have less money for devolved services.

Page 323 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) However, there are political issues around this. You can just imagine people seeing it as unfair—“You are taking money off us to fund a tax cut in England”—although that would not be the case. A system where you devolve income tax fully is slightly strange and creates some problems. It may have been more sensible to have a system where income tax was partially devolved, not fully devolved. Taking the Calman commission’s recommendations and increasing them, giving Scotland a bigger chunk of income tax but not completely devolving income tax to Scotland, might have had some benefits to it.

Baroness Wheatcroft: And allowing the Welsh to vary income tax by 10p?

David Phillips: That is fairly similar to the Calman commission. As I said, the idea behind that one is that it is a salient tax. What they have done with Wales is actually different from what was done under the Calman commission and the Scotland Act. Scotland has a lockstep—it can only move the tax rates up and down in line with each other. The House of Lords passed an amendment that said that Wales did not have a lockstep, so Wales would be able to vary the rates independently. That is kind of interesting. Suppose that Wales wanted to put up the top rate of income tax, from 45p back up to 50p. How would this work? Wales would get to keep all the additional revenue from the mechanical revenue effect—the extra 5p of income tax. If people cut how much they work or move to England and that reduces revenues, the Welsh Government bear the cost of that only on the 15p of income tax that they now control. The UK Government bear the costs of the behavioural effects on the amount that you would get from the other 35p of income tax and on national insurance. It gives a somewhat skewed incentive for Wales to increase the top rate of tax, because it gets all of the mechanical revenue effects but bears only a small part of the behavioural effects. Wales could have an incentive to put up, rather than cut, top rates of tax, because if it cut top rates it would gain only a small part of the behavioural effects. There are some interesting issues. Maybe there will not be tax competition with Wales but Wales putting up tax rates.

The other one to mention is Northern Ireland and corporation tax. Corporation tax is probably one of the taxes where the rationale for devolving is least strong. It is a very mobile tax base. I have never quite bought the idea that Northern Ireland is a special case because of its border with Ireland, given that business decisions are internationally mobile, not just mobile across land borders.

Baroness Wheatcroft: As you say, there are some interesting issues. Thank you.

Q66 The Chairman: I wonder whether, as a final question, we can climb out of the labyrinth we have been in for the last 50 minutes or so.

David Phillips: I am sorry about that.

The Chairman: Tell us about the benefits that flow from this. Are there any examples of devolved parts of countries having significantly better economic growth than the

Page 324 of 420 David Phillips, Institute for Fiscal Studies (IFS) – Oral evidence (QQ 56-66) (DPFOE0006) former host country? What is the evidence to suggest to those who argue for this that there will be an improvement in the overall economic performance of Scotland?

David Phillips: I must say that that is an area I have not really looked at in my research to any significant extent. The only comment I would like to make is that I suppose that would depend very much on just what fiscal arrangements were set up. If you have a system where the devolved area of the country is able to keep any revenue surplus it has—for instance, where you do not have fiscal sharing between the devolved area and the rest of the country—and it is doing well economically, it will get to keep more of the rewards itself. It will therefore have more to invest, be able to afford to cut taxes and maybe do even better again. On the other hand, if you have a system where you still have significant revenue equalisation across areas performing at different levels, these dynamic effects will be smaller. I guess that what I am saying is that there is no simple answer. It will depend not only on what powers they have but on how that interacts with the fiscal system.

The Chairman: So to the extent that the Scottish economy did better than the rest of the UK, these arrangements would mean that they would be able to keep some of that benefit but by no means all of it.

David Phillips: Yes. Actually, under the Barnett basis of it, they would get to keep all of the additional improvement in their economy. If the revenues go up faster than those in the UK, they keep all of that additional increment under the Barnett-based system. If you moved to a system of needs or revenue equalisation across different countries, because you were equalising that away they would not get to keep the additional benefits. Just what benefits accrue from tax devolution depends on the arrangements you have for fiscal equalisation.

The Chairman: Mr Phillips, thank you very much indeed for a very interesting journey through what is a highly complex system. Perhaps one should be thinking about a “no detriment” principle for the rest of the UK, on the basis of your last answer.

David Phillips: Thank you. I hope I illuminated rather than obfuscated.

Page 325 of 420 Plaid Cymru – The Party of Wales – Written evidence (DPF0008)

Plaid Cymru – The Party of Wales – Written evidence (DPF0008)

House of Lords Select Committee on Economic Affairs

“The devolution of public finances in the United Kingdom”

Written Evidence on behalf of Plaid Cymru- the Party of Wales

Dr Eurfyl ap Gwilym

1. Introduction

1.1 Plaid Cymru welcomes the Select Committee’s inquiry and Call for Evidence on the devolution of public finances in the UK. The party has previously contributed evidence to the House of Lords’ Select Committee on the Barnett Formula when it undertook its review in 2009. I (Dr Eurfyl ap Gwilym) have also presented evidence to the Independent Commission on Funding and Finance for Wales (the “Holtham Commission”) which was established by the Welsh Government in 2008, and which reported back in 2009 and 2010. The two reports of the commission shaped the debate within Wales on reform of the Barnett formula, and began a wider debate about the devolution of taxation powers. I later participated as Plaid Cymru’s official nominee to the UK Government’s Commission on Devolution in Wales (the “Silk Commission”), established in 2011, and which reported back on fiscal devolution in 2012, and on the devolution of further legislative and policy-making powers in 2014. The recommendations of the Silk Commission have directly informed the development of the UK Government’s Wales Bill 2014, and also the UK Government’s commitment to another Wales Bill during the current Parliament. Plaid Cymru, through its leader Leanne Wood and then Westminster Group Leader Elfyn Llwyd, also took part in the “St. David’s Day Process” convened by the Secretary of State for Wales during the earlier part of 2015.

1.2 It is correct for the Chair of the Committee to recognise that the UK’s constitutional arrangements are changing very rapidly. However, our responses (which are set out in line with the guidelines provided in the Call for Evidence) to the specific areas of inquiry argue that the kind of changes that are likely to emerge around public finances are not particularly unusual or abnormal in either the context of other developed European states, or in the comparable context of western democracies such as the United States, Australia and Canada. Further, we will state that despite fiscal federalism being a relatively normal feature in western democracies, the particular manner in which fiscal federalism is being developed in the UK (which we will point out is in a very ad hoc and arbitrary manner) is not suited to the principles of good governance, clarity or transparency.

2. Fiscal Framework

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2.1 The UK is well along the road to becoming a quasi-federal state. This should be recognised by all leading political actors. The principles which govern the way devolved nations are funded should be the same as those which inform fiscal federal systems elsewhere. Certain public spending programmes are clearly the responsibility of the central government and should be funded by taxes levied by that level of government. Such programmes include: defence; foreign affairs; and international aid. Another key role of the central government is to promote social cohesion by ensuring that spending programmes which in the UK fall under Social Protection are centrally funded. Programmes that are devolved such as education, health and housing should be funded by taxes raised both by the devolved and central administrations. The institutional mechanisms required to operate a fiscal federal system should be as independent from government as possible, and the UK should move away from the current system where the Treasury is the judge and the jury when it comes to financing the devolved nations. The Commonwealth Grants Commission in Australia is an example of an independent authority which oversees fiscal federalism in that country; although its work is still subject to negotiation between the treasury departments of the central government and the state/territorial governments. A recent and welcome development in the UK has been the establishment of independent, arm’s length agencies such as the Monetary Policy Committee of the Bank of England and the Office for Budget Responsibility. The establishment of an independent body to advise the governments of the UK on relative funding levels should be a similar initiative. Membership should be drawn not only from the Westminster/Whitehall nexus but from the devolved administrations, and from other countries with well- established federal financial systems such as the United States, Canada or Germany.

2.2 The correct institutional framework is certainly not place in the UK. The system is opaque. Typically, the UK Government resolves funding and other devolution issues in an ad hoc and tactical way, often with political rather than constitutional or institutional interests at the forefront of their approach. This is true both in Wales and Scotland with regard to the debate over the recommendations of the Silk Commission and the Smith Commission. The Barnett formula when introduced in the late 1970s was expected to last a few years, but despite sustained criticism remains in force. In the case of Wales, well thought-through recommendations by the Silk Commission which were made on a cross-party and unanimous basis (and which were informed by the kind of lessons from other countries which the Call for Evidence raises) were subsequently modified and watered down to the extent where what is proposed for Wales no longer makes sense as a comprehensive package where fiscal devolution and accountability reinforces additional policy responsibility. A further and vivid illustration of this problem is the way the Barnett formula has been operated since 1978/79 and how Wales has been under-funded historically. The lesson from the Barnett formula is that the political weight of a devolved nation informs the outcome, rather than any transparent and rational

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calculation of a country’s relative spending needs. It is not intended here to provide a detailed critique of the Barnett formula; this was done in our evidence to the House of Lords Select Committee on the formula in 2009. In terms of processes to make new settlements sustainable and effective, a more formal and less ad hoc system of inter-governmental relations is required, not only encompassing issues of funding, but also devolution issues more generally.

2.3 For Wales, consensus has been reached on the interaction of the block grant with future devolved income tax powers (by applying the “indexed deduction method” as recommended previously by the Holtham Commission). For the smaller devolved taxes, other agreements have been reached without any controversy. The principle of “no detriment” is a matter for Wales as well as for Scotland, but without a robust and independent framework being in place would be open to political and ad hoc manipulation. An issue affecting both Wales and Scotland on funding transparency is that of the Statement of Funding Policy having not been updated and published since 2010. This document is not transparent and its comparability factors (factors which determine the extent to which changes to a spending programme in England trigger consequential changes to funding for the devolved nations) are applied between spending reviews departmentally rather than on a line-by-line basis, leading to distortions. The current system is opaque, unfair and unsatisfactory.

2.4 Devolved governments should assume further borrowing powers. Where possible, devolved governments should be self-policing when it comes to borrowing limits, provided they are compatible with the UK's macro-economic strategy. Devolved administrations should have to take into account debt servicing capacity and should be responsible to their own parliaments or assemblies on how much they will borrow and for what purpose. Devolved governments should be allowed to borrow in the bond markets. This would subject the fiscal policies of the devolved administrations to the disciplines of the market. This was agreed straightforwardly in the case of Scotland, and was recommended by the Silk Commission for Wales but then ruled out by the UK Government during their cherry-picking of its recommendations. Wales was later granted the ability to use the bond markets. This is an example where fiscal devolution is being undertaken tactically rather than in a straightforward and rational way.

2.5 The implications of full fiscal autonomy for Scotland would depend on the performance of the Scottish economy and the policy activity of the Scottish Government. It is not for Plaid Cymru to speculate on those factors, except to recognise that the principle should be for Scotland (and indeed for Wales and any other devolved nation) to decide how much autonomy it wants over its finances.

2.6 The renegotiation of the fiscal framework for Scotland will undoubtedly have an impact on Wales and northern Ireland and will shape the debate in those countries. The asymmetry of devolution in the UK is a fact of life and the result

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of the historical development of each of its constituent parts. The legacy of the conflict in northern Ireland, and the nature of the national debate in England with regards to its regions, mean that different solutions are required in those territories. But generally, Wales can and should benefit from a settlement that is closer to Scotland’s arrangements. There should be more symmetry over financial powers and responsibilities so that any economic disadvantages between the devolved administrations are narrowed. The same independent fiscal framework and fiscal federal principles should be in place to underpin whatever arrangements the people of Wales decide to adopt for their country.

3. Tax Powers

3.1 The choice of taxes proposed to be devolved in the Scotland Bill is a matter to be agreed by the UK and Scottish Governments. In the case of Wales the Silk Commission, whose recommendations were unanimous and were endorsed by all four political parties in the National Assembly, set out which taxes should be devolved.

3.2 The rationale behind the choice of taxes devolved by the Wales Act 2014 is quite sound and is directly linked to the work of the Silk Commission; although Plaid Cymru would wish to go further. A share of income tax, stamp duty land tax, landfill tax and the full devolution of non-domestic rates were proposed for devolution by the Silk Commission in its first report. A significant problem emerged when the UK Government adopted a different version of income tax as to that recommended by the Commission (introducing the so-called “lockstep”). The “lockstep” would have rendered the powers effectively unusable. As a result of further debate setting out the difficulties of the “lockstep”, the proposal was dropped. Again, we were presented with an example of a UK Government not accepting a previous cross-party and independently informed tax proposal, for what appear to be arbitrary reasons. Across the range of taxes that should be considered for devolution, the rationale should always include: accountability and responsibility; the ability to boost the economy; and the ability to use taxes innovatively.

3.3 Devolution of Corporation Tax to northern Ireland will further the development of a single market in Ireland, interacting with the Great Britain and European single markets. As it is desired by the people of northern Ireland and its political parties it should be implemented. The effects on business in the rest of the UK are difficult to predict and depend upon the policy choices of the Stormont administration, but will be an additional lever for the ministers in Stormont to use that will not be available to other devolved administrations.

3.4 Plaid Cymru has supported the devolution of Corporation Tax for Wales. Issues to be considered would include measures to address “opportunistic” relocation of head offices, and measures correctly to identify where Corporation Tax is earned territorially: this is routinely done in the case of multinational companies. A less complex form of devolution of Corporation Tax might be

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around reliefs and allowances. This could be done straightforwardly. Without some form of autonomy over Corporation Tax, there is a significant risk that Wales and indeed Scotland could be disadvantaged.

3.5 An over-focus on tax competition between the different parts of the UK risks missing the point on innovation. The four territories’ ability to compete on tax rates will be constrained by their budgetary ability to sustain tax reductions versus the need to sustain public services. In discussions around tax competition within the UK, the scenario of a “race to the bottom” is often raised, but in reality this kind of mutually destructive tax competition would neither be desirable nor affordable to those administrations which are committed to providing a comprehensive range of public services. To answer the question in the Call for Evidence on whether competition would be welcome, Plaid Cymru supports the idea that some competition should be allowed. The UK Government talks about a “global race” in which it must compete with its peers. But it does not apply the same logic to the devolved nations competing with each other or with England. What should be accepted is the fact that the Welsh economy and also Welsh public services suffer from some in-built disadvantages, not least issues of geography and peripherality in relation to major British and European markets. Welsh Governments should be empowered to design their tax system in a way that might compensate for those (often natural) disadvantages, even if their ability to sustain a more competitive set of tax rates would be constrained by the reality of finite budgets.

3.6 Aside from marginal competition, tax devolution offers the prospect of innovation. Innovative use of taxation policy can be good for the devolved territory and for other parts of the UK. An example of this can be seen in the devolution of Stamp Duty Land Tax to the Scottish Government, where the restructuring of that tax has influenced the course of action now being taken by the UK Government and also the Welsh Government. The plastic bag levy introduced in Wales is another example of innovation under the current devolution settlement. Aside from those tax levers connected to the economy, environment or the housing market, there is also room for innovation on taxes linked to consumption and to the public health agenda. The UK Government has made a welcome provision for new taxes to be created. Plaid Cymru has been the first party in Wales to suggest a use for a new tax, which would be a levy on sugary drinks in order to help fund the health service. The provision of this tax power in law gives the electorate a real choice at a devolved election to vote on revenue-raising issues.

21 August 2015

Page 330 of 420 PricewaterhouseCoopers LLP – Written evidence (DPF0023)

PricewaterhouseCoopers LLP – Written evidence (DPF0023)

11 September 2015

Lord Hollick Chair of the Lords Economic Affairs Committee Economic Affairs Committee Committee Office House of Lords London SW1A 0PW

Dear Lord Hollick

Thank you for the opportunity to support the Committee in its inquiry into the implications of devolution for public finances.

We would like to take that opportunity to provide written evidence to supplement our meeting of Tuesday 7th July and to expand on some of the issues raised in that meeting and that have also been reflected in the recent debates on the Scotland Bill 2015.

We therefore enclose a paper (including an executive summary) based on the specific questions posed by the Committee and hope that this is useful to the Committee in its deliberations.

PwC is the largest professional services organisation in the UK where we employ around 16,000 people (of whom 300 staff and partners are in Wales, 850 in Scotland and 1,200 in Northern Ireland). We provide advisory services to government departments, public bodies and agencies, as well as to organisations throughout the private sector. PwC has also previously engaged in the consultation process for the Silk Commission in Wales and the Calman Commission in Scotland, and thus believes it is qualified to comment constructively and independently on the issues at hand. Drawing on our experience in the business community across the UK, we have sought to focus our comments on the way in which the devolution process impacts on businesses and on economic growth.

Should you consider it helpful, we would be very happy to discuss these issues further in writing or in person before the Committee.

Yours sincerely

Alexander Henderson, MA (Oxon), FCA, CTA, AMCT

Page 331 of 420 PricewaterhouseCoopers LLP – Written evidence (DPF0023)

House of Lords Economic Affairs Committee: The devolution of public finances in the UK

Executive Summary

We have considered the questions raised by the Committee in the light of our expertise and experience and hence have focused on the fiscal and practical consequences of the current and proposed changes. The main issues that we would be draw to the Committee’s attention are as follows:

(1) Devolution has the potential to provide economic and social benefits.

Devolution can and should be a positive development for the UK economy to the extent that it promotes fiscal accountability and can be used to enhance productivity. In order for a government to be fully accountable to its electorate, it must not only be responsible for its expenditures but also for the way in which those expenditures are raised. Taxation, when devolved in order to account for regional economic variations, can mean that local services are able to be delivered in different forms or in different quantities. One of the concepts underpinning devolution and decentralisation is that devolving - and thus adapting – previously centralised tax structures to local realities should lead to improved local outcomes. In principle, we accept that devolution and decentralisation, when implemented appropriately and as part of a coherent policy, could lead to enhanced economic growth and improved performance. This needs to be balanced against the additional costs arising from transitional and operational complexity.

(2) A clear and coherent policy for devolution should be established to ensure that those benefits are realised.

For devolution to achieve its economic and fiscal goals, a clear rationale and agreed principles should underlie the process. These goals may range from improving local services to encouraging further economic growth, but the process should have clear and measurable goals. Such goals could be to increase the overall level of accountability in relation to economic performance or the quality of public services in any devolved region. While devolved taxation should reflect local realities, this must be structured within a coordinated and coherent policy that is transparent and facilitates economic development and social inclusion.

(3) Policies on tax devolution should take account of the impact on the overall competitiveness of the UK and aim to minimise increased complexity.

The UK is already an attractive location for foreign investment and the tax system plays an important part in that success. The system goes well beyond the relatively low corporation tax rate and reflects the comparative stability, certainty and administrative ease of the current system. Devolving taxes across the UK will add to the technical and administrative complexity of the system. Increased costs to business and individuals is inevitable but should be considered in any assessment and kept to a minimum needed to achieve the policy goals. In reality, the tax system may play a lesser role in attracting business to the UK compared to other considerations such as skills, regulation and infrastructure, but it would be

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In this regard, we lay considerable emphasis on the importance of a coherent policy, applied consistently that does not distort national or regional competitiveness. A system under which devolved regions experience very different levels or types of devolution which are based on differing principles may give rise to potentially distortive forces. A balance is needed between maintaining coherence and recognising varying needs across the UK.

The practicalities of tax devolution are challenging but not insuperable. Lessons have been learned from the implementation of the changes in Scotland Act 2012, especially around the length of time that is required to properly consult on legislation and administration. Each tax needs to be assessed against the principles set out by the Holtham Commission as these provide an excellent benchmark for identifying taxes that can provide most benefit whilst minimising additional complexity. It is important, for example, to avoid a situation whereby variations in regional tax lead to distortions that encourage businesses to move within the UK, rather than enhancing both foreign investment and indigenous growth.

For businesses, a key concern is the continued stability of the UK business and investment environment. As such, we consider it important that Governments continue to engage actively with all sectors and sizes of business to understand both the potential benefits and practical implications of any proposed devolution. Clarity over the outcome of the devolution process (including stages and timing) would be welcomed, to ensure that businesses continue to feel confident and therefore continue to invest.

(4) Public understanding of the devolved powers and public finances generally is very low. The need to improve public understanding and business engagement must be recognised.

Our current Citizens’ Jury Research suggests the current allocation of powers as well as issues surrounding the fiscal deficit are misunderstood by the majority of citizens. Their opinions often change when the facts are properly explained to them. The need to improve awareness and understanding of these issues is clear. Such engagement is important in achieving the goals of devolution in a stable and coherent manner that is supported by the public and which improves accountability at all levels of government.

(5) Agreement on a fiscal framework for Scotland that can also accommodate changes to the position of Wales and Northern Ireland is needed.

Any proposed devolution of tax powers should take into account the current fiscal framework in place for devolved administrations. We note that there have been many discussions on the validity and operation of the current system and this is an area of ongoing debate. At present, we understand that the UK Government does not intend to revise this basis of funding but if that position were to change, there would obviously be significant implications for Scotland, Wales and Northern Ireland.

Agreement on fiscal adjustments to the block grant in relation to the Scotland Act 2012 powers were complex and drawn-out and this will almost certainly be the case for the

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Scotland Bill 2015. It is of course crucial for the stability of Scottish government finances that the agreement is a balanced reflection of the transfer of risks and rewards. Lord Smith in his report noted the importance of this aspect of any devolution settlement but refrained from commenting further on the ‘correct’ outcome. We would stress for our part that this is an area of great importance to the stability and efficacy of any devolution of tax (and other) powers and should be given due importance in the process. The impact of devolution cannot properly be assessed without understanding the ramifications for financing of sub-national governments.

We would particularly draw the Committee’s attention to the issues around indexing and developing appropriate fiscal frameworks that reward locally-appropriate initiatives and investment and do not merely permit the block grant to be reduced by the amount of new taxation raised and revenues earned in the sub-region. Such a framework must also recognise the constraints of EU law. We believe that resolving this in a suitable manner is the key to encouraging devolution and local responsibility.

Our overall conclusion is that tax policy should be coherently coordinated across the UK to achieve the aims of improving accountability and accommodating regional policy needs while ensuring the UK remains a competitive destination for global investment and is able to encourage economic growth at home.

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House of Lords Economic Affairs Committee Call for Evidence on the devolution of public finances in the UK 1.1 In its call for evidence the Committee has posed 11 questions under the general heading of “Issues”. In responding, we have sought to address those questions where our experience is most relevant and can add practical value to the Committee’s deliberations. There are areas where we have not been able to comment directly and/or in detail as there are not yet proposals available to assess. Some issues cannot be fully addressed without making prior assumptions as to the outcome of political discussions or by relying upon assumptions around future economic conditions, which would be inappropriate.

1.2 As context to our comments, we support the view that as a general principle of public finance, a body that spends public money should be accountable for raising at least some of it.

1.3 PwC is committed to supporting the creation and maintenance of a fiscal regime that makes the UK and its regions internationally competitive and compelling investment locations. We are aware that the business community seeks stability and certainty and we would emphasise the importance of maintaining business and investor confidence throughout the process.

1.4 Devolved taxes can work in the UK but we need an approach consistent with other objectives – a simple, coherent tax system which supports growth, investment and employment. Getting the right structure for devolved tax-raising powers should be part of the broader debate on UK tax reform in the years ahead.

2. International comparisons: “Are there lessons the UK might take from other countries that have devolved spending and revenue raising powers?”

2.1 The UK is hardly unique in facing challenges to its structure and integrity from sub- regional devolution, nor is the process new. Such federal structures represent a well- established mode of government that works successfully worldwide. The UK is unusual in its high degree of centralisation in fiscal matters. This does make international comparisons hard as the process in most countries was to build a federal model onto a number of autonomous regions rather than the opposite process which is in progress in the UK.

2.2 In assessing the value of international comparisons, we also have to bear in mind that we are considering a potential federal state where one region contains 85 per cent of the population. England is 10 times bigger than Scotland, 20 times bigger than Wales and 30 times the size of Northern Ireland.

2.3 To some extent, the UK already operates as a federal state, with the UK Parliament operating as a federal entity in respect of certain functions for the devolved nations of Scotland, Wales and Northern Ireland, and also as a sub-federal entity in respect of domestic functions for England. The proposals for further devolution in the Scotland Bill, the existing changes in the Wales Act and the Corporation Tax (Northern Ireland)

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Act plus the current proposals contained in the England Cities and Local Government Devolution Bill will reinforce this process. 63

2.4 A key argument for supporters of fiscal devolution is accountability. A government (be it central, regional or local) becomes more democratically accountable to the extent that decision makers make decisions not only about spending but also about tax revenues to pay for that spending. It is also possible that greater accountability could improve governance and hence, in turn, the quality of policy making.

2.5 At the same time, some economists have developed theories of fiscal federalism which attempt to identify how far devolution of particular taxes could be compatible with principles of equity and efficiency64.

2.6 Therefore we consider that these international comparisons are not perhaps as useful as might be hoped and unfortunately do not provide entirely suitable solutions or structures for the UK. Nevertheless, there is a considerable body of published material concerning the decentralisation of tax powers of sub-central governments and the relative merits of such processes from which practical lessons can be drawn. Such lessons would include the following general principles:

2.7 The need for a broad and clear purpose for devolution. Devolution is not an end in itself but a means to achieve improved outcomes so there needs to be agreement as to those outcomes and how devolution will contribute to them. 65 The potential dividend, we would argue, comprises three inter-related elements: a rebalancing of the economy with inclusive and widespread growth; public service reform with better value services; and enhanced public engagement and accountability for the delivery of local services and improved local outcomes.

2.8 Greater understanding of the impact of devolution on investment and business confidence. Whilst tax is only one of a number of interrelated factors that drives investment decisions, it is an important part of a business environment that attracts investment and encourages growth. Our experience with both foreign direct investment (FDI) and indigenous companies across the UK suggests that the simplicity of the tax regime can be of greater importance than the tax rate. Our research66 suggests that cutting profits tax did not necessarily make a region more attractive to FDI. The UK, despite having a higher rate of profits tax (corporation tax) than many regions, ranked 16th place in a league table of 189 countries, thanks to a transparent tax system allied with moderate overall levels of tax (on profits, employment and sales/goods). Where tax does influence investment, issues are considerably more complex than the headline corporation tax rate and will include bilateral arrangements on the taxation of foreign income, the total combined tax rate , the complexity of the tax regime, and the number of different taxes a typical FDI company may have to pay in

63 Hazell. Devolution and the Future of the Union, University College London, London, 2015 64 R. Musgrave 1971, “Economics of fiscal federalism”, Nebraska Journal of Economics and Business, vol. 10., no. 4, and T. Persson and G. Tabellini 1996, “Federal Fiscal Constitutions: Risk Sharing and Moral Hazard”, Econometrica, May. 65 PwC. Delivering the Decentralisation Dividend. PwC, London, 2015. 66 World Bank/PwC. Paying Taxes 2015, London 2014.

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the host country. International comparison can therefore provide lesson on which taxes are most easily devolved without causing distortions and lost revenues.

2.9 Uncertainty as to the direction of travel and the cost of transition is not a combination conducive to business confidence. If indeed, we are on a journey towards federalism or greater devolution, the business community would expect to understand the destination, the route to be travelled and the prize that awaits when the journey is complete.

2.10 Decisions on tax devolution need to take place hand in hand with wider decisions on fiscal frameworks and public finances. A common feature of the devolved systems across the world is a system of equalisation or funding that underpins the tax powers that have been devolved. These obviously vary but most arrangements are not static and allow for variation to reflect economic and regional change. We believe that, as the devolution and decentralisation process matures, the question of fiscal devolution will become more pressing –a further reason for legislators to look ahead of the process to the likely outcomes and plan accordingly

2.11 The relationship between devolution and economic growth. There may be lessons to learn from the role that devolution has had in some regions in increasing/enhancing economic growth. The impact of devolution may be difficult to measure on a comparative basis but we would, for example, look to international measures of competitiveness that attract and retain high gross value-added investment for guidance on the potential benefits. Devolution will inevitably lead to tax competition between regions and whilst this competition is not inherently unhealthy or a threat to the broader democratic structures, the implications need to be understood and addressed before powers are devolved. 67

3. Tax Powers: “What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill / by the Wales Act 2014?”

3.1 The tax (and other) powers currently reflected in the Wales Act and Scotland Bill are to some extent a reflection of political agreements and circumstances. In that respect therefore, we cannot speak fully to the rationale but clearly there are practical constraints as well as policy decisions that underlie the current settlements. These practical constraints have been reflected in the Calman Commission recommendations and also in the Silk Commission findings and we have elaborated below on some of the principles underlying these decision and would suggest that these principles should also guide further devolution.

3.2 The best summary of these principles are found in the Holtham Commission report which articulated them when considering the position of Wales. 68 The report concluded that a tax will be a strong candidate for devolution if it scores well across the following six principles:

67 Barnes. Federal Britain, Centre for Policy Studies, London, 1998 68 Independent Commission on Funding and Finance for Wales 2010, op.cit.p. 42.

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1. Promotes accountability because the tax is: a. Paid by a high % of residents; b. Raises a substantial revenue; c. Visible to most citizens; d. Well understood by the general population. 2. Does not harm economic efficiency because: a. Avoids distorting the region’s economic relationship with the rest of the UK b. Avoids altering economic behaviour (to avoid paying the tax) in ways which damage efficiency. 3. Does not harm administrative efficiency because: a. Avoids a substantial compliance burden on citizens and businesses; b. Avoids a relatively high costs of administering collection (especially, as % of revenues raised). 4. Is relevant to policy in terms of providing a useful policy lever and helping to achieve policy goals of the devolved Assembly (could be economic but also social, health or environmental policy objectives). 5. Is compatible with legal constraints (notably, EU law). 6. Has minimal impact on the tax base of the rest of the UK.

3.3 Accountability will reflect the scale of a tax (in terms of the size of the revenues raised). Devolving a major tax will potentially make a greater contribution to increasing the revenue stream, autonomy and accountability of a devolved assembly. Having said that, it might still be decided to devolve certain minor taxes because of their potential contribution to particular economic, social or environmental policy agendas.

3.4 In terms of the scale of revenues collected, three taxes stand out as major: Income Tax, National Insurance Contributions and VAT. In practice, only Income Tax is a strong candidate for devolution, as has been identified in both Scotland and Wales. Devolving and thus potentially varying the rate of National Insurance Contributions (NIC) from that of the rest of the UK would in practical terms be hard to reconcile with welfare and benefits policy commitments and with the practicalities of administration. Of course, were NIC to be radically reformed, the contributory nature of NICs and the compensating benefit might no longer be directly aligned.

3.5 While VAT may appear to be the next most significant tax, insofar as it is effectively a sales tax, EU law prohibits regional variations in VAT rates within the member state.

3.6 Corporation Tax (CT) is not a “major tax”, insofar as it only accounts for some 8% of total UK tax revenues (although the revenue raised is greater than some of the minor taxes). There remains considerable debate about both the competitive sub-regional advantages of devolving corporation tax and the potential complexity, administrative and business costs and tax competition issues.

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3.7 It is important to note that the Corporation Tax (Northern Ireland) Act does not devolve CT to Northern Ireland but grant the Assembly the power to set the rate of CT. Decisions as to who pays CT and on which profits still rests with Westminster. As such, the power devolved is limited and is intended to assist Northern Ireland with its competitive position vis a vis the Republic of Ireland.

3.8 In addition, devolution of taxes is subject to the strict Azores Ruling (see Appendix One) and hence there are barriers to devolving it (or the rate-setting power) to other parts of the UK. The impact on public finances in the regions would be a key constraint, as it is in Northern Ireland due to the impact on the block grant.

4. Tax Powers: “What are the implications of devolving corporation tax to Northern Ireland? Will it have on effect on business in the rest of the UK?”

4.1 Once the Act is ‘switched on’, the Assembly will have the power to set a Northern Ireland corporation tax rate (NIr) applying to certain trading profits arising in Northern Ireland. All other powers will remain with the UK government. The power therefore falls short of devolving corporation tax in full. The delay in implementing the Act is to ensure that the impact on public finances is agreed, reflecting once again how crucial a robust fiscal framework is to the devolution process.

4.2 The structure of the devolved power also reflects the care that is needed to ensure that it achieves the objectives set out by the Secretary of State, which are to:

 Encourage genuine economic activity in Northern Ireland;  Be attractive to businesses and ensure that any administrative burden is proportionate;  Satisfy EU State Aid rules;  Ensure that the cost to the Northern Ireland Executive remains proportionate and a kept to a minimum.

4.3 The practical limitations are clear and would also apply to any proposed devolution of even a limited power such as this to other regions. The devolved power is intended to attract and reward new foreign direct investment (FDI) rather than to provide indigenous businesses with a windfall boost to their profits through a discount on their CT bill. So to avoid providing merely a benefit to existing business (and to avoid being classed as State Aid) the Act is complex, particularly relating to eligibility.

4.4 For example, “qualifying trades” specifically exclude banking, insurance, lending, investment and investment management, insurance/re-insurance and oil and gas 'ring fence trades.’ However, some back-office activities of excluded trades will become eligible for the NIr, while all corporate non-trading income will remain subject to the main UK rate. This will serve to ensure that large financial organisations seeking to locate in Northern Ireland will have to be fully compliant with the Act in order to benefit from the relevant reliefs.

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4.5 Small and medium sized- companies (SMEs) 69 will need to assess the amount, by time and cost, of their workforce activity undertaken in Northern Ireland and Great Britain. If at least 75% is spent in Northern Ireland, then all the company’s qualifying trading profits will be subject to the NIr. If less than 75% of the activity is in Northern Ireland then none of the company’s profits (irrespective of whether they are ‘qualifying’ or not) will be subject to the NIr.

4.6 This 75% rule, while proving disadvantageous to Northern Ireland SMEs that have built up substantial export markets (and staff) in GB, serves as a significant disincentive to UK-based SMEs seeking locate in Northern Ireland without becoming fully compliant with the Act. It will therefore help to boost jobs in Northern Ireland.

4.7 There is further complexity for SMEs in the Act. The EU size test provides that a company meeting the criteria in year one is automatically deemed to pass in year two, regardless of the actual size of the business in year two. This could create circumstances in which companies ‘flip-flop’ in and out of the SME regime on a biennial basis.

4.8 For some large companies with a presence in Northern Ireland and particularly those that are part of larger groups and chains, the Act means accounting for the trade and profits their Northern Ireland operations (NIRE) separately from their other UK activities. As large companies with a NIRE can’t opt out from the Act, this could mean for some organisations that the cost of complying with the Act could be greater than any saving from a reduced rate of CT. Consequently, for fiscal purposes, large companies will, in effect, have to operate any existing or planned Northern Ireland operations as if they were outside the UK.

4.9 This is a very simplified snapshot of eligibility, which ignores numerous conditions relating to profits, allowances and taxation, but it helps to explain why, with around 70,000 VAT-registered companies in Northern Ireland, fewer than half will be eligible for the new NIr. For those that can take advantage of it, the complexity of the rules (which is necessary to reflect the objectives noted above) will create uncertainty in regard to their tax position and bring about additional compliance costs.

4.10 In our technical paper to the Public Bill Committee in respect of the Corporation Tax (Northern Ireland) Bill, we noted, but did not comment on, the achievability of the forecast benefits that may accrue from reducing the rate of Corporation Tax to 12.5%. We noted however, that these have been modified from the original 2006 Northern Ireland Economic Research Institute (ERINI) estimate of 180,000 net new jobs created by 2030, to the most recent 2014 Department of Enterprise Trade & Investment (DETI) / Ulster University Economic Policy Centre (UUEPC) estimate of 37,400 net new jobs created by 2033.

4.11 In summary therefore, the Act has been designed to tightly limit eligibility to organisations (whether SMEs or large companies) that invest in “people and place” within Northern Ireland. We believe that the administrative burden will potentially be

69 SME is a company that meets the SME definition under EU regulations (less than 250 employees, and either of; turnover below €50m, or balance sheet value below €43m)

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substantial, particularly for large companies, but we do not believe that there will be any marked relocation from outside Northern Ireland.

4.12 We would point out however, that the Act remains subject to adjudication by the European Commission as being fully compliant with the Azores Ruling with the cost (estimated as £300m annually) being a charge on the Block Grant. At this time, ‘switching on’ the Act is subject to the full implementation of the Stormont House Agreement, which includes a resolution of the current impasse over welfare reform and the Northern Ireland Executive putting the Executive finance on a sustainable basis.

4.13 In our opinion, the power to vary the CT rate is not, in itself, a “game changer” to transform the economy as it was described by the Northern Ireland Economic Reform Group .70 Tax is only one of a number of factors influencing investment decisions and our research clearly indicates that cutting profits tax is not, in itself a driver of new investment. The circumstances of NI (in relation to the tax rate in the Republic) may mean that it has more impact than in other regions. Given the falling rate of corporation tax in the UK, the rate in NI would need to be very low for internal competition to make a significant impact.

5. Tax Powers. “With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)?”

5.1 If the principles underlying devolution noted above are followed, the UK should be able to develop a stable position that achieve the goals of accountability and economic growth. For us, a ‘correct’ position would be one that gives a reasonable level of certainty, simplicity and stability to the tax system and would maintain the elements of the current tax system which help to attract FDI. The tax system (whether at UK level or devolved), should continue to contribute to sustainable economic growth.

5.2 Currently the balance of accountability in the devolved Assemblies is heavily on the side of spending powers rather than revenue-raising. The opportunity to increase accountability may also be an opportunity to improve the flexibility of the current system and enable policies to be put in place that can enhance the economy and society of the devolved regions.

5.3 We noted above the six criteria to be applied when assessing whether a tax is potentially suitable for devolution, and we consider that these are an excellent starting point for such discussions. For example, when applied to the range of taxes available to devolve to Northern Ireland, one might usefully group them as below based on their potential impact and also feasibility.71

Feasibility and desirability of devolving each tax

70 PwC, Corporation Tax: Game Changer or Game Over?, January 2011; World Bank/PwC. Paying Taxes 2015, London 2014 op.cit 71 PwC, Fiscal Powers: A review of the fiscal powers of the Northern Ireland Assembly, June 2013 p.39.

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5.4 Whilst parties and organisations may give different weight to these criteria (and no one tax will probably fulfil all six conditions), they enable us to make a more objective assessment of the devolution proposals.

5.5 It is probably no surprise that the taxes that are easiest and most suitable for devolution are those that are linked to a physical asset or location (property taxes, landfill, Air Passenger Duty) and that these are therefore the taxes that have been proposed in the first wave of devolution.

5.6 We have set out our specific views on the tax proposals in the Smith Agreement in our submission to that Commission (Appendix 2) and these views have not changed with the progress of the Scotland Bill 2015.

5.7 We should also note that the experience of implementing this first wave of devolution (Scotland Act 2012) has reinforced our view that most governments underestimate the time needed to draft and consult meaningfully on legislation and the time needed for a tax authority to prepare for change. Both are vital in producing a system that is robust and facilitates compliance. It is not a process that should be rushed.

5.8 In considering further devolution, we would stress that a tax system within the UK where there are multiple rates of income taxation and corporation tax will greatly increase the complexity of operating in the UK economy. We have already highlighted in our research how transparency favours the UK tax system as much as the levels of business taxation. 72 The UK tax system has become much more complex over the last two decades and the devolved tax agenda risks becoming an added complicating factor for businesses operating in the UK.

5.9 This could have an impact on UK competitiveness. The Coalition government put a strong emphasis on boosting the competitiveness of the UK economy through reforms to the corporate tax system but further devolved taxes will create a more confused picture for inward investors. The recent Summer Budget focused on productivity, with the Chancellor arguing that matching US workforce productivity levels would raise UK GDP by 31% - worth around £21,000 a year for each UK household. Hence his strategy

72 World Bank/PwC. Paying Taxes 2015, London 2014. Op cit

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to create a, “…higher wage, lower tax, lower welfare country,” by cutting working tax credits, compensating workers with the new National Living Wage and persuading employers to create the essential conditions for sustainable wage growth through increasing productivity.

5.10 Cutting working tax credits and creating a mandatory National Living Wage are within the Chancellor’s gift, but the UK private sector – and particularly those organisations in low-wage, low productivity sectors - faces a tough challenge if it is to boost productivity in order to reward workers, employers and shareholders alike. Nevertheless, the message is that a steep increase in productivity is the only way to increase national, corporate and family prosperity. But with the incentives to increased productivity (as included in the associated Productivity Plan73) largely focused on England, a further gap may open between the devolved nations and the English regions. Consequently, while headline corporate tax rates will remain attractive for investment, the complexity of operating within different regions and nations within the UK risks becoming a deterrent for investors.

6. Fiscal Framework. “Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?”

6.1 The reality of regional economic development policy is that there already exists competition between England and the devolved regions for investment and for FDI, in particular. Given the current level of proposed devolution and the structure of the legislation, that level of competition will continue but, in the short-term at least, is likely to be minimal. There is currently a harmonised UK-wide series of incentives to encourage R&D and innovation, while Northern Ireland’s ability to utilise special incentives under the EC Regional Aid Guidelines has expired. In addition, the current and proposed changes in the UK CT rate reduce, to some extent, the potential for significant competitive advantage to NI in reducing their rate.

6.2 However, any devolved tax structure needs to have a consistent approach in order to manage that competition. Income taxes will be set nationally with the exception of Scotland, while Wales may also acquire the ability to set its own income taxes if a referendum supports this outcome and the Stormont House Agreement contains a paragraph hinting that that may be a second wave of devolution to Northern Ireland. While the Azores ruling prevents the devolution of income tax-setting powers to the English regions, it does not preclude the assignment of revenue, although this would not meet accountability criteria.

6.3 In Northern Ireland, the emphasis is on corporation tax devolution – with the objective of maintaining competitiveness with the low corporate tax rate in the Republic of Ireland. But other parts of the UK will not be able to vary their corporate tax rate. This inconsistent approach risks creating economic distortions and is only beneficial if the net effect is to increase FDI into the UK - not shuffle it around.

6.4 In our view, none of these problems is insuperable, and it should be possible to design a rational and efficient devolved tax system for the UK where competition is

73 HM Treasury. Fixing the Foundations, creating a more prosperous nation. Cm9098. July 2015

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beneficial. A consistent approach based on clear objectives is needed to avoid distorting economic relationships with in the UK and creating administrative inefficiencies.

7. Fiscal framework. (1) “What principles should govern the way devolved nations are funded? Is a new needs assessment required and if so, what should it take into account?”

7.1 The principle of how devolved funding of the United Kingdom and its regions should be allocated has been challenging legislators for close to 150 years. The use of a formula to allocate expenditure among the countries comprising the United Kingdom originates in 1888 when the then Chancellor, George Goschen, prepared for Irish Home Rule by introducing a formula for allocating resources between England and Wales, Scotland and Ireland in the ratio of 80:11:9 (based on the, approximate, share of population at that time, respectively. This formula remained operational in Scotland into the 1950s, although the partition of Ireland and devolved government in the north of the island made that element of the so-called, Goschen Proportions redundant.74

7.2 Some 90 years later in 1978, when Labour’s Chief Secretary to the Treasury, Joel Barnett devised the funding formula that still carries his name75, Labour was also turning its mind to devolution. Almost four decades later and with devolved administrations in place in Scotland, Wales and Northern Ireland, Barnett is impacting on spending across the UK in a way not imagined by its author. Indeed, the late Lord Barnett himself expressed some surprise that “his” formula has lasted so long and on several occasions suggested that the time for reform was nigh. It is also worth noting that the Barnett Formula is not covered by legislation, is not embodied in any legislation, “… it is just something which is done.”76

7.3 Today the Barnett Formula implies either a slow squeeze down towards English levels of spending per capita77 or if Barnett is replaced by a needs-based approach a possibly more sudden (negative) adjustment to spending levels. In the context of devolution bringing a wider range of tax varying powers (including Income Tax, Corporation Tax, Air Passenger Duty and Aggregates Levy) the devolved administrations will face some increasingly tough decisions about future public expenditure, particularly if pressure increases, across the UK, to replace Barnett with a revised mechanism.

7.4 It is also worth noting how this translated into what is now the subvention. In 1961 the Joint Working Party on the Economy of Northern Ireland, chaired by Sir Robert Hall,

74 Northern Ireland had no formal equivalent to Goschen as the Government of Ireland Act 1920, (under which Northern Ireland was governed for some fifty years until the introduction of direct rule in 1972), provided for two parliaments and governments, one for Southern Ireland and one for Northern Ireland, and for a Council of Ireland, the latter to bring about ‘harmonious action between the parliaments and governments’ and to administer certain services that in the common interest it was felt should be administered on an all- Ireland basis; mainly fisheries, animal diseases and railways. Both governments and parliaments were to be subordinate jurisdictions within the United Kingdom. The southern government and parliament never became established; they could not be established without the support of Sinn Féin, and this was not forthcoming. 75 The formula was actually devised by the Treasury deputy Permanent Secretary, Sir Leo Pliatsky.

76 Welsh Affairs Committee. Evidence EV53. 26 January 2010.

77 In the late 1970s the per capita levels of public expenditure in Scotland, Wales and Northern Ireland were even higher relative to England than they are now. While the Barnett Formula was introduced to reflect this differential, there was a Treasury policy caveat that there should be convergence in the level of public expenditure per capita.

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exposed more publicly than ever Northern Ireland’s financial dependence on Britain. This total reliance on the British exchequer was in stark contrast to the intention of the Government of Ireland Act 1920 which, in effect, required Northern Ireland to be financially self-sufficient. In 1973 the Northern Ireland Constitution Act formally acknowledged this situation by stating that public finance in Northern Ireland had come to be ‘worked on an expenditure basis, that is to say that money is provided to the extent necessary to pay for approved programmes of expenditure’. In effect, once expenditure was approved, money would be found to finance it and, if regional revenue was insufficient to meet their cost the difference would be made up by subvention transfers from Westminster.

7.5 It is worth noting that, beyond London, the South East and East of England, the remaining regions of the UK (with the exception of Scotland where the allocation of oil & gas revenues is equivalent to the subsidy) receive a subvention and where, according to the Centre for Economics and Business Research78, “… one pound in five earned in London subsidises the rest of the UK – Northern Ireland, Wales and the North-East receive more than a fifth of their income as subsidies from outside the region.” In that sense therefore, the devolved nations and most English regions, already have a funding formula, based upon some notional basis of ‘need’.

7.6 It is often assumed that the Barnett Formula determines the full allocation of public expenditure to Scotland, Wales and Northern Ireland. However, the formula is merely a mechanism to determine a large part of the level of public expenditure and excludes demand-led expenditure such as social security benefits which are funded on the basis of need, as defined by claimant demand. The principal underlying Barnett when it was accepted in 1978 was that the regions would get a share - relative to population- of any change in spending on a comparable English programme. There are three key elements that collectively comprise the Barnett Formula and the sum of the three elements is the amount of additional spending made available to the devolved administrations and is known as the ‘Barnett consequential’. The three areas are:

 changes in expenditure on services in England, England and Wales or Great Britain, depending on the coverage of the expenditure under consideration;  the degree to which the English (or England and Wales or Great Britain, as above) services have counterparts in the devolved administrations. This is called the ‘comparability proportions’; and  each country’s population as a proportion of the population of England, England and Wales or Great Britain – again, depending on the coverage of the expenditure being considered.

7.7 In practice, Barnett has a number of advantages:

 it largely avoids annual negotiations with Treasury;  once they have received their allocation, regions enjoy flexibility to spend in line with local needs and priorities; 

78 Cebr, Media release, London, February 2012

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 the mechanical nature of Barnett is sometimes viewed as “fair”; and  as the formula is based on population, it is simpler and more transparent than one based on need.

There are however, some disadvantages:79  in practice, the Treasury makes decisions around issues of comparability and there is no facility for arbitration; and  it leads to convergence with English per capita spending

7.8 It is this latter problem- convergence- that has led to the so-called ‘Barnett Squeeze’ that has been exercising the minds of devolved assemblies during the periods of devolution since 1999.

7.9 Because the Barnett Formula is population based, the devolved nations gets the same pound-for-pound per capita increase- or decrease- as do comparable English programmes. That means, as English public spending per capita grows, it closes the gap with the devolved regions and therefore reduces the devolved ‘premium.’ This mathematical inevitability is the ‘Barnett Squeeze’ and this was most noticeable in the 1998 Comprehensive Spending Review and the subsequent 2000 Spending Review. This is partly because convergence happens more quickly when expenditure is rising rapidly but especially where public spending is directed at large programmes like health and education- key targets for increased public expenditure under Labour.

7.10 In 2008 the Welsh Assembly Government set up an Independent Commission on Funding and Finance for Wales80 (the Holtham Commission) to review the formula- based approach to the distribution of public expenditure to the Welsh Assembly Government and to identify possible alternative funding mechanisms (including tax- varying powers as well as greater powers to borrow).

7.11 The Scottish Parliament and the United Kingdom Government established the Commission on Scottish Devolution81 (the Calman Commission), which began work in April 2008 (reporting in June 2009). Calman was tasked with reviewing the provisions of the Scotland Act 1998; recommending any changes to the present constitutional arrangements that would improve the financial accountability of the Scottish Parliament, which would continue to secure the position of Scotland within the United Kingdom.

7.12 These followed the appointment, in March 2007, of Sir David Varney to undertake a review of how current and future tax policy might support the sustainable growth of businesses and long term investment in Northern Ireland82.

79 See also, Northern Ireland Assembly Research and Information Service, 16 January 2012, “Barnett consequentials”, Briefing Paper, 04/12, NIAR 911-11, and Northern Ireland Assembly Research and Information Service 8 February 2012, “Pros and Cons of the Barnett Formula for Northern Ireland”, Briefing Note, 29/12, NIAR 17-12. 80 Holtham, Independent Commission on Funding and Finance for Wales , Cardiff, July 2010, op.cit 81 Calman, Serving Scotland Better: Scotland and the United Kingdom in the 21st Century, Edinburgh, June 2009. 82 Varney. Review of the Competitiveness of Northern Ireland. HM Treasury. April 2008

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7.13 The outcomes of these reviews informed the potential for further devolution. Holtham concluded that the current arrangements for the financing of Wales lacked sufficient, ‘fairness and accountability83,’ and that the Barnett formula84, through which the block grant to the devolved legislatures is determined, should be replaced by a formula based on need. It also recommended devolution of limited powers over certain taxes and borrowing. Calman, in turn, recommended, inter alia, that, “...part of the Budget of the Scottish Parliament should now be found from devolved taxation under its control rather than from grant from the UK Parliament.85”

7.14 Effectively, the outcomes of the Holtham and Calman Commissions concluded that the devolution of additional tax-varying and other powers to the devolved regions of the UK was appropriate but that the issue of ‘fairness’ should remain a key consideration and that this would, de facto, impact on the current method of regional funding. Holtham also concluded that, “… the design criteria [for any new funding model] should be according to a uniform set of principles and, that if circumstances differed in the different places then the uniform principles would result in different allocations but that what [the Commission] recommended for Wales should be applicable to the other areas as well.”86

7.15 Furthermore, in its review of the Barnett formula87 in 2009, the House of Lords concluded that, although the annual increment in funds is made on the basis of recent population figures, the (Barnett) baseline failed to reflect the then population in the devolved administrations and took no account of the relative needs of any of the devolved administrations. Their report concluded: “The Barnett Formula should no longer be used to determine annual increases in the block grant for the United Kingdom's devolved administrations... we find the argument that devolution funding should be based on relative need to be a compelling one. Public spending per head of population should be allocated across the United Kingdom on the basis of relative need... a new system which allocates resources to the devolved administrations based on an explicit assessment of their relative needs should be introduced.”

7.16 The House of Lords also concluded that it was possible to achieve fairness without added complexity, echoing the findings of the 1979 Needs Assessment88 which determined that a simplified method of assessing need produced a very similar outcome to the more comprehensive and time-consuming approach which was the main focus of the study. Holtham came to a similar conclusion89, suggesting that there

83 Holtham, July 2010, op.cit 84 In the late 1970s per capita levels of public expenditure in Scotland, Wales and Northern Ireland were higher relative to England. The Barnett Formula (named after Labour’s Chief Secretary to the Treasury, Joel Barnett, but actually devised by Treasury official, Sir Leo Pliatsky) was introduced to reflect this differential, but with a Treasury policy caveat that there should be convergence in the level of public expenditure per capita. Barnett remains an integral part of regional funding, but appreciating its significance hinges on understanding the wider UK public expenditure framework. HM Treasury. Funding the Scottish Parliament, National Assembly for Wales, and the Northern Ireland assembly: Statement of Finding Policy. http://www.hm-treasury.gov.uk/spend_sr2010_fundingpolicy.htm 85 Calman, June 2009. op. cit

86 Welsh Affairs Committee. Oral Evidence EV53. Mr Gerald Holtham 26 January 2010.

87 House of Lords. Select Committee on the Barnett Formula - First Report. July 2009. House of Lords Publications. 88 Needs Assessment Study - Report, H M Treasury, December 1979 89 Holtham, July 2010, op.cit

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is a body of opinion, both within and outside government, supporting the view that a small number of broad-brush, proxy indicators may be a viable way to assess the relative needs of the devolved administrations.

7.17 There is a further political consideration around the definition of both ‘fairness’ and ‘need’, specifically relating to the cost or impact of so-called ‘super-parity’ issues. In Northern Ireland, for example, a number of services have been retained in public ownership/under public control, where the equivalent services in England are not and are therefore not subject to Barnett consequentials. These super-parity areas include, inter alia, discretionary travel, public transport, free prescriptions and the provision of water, wastewater and sewerage, which, collectively, are a cost to the Executive and amount to revenues forgone of between £350m-£500m. Assessing how super-parity issues would be treated, particularly where a devolved administration opposes the private ownership of assets and services, would require careful consideration.

7.18 Reform of Barnett and any new mechanism to determine funding of the devolved nations is inextricably linked with the growing extent of devolution and decentralisation, the extent to which such powers may differ between jurisdictions and the extent to which the devolved powers might improve potential outcomes (in terms of economic or social change). If the “design criteria” recommended by Calman and based upon the notion of what [the Commission] recommended for Wales should be applicable to the other areas as well,”90 is not delivered, it raises issues around the sustainability of the fiscal framework.

7.19 In its Programme for Government, the coalition government acknowledged the imperative for reform of Barnett as enshrined in Holtham, “...we recognise the concerns expressed by the Holtham commission on the system of devolution funding... [However]... any change to the system must await the stabilisation of the public finances.91” In that sense therefore, any new system will be complicated by the differential level and extent of devolution.

7.20 This raises the issue of indexing and the complexity of this was particularly apparent in the recommendations of the Smith Commission92under which devolved or assigned revenues would comprise more than 50% of Scottish government spending. Such a level of devolution would, of necessity require an adjustment of the Scottish block grant to account for the additional revenues and spending responsibilities. Adjusting the block grant in Year 1, would therefore be relatively simple and would reflect a formula:

(Initial Block Grant) + (Additional Spending) – (Additional Revenues) = (Revised Year 1 Block Grant) 7.21 But what about subsequent years? Year 2 and beyond? Block grants cannot be based upon the Year 1 cash adjustments and must account for issues like differential levels of

90 Welsh Affairs Committee. Oral Evidence EV53. Mr Gerald Holtham 26 January 2010. op cit 91 The Coalition. May 2010. op.cit 92 Report of the Smith Commission for further devolution of powers to the Scottish Parliament. November 2014.

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economic growth otherwise there is no incentive for Scottish Government to grow tax revenues through stimulating economic activity and limit expenditure growth by incentives to employment and changes to welfare provision. In that situation, changes to the block grant would be disincentives to intervention:

(Revenue increase: £750m) – (Block Grant reduction; £750m) = (No net change) 7.22 Smith recognised the importance of this issue and argued that adjustments should be “indexed appropriately” but did not expand on how that could be achieved Smith (Para 95) identified a number of fiscal principles including retention of the Barnett Formula, the assumption of economic responsibility, and also argued that there should be no detriment as a result of the decision to devolve further powers. In addition, it was also agreed that no detriment should arise as a result of UK or Scottish Government policy decisions post devolution (para 95.4). Smith also contended that borrowing powers should be consistent with the mechanism by which the block grant is adjusted to account for tax and spending devolution; that the UK government should continue to manage risks and economic shocks that affect the whole of the UK; and that, once a funding framework was agreed, its effective operation should not require frequent and ongoing negotiation.

7.23 The Institute for Fiscal Studies93, in its assessment of the challenge of indexing, offered a number of ways by which block grant calculations could be calculated in subsequent years and we commend these to the Committee for more detailed consideration. These included:

a) Adjusting the block grant by a constant percentage

b) Indexing the adjustment to what happens to revenues from equivalent taxes (or spending on equivalent welfare) in the rest of the UK (rUK) either in percentage terms or in £ per capita.

7.24 At present, the stated intention of all political parties is to retain the Barnett formula but an examination of alternative options cannot be ruled out entirely.

7.25 In considering options for reform, government will have to balance economic, social and political consideration as well as the concerns expressed by Holtham, the House of Lords, Smith and others, who have argued that Barnett and the allocation of public expenditure increasingly fails to recognise the needs, not merely of the devolved administrations, but of the regions of England. However, unless there is a broad consensus as to the purpose and impact of reform, they will not enjoy universal support and will damage confidence and investment.

7.26 In summary therefore, since Goschen in 1888 and through Barnett and Holtham and the more recent Smith Commission, there has been an emphasis on ‘fairness’, but in order to achieve ‘fairness’ the challenges of the fiscal framework and ‘indexing appropriately’ must be identified and overcome.

93 Institute for Fiscal Studies. Smith Commission proposals- the unresolved issue of the “fiscal framework”. March 2015

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8. Fiscal framework. “Should devolved governments receive further borrowing powers? What form of contract between the UK government and the devolved nations will prevent bailouts of governments that do not stick to their borrowing limits?”

8.1 It has been generally accepted that, for real devolution within the UK to succeed, the devolved nations must make their own decisions on economic policy and that they should be accountable for the outcomes of those decisions. Only then will local representatives be responsible for their actions and accountable to the electorate for those actions.

8.2 The Smith Commission agreement noted that the further devolved powers would require the borrowing powers of the Scottish Government to be extended such that the Scottish government had ‘sufficient additional borrowing powers to ensure budgetary stability and provide safeguards to smooth Scottish public spending’. It recommended that the Scottish and UK Governments should look into establishing a ‘prudential borrowing regime’ for capital investment.94

8.3 We would agree with this as clearly the borrowing powers should develop as further devolution is put in place. No proposals have been put forward as yet on the extended powers but in our view it is important that they are addressed as part of the overall fiscal framework needed to sustain devolution and that they are based on sound financial principles that can ideally be replicated in other devolved nations/regions.

8.4 For example, the devolution of bond issuance powers to the Scottish Government (or to any other sub-sovereign authority) has implications for the UK’s national debt management and consequently for fiscal and economic policy. However, devolving the power to issue bonds to Scotland (as a sub-sovereign authority) has a number of theoretical advantages; these include:

 The reduction of moral hazard

 The imposition of market discipline

 Increasing the transparency of fiscal activities.

8.5 The nature of bond finance generally entails borrowing over the long-term and therefore requires a consistency and discipline in forward financial planning. Devolving bond issuance powers to Scottish Ministers may therefore help to support improvements in long-term financial decision-making, particularly around public investment projects.

8.6 The National Institute of Economic & Social research (NIESR) has argued that devolution can only be meaningful if Scotland - and, crucially, Wales, Northern Ireland and local government in England - have the power to borrow on their own account95. NIESR has argued that permitting limited borrowing powers to be devolved to the English regions,

94 Smith Commission Agreement, p.26 95 Armstrong & Ebell. Real Devolution: the Power to Borrow, NIESR, London, September 2014

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as well as to Wales and Northern Ireland, would, providing these same powers were devolved within a political union, alleviate the risk of moral hazard and drive economic accountability to local electorates.

9. Fiscal framework, “What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?”

9.1 This question is hard to answer meaningfully without a much fuller economic context and a more comprehensive definition of FFA. The impact would depend entirely on the underlying fiscal framework and on economic projections that are currently unavailable.

9.2 At per the March Budget, the IFS (using OBR data) said there will be a £7.6bn annual shortfall (based on oil revenue forecasts of c £700m, down from around £5bn a couple of years ago) which highlights how difficult it would be to comment on the implications of FFA at this stage. 10. Fiscal framework: “What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland?”

10.1 Following the implementation of Scotland Act 2012, the fiscal framework for Scotland will remain broadly the same in principle, although the balances between sources of funding will change. Currently the Scottish Government receives a proportion of its revenues from devolved sources such as Council Tax and Business rates and a proportion from the UK government in the form of the block grant. Under Scotland Act 2012, it will also receive revenue from the Land and Buildings Transaction Tax, Scottish Landfill Tax and income tax receipts derived from the Scottish rate of income tax (SRIT).

10.2 The Scottish Government will continue to receive revenue from the UK Government in the form of the Block Grant but this will be adjusted (reduced) to reflect the income received by the Scottish Government from the devolved taxes and SRIT. The adjustments to the block grant will be calculated in a form agreed between the Scottish Government and HMT. The mechanism is intended to result in the Scottish Government bearing the risks and rewards of the devolved taxes e.g. if the income tax base in Scotland grows at a greater rate than that across the UK, the Scottish Government will receive more tax revenues from SRIT than it would have done under the Block Grant.

10.3 The implementation of the Scotland Act 2015 will extend this process and, as above, reduce the proportion of Scottish Government revenues that derive from the block grant. Nevertheless, that proportion will still be significant. In this sense, the fiscal framework for Scotland is not renegotiated. The Barnett formula remains the basis for determining the Block Grant which is then adjusted in the agreed manner.

10.4 Looking to the future, the most important factor for the UK Parliament and the devolved bodies will be to agree a formula that will govern appropriate adjustments to the block grants of the devolved nations. This formula will have to cover both the impact of any appropriate Azores reductions as well as the sharing of income tax and

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any other shared receipts. It would also need to take account of any super-parity measures (where activities undertaken in a devolved region remain under public control but where matching English activities are in the private sector and not therefore subject to the Barnett formula).

10.5 We note that there have been many discussions on the validity and operation of the Barnett formula and this is an area of ongoing debate and have dealt with some of these in foregoing paragraphs. At present, we understand that the UK Government does not intend to revise this basis of funding but if that position were to change, there would obviously be significant implications for Scotland, Wales and NI. We cannot speculate on what these would be in the absence of detailed alternative proposals especially as the changes from Scotland Act 2012 have not taken effect or been assessed.

10.6 We would also stress the importance of two issues raised by Lord Smith as part of his report i.e. improving inter-government working and public awareness. Both are vital to establishing a sustainable fiscal framework that achieves the goals of devolution and decentralisation. The principles set out in the Smith Commission report form a good starting point for agreeing such a fiscal framework.

PricewaterhouseCoopers 8th September 2015

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Appendix One - Azores Judgement

The Azores (an autonomous regions of Portugal) reduced income tax and Corporation Tax rates for companies locating there as part of its competence to adjust national tax arrangements to meet its “specific characteristics.” However, the European Commission stated that this action violated rule 87(1), was State Aid and thus incompatible with the common market.

Portugal appealed the decision to the European Court of Justice (ECJ) on the basis that the Commission’s interpretation of regional selectivity in this case was inappropriate because it was a ‘local’ decision in keeping with the Portuguese constitution and its general system of taxation and that it was incorrect to define the ‘reference framework’ (i.e. The Azores), as ‘Portugal.’

While the ECJ upheld the principle that regional tax preferences constitute ‘selective’ state aid under the terms of 87(1), it also accepted that certain of the tax privileges being provided by the Azores authorities were justified under 87(3) and so were permitted to stand.

Consequently, the 2006 ECJ ruling concluded that to adjust national tax arrangements to meet sub-regional “specific characteristics,” was possible. However, several tests must be met to determine that the sub-region exercised “sufficiently autonomous powers” in reducing and/or altering the tax rate:

• the decision must be taken by a (sub-regional) authority which has a constitutionally political and administrative status separate from the central government

• the decision must be adopted without the central government being able to intervene in its content (inferring that the appropriate constitutional, political and administrative status

• power is already devolved before the adjustment of national tax arrangements to meet sub-regional “specific characteristics”)

• the financial consequences of a reduction in the national tax rate for undertakings in the sub-region must not be offset by aid or subsidies from other regions or central government.

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Appendix Two

PricewaterhouseCoopers (PwC) submission to the Smith Commission on increasing the powers of the Scottish parliament - Extract

Conclusions  Transparency and simplicity should be key principles governing taxation policy at any level. Creating additional administrative burdens should be avoided wherever possible.

 For reasons of legality and practicality, certain taxes are not suitable for devolution. In this category, we include National Insurance contributions (NIC), VAT, Capital Gains Tax (CGT), Inheritance Tax (IHT), excise duties, betting and gaming taxes, alcohol and tobacco duties and Corporation Tax (CT).

 The considerable costs to UK businesses of devolving corporation tax should not be underestimated and could impose a disproportionate burden on SMEs.

 Devolving the power to set and vary the rate of CT in Scotland would be at best a blunt – and likely costly - instrument. While experience of other nations suggests that a lower rate of CT can contribute to the attractiveness of a region as part of a package of other incentives, there is also a risk of damaging tax competition and there is no clear evidence of a simple correlation between low CT rates and high levels of foreign investment. Further consideration should be given to ways of adapting the current provisions to give greater flexibility to policy-makers in Scotland.

 The tax most suitable for devolution is income tax, but we have concluded that partial devolution (e.g. over rates and bands) would balance the benefits of accountability with the need to maintain the UK-wide market for financial services whilst not over-burdening businesses and individuals with complexity.

 Assigning tax revenues (as an alternative to devolution) may seem an attractive compromise. Our concern is that this would increase both administrative complexity and exposure to tax volatility without any commensurate increase in the direct control of the Scottish Parliament over revenue-raising. Accountability would not be enhanced.

 The impact of devolution on the overall funding position under the Barnett formula should be considered.

 The devolution of APD is both feasible and desirable for reasons given late in this submission.

 Increased borrowing powers are likely to be necessary following further fiscal devolution. Consideration should be given to devolving those borrowing powers to a local level (e.g. to key cities).

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 Whilst devolution of locally-delivered welfare spending would be beneficial, wholesale devolution of all welfare spending including pensions is not, in our opinion, advisable.

 The oil and gas and financial services sectors are vital to the Scottish economy and their continued success should not be undermined by changes to the tax system.

Taxation The Holtham Commission identified six criteria to be applied when assessing whether a tax is potentially suitable for devolution, and we consider that these are an excellent starting point for such discussions. Those criteria are that a devolved tax will: (1) promote accountability because the tax is highly visible, well-understood and raises substantial revenue;

(2) not harm administrative efficiency, because devolution does not alter economic behaviour to create inefficiencies or distort the economic relationships between regions of the UK;

(3) not harm administrative efficiency because it does not impose a substantial compliance burden on citizens and businesses, nor impose relatively high costs of administering collection (especially as a % of revenue raised);

(4) be relevant to policy in terms of providing a useful policy lever and helping to achieve the goals of the devolved government;

(5) be compatible with legal constraints (notably EU law); and

(6) have minimal impact on the tax base of the rest of the UK.

Whilst parties and organisations may give different weight to these criteria (and no one tax will probably fulfil all six conditions), they enable us to make an objective assessment of the current proposals. Where devolution of a specific tax is not possible or practical, it has been suggested that revenues from that tax could be assigned to the Scottish Parliament as an alternative. There has been very little discussion of how this might work in practice but it does not, to us, seem an attractive alternative. Assignment of revenues, for example of VAT or corporation tax, would require additional layers of information gathering and allocation of income, profits or turnover. The Scottish Government would receive revenues from tax streams rather than direct from central government, and would therefore bear the risk of any fluctuations or falls in that revenue, whilst having no direct influence on the setting or collection of the tax. Their policies would only have an indirect influence on the level of the tax. For example, if consumption of certain good or services increased in Scotland, VAT paid by Scottish consumers would rise and hence the revenues flowing to the Scottish Government. This would do little to enhance accountability, as so many other factors would influence the level of tax raised.

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VAT It has been noted many times that VAT cannot be devolved within a territory as this contravenes EU law. Assignment of VAT revenues has been suggested as a solution which would provide accountability within UK law. Given that VAT makes up a large (approximately 20%) part of Scottish and UK tax revenues, this would be a significant undertaking and the administrative burden will need to be considered. Given the above, we have concluded that assignment of VAT revenues would not achieve key objectives. Excise duties We would agree with the generally accepted premise that devolution of some taxes such as excise duties and tobacco and alcohol duties would be vulnerable to evasion to an unacceptable extent. Whilst these taxes are highly relevant as policy levers, the distortions arising from devolution would be considerable. Air passenger duty We considered the devolution of air passenger duty (APD) to Northern Ireland in December 2011, and we would regard it as a tax which is appropriate for devolution in Scotland beyond the existing exemption already afforded to airports in the Highlands and Islands. APD was identified by the Calman Commission as suitable due to both the relative ease of administration and the potential economic benefits, and this position is reflected in many of the submissions to the Smith Commission. Our wider report on APD, the Economic Impact of Air Passenger Duty (February 2013) concluded that the abolition of APD across the UK could provide a short-term GDP boost of around 0.45% in the first 12 months, stabilising at around 0.3% per annum thereafter and increasing the UK economy by some £16 billion in the three years following. On this basis Scotland could expect to benefit from a pro-rate rate of economic growth. National Insurance Contributions (NICs) National Insurance receipts contribute about 18% of tax revenues and so would, particularly in combination with income tax, make a significant difference to the revenue-raising powers of the Scottish Parliament. As noted by others, contributory benefits and welfare spending are closely linked to NICs, although the link between welfare and NICs is not as direct as it once was. There are, however issues of feasibility around devolving NICs that make it less attractive for devolution, such as funding pensions. The issue of devolution of welfare spending is discussed below and is integral to any discussion on devolution of National Insurance. Hence we have concluded that devolution of NICs is not appropriate. Capital gains tax (CGT) and Inheritance tax (IHT) Together these taxes contribute approximately 1.2% of tax revenues. They are paid by a very small number of people and can be seen as complex the general population. As such, they do not immediately appear good candidates for devolution. A further consideration is the impact that devolution might have on the market for financial products and services. Financial products that are commonly used for savings and investment (such as pensions, ISAs, and life insurance policies) are all based on the UK regime for CGT and IHT, and if Scottish taxes on such products were to diverge this could

PricewaterhouseCoopers LLP – Written evidence (DPF0023) have a detrimental effect on access to the wider UK market that Scottish people currently enjoy. The reality is that Scottish taxpayers would be a relatively small market for such products compared to the rest of the UK, and providers would make decisions on a commercial basis as to how much they would be willing to invest in servicing that market. We have therefore concluded that any policy benefits or increase in accountability would be minimal compared to the practical disadvantages, and hence believe that these taxes are not suitable for devolution. Corporation tax (CT) The scope to devolve CT (or the power to vary the rate of CT) would be strictly governed by an exemption to the general EU regulation forbidding sub-regional tax variation. Based on that exemption (the ‘Azores Judgement’), a state can reduce the headline rate of CT in sub- regions only if certain conditions around the constitutional arrangements and financial consequences of the devolution are met.

Under the Azores Judgement, the UK Government could legally devolve the power to set and vary the CT rate to Scotland. The Scottish Government would be required to extend any reduced rate to all entities incorporated in Scotland. In addition, the revenues ‘lost’ to the UK Government by virtue of Scottish Government reducing the headline rate (including the ‘loss’ incurred were English entities to relocate to Scotland to enjoy a lower rate of CT) would be deducted from the block grant.

Devolution of CT is therefore legal under EU law provided that the conditions are met, but the cost and complications associated with such a change, including compliance costs to business, must not be underestimated. Full devolution of CT will result in a considerable burden for businesses operating on both sides of the border as profits will need to be allocated between Scotland and the rest of the UK and they will need to comply with two sets of diverging rules. Giving powers to the Scottish Parliament to target incentives and reliefs within Scotland (subject to EU issues such as State Aid) would potentially have more benefit that either devolution of the headline rate of tax or full devolution of CT. It would minimise administrative issues and potential distortion of behaviours whilst enabling the Scottish Parliament to refine the UK system to suit the Scottish economic environment. For example, tax incentives for start-up businesses, SMEs and entrepreneurs play an important part in support for new businesses which are one of the key drivers to new job creation. These are provided not only through CT (e.g. research and development tax credits, NIC exemption for new companies employing fewer than ten people) but also CGT (rollover relief, EIS relief) and IHT (business property relief). These incentives are sometime of far greater importance to businesses than the headline rate of tax. Whilst a competitive level of CT is desirable to ensure Scottish competitiveness, there is no clear evidence of a simple correlation between a low rate of CT, and increased levels of high-value foreign investment and indigenous entrepreneurial activity. An overriding issue for businesses is the stability and administrative simplicity of any CT regime. For all but the most localised organisations, any devolution measure could undermine that position. Tax is just one of the many factors affecting the choice of business location. Where tax does influence investment, issues are considerably more complex than the headline CT rate,

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ranging from bilateral arrangements on the taxation of foreign income, to the total tax rate (the sum of all taxes in the destination region), the complexity of the (host) tax regime, and the number of different taxes a typical company may have to pay in the host country. Income tax (IT) Proposals to the Commission to date include extending the powers of the Scottish Parliament over income tax beyond those currently included in the Scotland Act 2012. Further devolution, including the power to adjust rates and bands, would potentially enable a more flexible use of this taxation power to have a more nuanced effect on the Scottish economy. However, the impact of changes in income tax on economic growth and job creation is unclear, and must be balanced against the greater complexity for individuals and businesses that will inevitably arise. There is also potential to distort other drivers of competitiveness, and to encourage cross-boundary migration by individuals seeking to minimise their personal liability. We consider that devolution of personal taxation should maintain the current UK-wide market for financial services products. The products and services offered by financial institutions across the UK are designed for the UK tax and regulatory environment, and the advantages of this to Scottish savers, borrowers and investors are manifold. Given that this sector is such an important part of the Scottish economy, we believe that fiscal devolution which could undermine it would be counter-productive. Our conclusion is that there is scope for devolving further elements of IT (over and above the Scotland Act 2012) whilst maintaining the integrity of the UK system and not distorting economic behaviour and creating burdensome costs. Full devolution over income tax would create such distortions. Sectoral issues Oil and gas and financial services are sectors of vital importance to the Scottish economy. We have noted above how important the seamless UK market is to the strength of the financial services sector and we would also stress that the robust and well-respected regulatory regime across the UK that enables businesses to operate in a seamless market is of equal importance. Devolution of regulation would create additional costs with no apparent enhancement to consumer protection. Oil and gas companies are, of course, closely following the fiscal review that is currently underway, with submissions recently being made to HM Treasury. A separate tax code for Scotland may introduce more complexity for both government and business. Tax has an important part to play in the future health of the UK oil and gas industry by ensuring that investors can have confidence in their investments. The regime needs to be predictable for an industry that requires investment for the long term, and it also needs to be flexible enough to adapt to the significant change in the economics of what is now a mature and high-cost oil region. Oil and gas production occurs outside Scotland as well as within it, as does much of the activity that supports the oil industry. Like all corporate taxes, to subdivide the activities that take place within the UK is complex, particularly in relation to the very significant tax refunds that will be due in respect of decommissioning. Conclusions

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As noted above, there are challenges in devolving many of the existing taxes as these are integrated into the wider fiscal and spending arrangements. The tax most suitable for further devolution is income tax.

Devolution of powers should only be implemented where there is clear evidence that it will fulfil agreed policy objectives, such as attracting greater numbers of high-value foreign direct investment (FDI), stimulating greater international competitiveness amongst indigenous undertakings and creating sustainable employment. Developing fiscal instruments intended to stimulate these objectives should therefore be primary goals in any review of Scottish fiscal autonomy. It is clear that for Scotland to thrive, economically and socially, progress will be needed on a wide range of other issues which lie beyond the direct control of government - either in Whitehall, Holyrood, or locally. Whatever new settlement on powers the Commission arrives at, this will not alone determine Scotland’s ability to fully capitalise on its many strengths and opportunities. Of fundamental importance is the evolution of local systems to support good growth, which frequently rely on changing individual and organisational outlooks and approaches, and which have much less to do with powers, than with personal levels of confidence, openness, and ambition. The willingness and ability to form partnerships and public-private collaborations, for example, feature as consistently important themes in multiple reports, commissions and surveys. To the extent that the Scottish Government already has many powers within its remit, these can be brought to bear to support the evolution noted above without relying on an expansion in formal powers devolved

11 September 2015

Nicholas Ramsay – Written evidence (DPF0005)

The House of Lords Committee on Economic Affairs

‘The devolution of public finances in the United Kingdom’

Written Evidence from Nick Ramsay AM, Shadow Minister for Finance and Europe at the National Assembly for Wales.

1. Introduction

1.1 The purpose of this paper is to provide written evidence to inform the House of Lords Economic Affairs Committee’s inquiry into the devolution of public finances in the United Kingdom.

1.2. This paper is made reflecting my professional and personal interest in the devolution of public finances and provides comments regarding the way that devolved nations are funded, devolving further fiscal autonomy and the devolution of taxation powers.

2. Fiscal Framework

2.1. The non-statutory Barnett formula determines changes to planned spending within the given budget but does not determine its overall size. At present, the Welsh block receives a population-based proportion of the changes in planned spending on comparable government services in England.

2.2 I wholeheartedly believe that a needs-based assessment should be taken into account when funding the devolved nations. The House of Lords Select Committee on the Barnett formula found the ‘argument that devolution funding should be based on relative need to be a compelling one’ (The Barnett Formula, House of Lords Select Committee First Report of Session 2008-09, House of Lords Paper 139, 17 July 2009, paragraph 81.)

2.3. The Calman Commission further argued: ‘In our view need is the only basis on which grant funding can be properly justified’ (Serving Scotland Better: Scotland and the United Kingdom in the 21st Century, An Executive Summary of the Final Report, Commission on Scottish Devolution, June 2009, paragraph 36.)

2.4. In Wales, the Independent Commission on Funding and Finance for Wales (Holtham Commission) concluded that the Barnett formula “makes little effort to align budgetary allocations with the need for public services” and “must ultimately be superseded by a needs-based formula.” (Funding devolved government in Wales: Barnett and beyond, Independent Commission on Funding and Finance for Wales First Report, summary, July 2009, pp. 13-14.) I fully accept the Commission’s conclusion and believe that Wales is suffering under the present funding arrangements.

Nicholas Ramsay – Written evidence (DPF0005)

2.5. I believe that at the heart of any governance of the way devolved nations are funded should be a question of fairness. The UK Government should not introduce, or continue with any formula that only benefits certain parts of the UK. I believe it is time to bring forward a formula that treats each region and country of the UK fairly.

3. Taxation

3.1. It is clear that action is needed to turn the Welsh economy around, reduce Wales’ dependence on the public sector and allow for the provision of equitable and modern public services. I believe that taxation can have an important role in achieving these aims. The rationale behind the Wales Act 2014 and devolving taxation powers to Wales is to increase fiscal accountability of the National Assembly for Wales and that by devolving taxation powers, the Welsh Government would have borrowing ability on the international markets.

3.2. There are some taxes which would be attractive to the Welsh Government. For example, Corporation Tax would be an attractive tax to devolve to Wales because it would give the Welsh Government the ability to lower rates and to promote headquartering of international companies. There would be little danger of a Welsh Government increasing Corporation tax above that levied in England as the revenue Wales receives from corporation tax would be subtracted from the block grant and the Welsh Government could not afford to lose its share by discouraging business with a punitive rate. Indeed, the Holtham Commission found that ‘no other single change would be likely to be as effective [to improve Wales’ relative economic performance] as giving Welsh Ministers the scope to reduce corporation tax’ (Independent Commission, July 2010.)

3.3. The Wales Act 2014 gives effect to some of the recommendations of the Silk Commission’s first report, including giving new powers to the Assembly around tax raising and borrowing powers to Welsh Ministers. The Act allows the National Assembly for Wales to hold a referendum on whether it should be able to vary the rate of income tax in Wales by up to ten pence in the pound.

3.4. In 1997, Scotland’s referendum on devolution included a referendum on the principles of tax-varying powers, which was an important constitutional precedent. Therefore, I fully support the view of the Holtham Commission, that ‘devolution of powers over income tax would [likely] take place only after a referendum’ and that ‘without that, devolving income tax may be too big a change to make without public endorsement’ (2010:121).

3.4. I believe we need to look again at the mechanisms proposed for the devolution of income tax. In the case of the basic rate of taxation the UK Government would still continue to control half of the existing rate and will therefore have the ability make significant changes to the rate, which would have an effect on expenditure in the UK/England and the consequent size of the block grant given to Wales. Ideally there would be a mechanism that insulates the Block Grant from shocks caused by changes in UK taxation policy.

3.5. Therefore the UK Government will need to provide assurance that it will continue to retain the responsibility for the consequences of its decisions. Under the system proposed, the Welsh Government could be put in a position where it needs to readjust the tax rate to

Nicholas Ramsay – Written evidence (DPF0005) compensate for a funding shortfall from the block grant. This is potentially unfair, disadvantageous to Welsh taxpayers and could undermine the spirit in which these taxation powers were meant to be devolved.

3.6. The Welsh Government was given the power to borrow up to £500 million from the Secretary of State in order to meet ‘a temporary excess of sums paid out of the Welsh Consolidated Fund’ (Government of Wales Act 2006). However, unlike local authorities, the Welsh Government currently has no powers to borrow from the Public Works Loan Board in order to finance capital spending. Therefore, it is only wholly appropriate that the Welsh Government has the ability to borrow and that those powers are capped.

4. Conclusions

4.1. Tax devolution is an interesting philosophical concept and potential economic tool but ultimately the people of Wales are more interested in the effective delivery of public services. Most people remain unconcerned as to whether those services are delivered from funding through the block grant or through tax devolution.

4.2. It is evident that the way that devolved nations are funded needs to change to create a much fairer and equitable system across the UK. The Welsh people should certainly not have to pick up the tab for any injustices now or in the future in the funding of the different countries and regions of the UK. I accept that there are some merits to devolving certain taxes and there has been considerable debate around those matters. However, I remain concerned that the current proposals for income tax to be devolved could disadvantage Welsh taxpayers. It is more important than ever that the Welsh people fully understand the nature of tax devolution and are able to have their say via a referendum. Any change to the Welsh Government’s fiscal governance must carry the goodwill of the people of Wales with it.

19 August 2015

Scottish Government – Written evidence (DPF0016)

Lord Hollick Chairman Economic Affairs Committee House of Lords London SW1A 0PW

28 August 2015

Dear Lord Hollick,

Thank you for your letter of 14 July 2015 inviting me to provide written evidence to the Economic Affairs Committee inquiry into the devolution of public finances in the United Kingdom. I have set out my response to your questions below.

As you will be aware, Scottish Government and HM Treasury Ministers are currently negotiating the format and content of the Fiscal Framework for Scotland .These discussions are still at an early stage and it would be premature to discuss the Scottish Government's positions or the outcome of these with the Committee. In the light of this, I will not therefore, be able to provide oral evidence to the Committee in Edinburgh on 9 September.

Following the conclusion of this work I would be happy to provide a further update if the Committee would find that helpful.

Yours sincerely

JOHN SWINNEY

Scottish Government – Written evidence (DPF0016)

WRITTEN EVIDENCE FROM SCOTTISH GOVERNMENT TO ECONOMIC AFFAIRS COMMITTEE

This papers sets out the Scottish Government's evidence to the House of Lords Economic Affairs Committee Inquiry into the devolution of public finances in the United Kingdom.

1. The Scottish Government played a full part in the work of the Smith Commission and supported its proposals for further devolution. However, the Scottish Government has made clear that we believe the recommendations of the Commission should have gone further to provide coherent powers to promote economic growth and tackle inequality. The outcome of the 2015 General Election demonstrated public support for further devolution beyond the recommendations of the Smith Commission, with a majority of voters supporting such proposals.

Scottish Government economic aims

2. Scotland's Economic Strategy96 sets out an overarching framework for a more competitive and a fairer Scotland and reaffirms the Scottish Government's commitment to creating a more successful country, with opportunities for all of Scotland to flourish, through increasing sustainable economic growth. It forms the strategic plan for existing and all future Scottish Government policy and prioritises boosting investment and innovation, supporting inclusive growth and maintaining our focus on increasing internationalisation.

3. Our approach to delivering sustainable economic growth is characterised by four key priorities:

• An economy where growth is underpinned by long-term sustainable investment in people, infrastructure and assets;

• An economy where growth is based on innovation, change and openness to new ways of doing things;

• A society that promotes inclusive growth and creates opportunity through a fair and inclusive jobs market and regional cohesion to provide economic opportunities across all of Scotland; and

• A country with an international outlook and focus, open to trade, migration and new ideas.

4. Scotland's public finances and the devolution of further powers are used to support and underpin these priorities.

96 http://www.gov.scoUPublications/201 5/03/5984

Scottish Government – Written evidence (DPF0016)

Scotland Act 2012 powers and their implementation

Devolved taxes

5. The first national taxes designed and implemented in Scotland came into force on 1 April 2015 when Land and Buildings Transaction Tax (LBTT) and Scottish Landfill Tax (SLfT) replaced Stamp Duty Land Tax (SDLT) and Landfill Tax. The power to legislate for these new taxes was devolved by the Scotland Act 2012. Responsibility for the collection and management of these taxes rests with Revenue Scotland, Scotland's devolved tax authority.

6. We have developed a distinctive Scottish approach to tax, which we applied in developing LBTT and SLfT and which will continue to inform our use of the new tax powers to be devolved by the current Scotland Bill. The Scottish approach has

three key features: principles-based; collaborative; and a clear but robust approach to counteracting tax avoidance. This Scottish approach applies the maxims set out by Adam Smith - that taxes should be proportionate to the abilitylo pay, that there must be certainty; convenience for the tax payer; and efficiency of tax collection.

7. The devolution of these tax powers has enabled us to design Scottish taxes which better meet the needs of the people and the economy of Scotland, and to take decisions on tax rates which redistribute the burden of taxation.

8. For example, SLfT applies to illegally dumped waste, unlike the predecessor UK tax. This serves to disincentivise illegal activity, support legitimate landfill operators and clamp down on tax evasion. The Scottish Landfill Tax Act has also allowed the Scottish Government to simplify the system for administering the Landfill Communities Fund.

9. The Scottish Parliament legislated for a progressive rate structure for LBTT back in 2013. Our decision to replace the distortive slab rate system of SDLT attracted universal support across the Scottish Parliament and from a wide range of stakeholders. The UK Government subsequently introduced a progressive rate structure for the taxation of residential property transactions under SDLT in December 2015, demonstrating that Scotland can take the lead in driving positive tax reforms across the United Kingdom.

Scottish Rate of Income Tax

10. The final taxation provisions of the 2012 Act are due to come into force when the Scottish Rate of Income Tax is introduced on 6 April 2016. The main UK rates of income tax will be reduced by 10p for Scottish taxpayers and in its place the Scottish Parliament will set a Scottish Rate.

11. While the power to set the rate of SRIT is devolved to the Scottish Parliament, income tax remains a reserved tax. SRIT is part of the UK income tax system and HMRC is responsible for implementing and operating the tax. The tax base and any changes to it, along with tax bands and thresholds, will remain under the control of the UK Government. Whilst it is the responsibility of HMRC to implement SRIT, Scottish Government officials have been closely involved seeking to ensure that HMRC are

Scottish Government – Written evidence (DPF0016)

providing value for money in their delivery by providing a challenge function on both HMRC project and programme boards.

12. The Scotland Act 2012 income tax powers are limited in that the same rate of tax is applied equally to all tax bands, which severely restricts the ability of the Scottish Government to make the tax more progressive. The new Scotland Bill will bring forward the Smith Commission recommended powers which will allow the Scottish Government full control to set the rates, and will also have the power to set the thresholds other than the personal allowance. These powers will increase the flexibility of the Scottish Government to design an income tax to best support our Economic Strategy and the Scottish economy. However, under the Scotland Bill, income tax still remains a reserved tax. The Scottish Parliament will have no legislative competence over key elements of the system, issues such as the tax base, personal allowances and taxation of savings and dividends will remain matters for the UK Government.

Capital borrowing

13. From April 2015 Scottish Ministers have had the power to undertake borrowing to fund capital expenditure up to a statutory aggregate limit of £2.2 billion.

HM Treasury has limited this borrowing in any one year to 10 per cent of the capital budget. The 2015-16 Draft Budget set out our plans to borrow up to £304 million this year, the maximum permitted by HM Treasury, in order to maximise our infrastructure investment programme. This programme focuses on support for strategic infrastructure investment plans that underpin productivity growth and secondly, on promoting wellbeing to help address the challenge of poverty and inequality.

The Smith Commission and the fiscal framework

The Smith Commission and the Scotland Bill

14. The Scottish Government has consistently argued for extending the powers and responsibilities of the Scottish Parliament. The Scottish Government therefore played a full role in the work of the Smith Commission, established after the referendum to take forward undertakings made during the campaign. The Westminster and Scottish Parliaments are now considering a Scotland Bill, which sets out the UK Government's proposals for the implementation of the Smith Commission.

15. The main provisions of the Bill cover:

• The status of and arrangements for the Scottish Parliament, including elections.

• Powers for the Scottish Parliament to set rates and thresholds of Income Tax, and devolution of Air Passenger Duty.

• Devolution of certain social security benefits, including disability and carers' benefits.

Scottish Government – Written evidence (DPF0016)

• Powers for the Scottish Parliament to adjust Universal Credit in Scotland including the housing element.

• Devolution of some employment services.

• Devolution of the Crown Estate in Scotland.

• Devolution of Tribunals in reserved areas - such as the Employment Tribunals - in Scotland.

• Devolution of some power over equal opportunities.

• Devolution of British Transport Police.

16. The Scottish Government set out its views on the Bill in detail in June 201597. While the Scotland Bill would provide some of the powers needed to tackle the issues that face Scotland, the Scottish .Government continues to believe it has significant shortcomings. We are currently in discussions with the UK Government on changes to the Bill both to meet the Smith Commission in full and to provide sensible changes to beyond those recommendations The Bill will require the agreement of the Scottish Parliament under the Legislative Consent procedure. The aim of the Government is to secure agreement with the UK Government on a satisfactory Bill, and importantly, the accompanying financial arrangements (the "fiscal framework"), in time for the Parliament to consent to the Bill before it dissolves for the Scottish General Election in March 2016.

17. A robust and credible fiscal framework will need to be agreed before recommending to the Scottish Parliament that legislative consent be given.

18. The Scottish Government is also developing policies for the use of new powers in the Bill. We have already set out some early policy priorities we would propose to implement under newly devolved powers, such as reforming the work programme, reducing Air Passenger Duty and abolishing the bedroom tax.

19. The Government is consulting extensively on these proposals and more widely on the subjects covered in the Bill. This programme of engagement will expand and intensify through the remainder of this year, with the aim of producing further specific proposals when the final form of the Bill is clear, and to reflect the outcome of negotiations on financial arrangements as well as the outcome of the Spending Review.

Beyond the Smith Commission

20. In the report "Furlher Devolution Beyond the Smith Commission98 published earlier this year the Scottish Government put forward proposals further devolution beyond the recommendations of the Smith Commission. That report sets out more detail of the Scottish Government's proposals for further devolution summarised below.

97 http://www.scottish.parliament.uk/S4 ScotlandBillCommittee/General%20Documentsl SG Response. 98 http://www.gov.scot/Resource/00471 00479299.pdf

Scottish Government – Written evidence (DPF0016)

21. As it stands, the Scotland Bill will only increase those taxes fully or partly under the control of the Scottish Parliament to around 29% of tax receipts in Scotland and 36% of devolved expenditure. This falls far short of "Home Rule" as over 70% of tax receipts and 86% of welfare spending in Scotland remain in the control of Westminster. The proposals do not provide the Scottish Parliament with control over key taxes - like corporation tax or Employers National Insurance Contributions - and key elements of the welfare system such as tax credits and out of work benefits. Narrowing the gap between the Parliament's spending and revenue raising powers would both increase its accountability and enable the Scottish Government to align better all elements of public policy with its objectives.

22. Short of independence, the Scottish Government's preferred approach is full fiscal autonomy. We believe this would provide the maximum financial and democratic accountability within the United Kingdom, enabling the Scottish Government to increase economic growth while allowing Scotland to contribute to the United Kingdom as a whole.

23. Full fiscal autonomy would mean that all onshore and offshore taxes would be designed and set in Scotland, including tax rates, allowances, thresholds and the tax bases. There would be some exceptions - such as VAT - where EU rules require uniformity across the UK. The Scottish Parliament would also take responsibility for all key elements of domestic expenditure, including welfare, and a direct payment would be made for the services Scotland receives from being part of the UK. These would include agreed amounts for defence, security, foreign policy and servicing of historic debt interest. In addition to a full range of tax powers, it is essential to full fiscal autonomy that the Scottish Parliament has access to other economic levers, such as employment rights and aspects of migration.

24. Transition to full fiscal autonomy would take some years to complete, as implementation of the Scotland Act 2012 has demonstrated. During that transition period the Barnett formula would need to be retained to ensure that Scotland's public finances remain predictable and sustainable as the Scottish Parliament assumes responsibility for raising a greater proportion of its own revenues, and begins to benefit from measures to improve Scotland's economic performance.

25. The Scottish Government has also published proposals for priority areas beyond the Smith Commission recommendations that could be devolved to provide a coherent package of powers to boost competitiveness and tackle inequality. These include:

• employment policy, including the minimum wage

• welfare

• business taxes

• national insurance

• equality policy.

Scottish Government – Written evidence (DPF0016)

26. These proposals, set out in Further Devolution Beyond the Smith Commission build on the existing devolved powers and the Smith proposals to enable the Scottish Government and Parliament to take an integrated approach to a range of issues, such as support for employers and those seeking employment, tackling in work poverty and addressing inequality the Scottish Government believes they better meet any tests for further devolution, especially coherence, than the current Scotland Bill.

27. In addition to devolving powers beyond the recommendations of the Smith Commission, the Scottish Government believes that the outcome of the General Election highlights the need for both governments to examine how they work together, particularly in reserved areas as they directly affected Scotland. That a particular area remains reserved to Westminster should not mean that the Scottish Parliament and Scottish Government should have no formal role in decision-making. The direction of the Smith proposals, and the outcome of the General Election, point to the need for better working between the governments. There is a particular need to consider how policy in reserved areas that directly affects Scotland is developed, to ensure that Scottish views and priorities are taken into account, and that policy effectively operates with related devolved policies. The Scottish Government believes that formal mechanisms would ensure improved process and outcomes for both governments, and for the people of Scotland.

Fiscal Framework for Scotland

28. The Smith Commission recommended that the devolution of new powers should be accompanied by an updated fiscal framework for Scotland, consistent with the overall UK fiscal framework. The Framework must be agreed by both Governments and be implementable and sustainable.

29. There are a number of key areas which need to be agreed with the UK Government as part of these discussions. These include:

• A sustainable funding model - initial block grant and on-going adjustments, implementation of the principles of "no detriment";

• Tools for managing risk, including sufficient, additional borrowing powers to ensure budgetary stability and to support capital investment;

• Credible fiscal rules to enable the development and delivery of distinct Scottish policies within the UK fiscal framework;

• The role of independent scrutiny.

30. A well designed fiscal framework will ensure that further devolution provides the right incentives and increases accountability- linking Scottish Government budget to Scottish economic performance.

31. There are aspects of the framework that are currently not well defined- the principles of "no detriment" being one of the most key. We are working with the UK Government to clarify the meaning and application of "no detriment" so that it can be

Scottish Government – Written evidence (DPF0016)

embedded in the agreed framework in a way that is clear, fair and transparent. It must be applied in a symmetrical way and operate on a shared understanding of how it will work in practice.

32. The Smith Commission recommended additional borrowing powers to enable the Scottish Government to balance risk and volatility in the Scottish budget and to support a long-term strategy for funding key infrastructure investment and further boost the Scottish economy.

33. Capital borrowing powers must also offer the Scottish Government the flexibility to make additional investment in our infrastructure programme, over and above existing funding levels. The Scottish Government welcomes the Smith recommendation that both Governments should consider the merits of a prudential borrowing regime. Scotland has a track record of creating and operating sustainable fiscal rules. We already have a stated policy of limiting our future revenue commitments to a maximum of 5% of our expected future annual Departmental

Expenditure Limits. The Scottish Government would not seek to borrow to fund any structural deficit and would seek to balance its current budget over the cycle.

34. Negotiations with HM Treasury Ministers are currently on-going and we hope to agree a fiscal framework for Scotland during the autumn.

28 August 2015

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

Evidence Session No. 5 Heard in Public Questions 47 - 55

WEDNESDAY 9 SEPTEMBER 2015

Members present

Lord Hollick (Chairman) Lord Kerr of Kinlochard Lord Lamont of Lerwick ______

Examination of Witnesses

Lesley Riddoch, Director of the Nordic Horizons Policy Group, radio broadcaster and journalist, and Peter Jones, freelance journalist

Q47 The Chairman: Thank you very much for coming. We will make a start, despite the traffic situation delaying Lesley. You have seen the list of questions that we have. We do not need to go through them one by one, but just pick out some of them. Clearly you are in the business of explaining things from a certain point of view and shedding light on issues that may not be fully appreciated by your audience.

Peter Jones: Hopefully, yes.

The Chairman: Transparency is at the heart of what you do. How would you characterise the current situation in terms of the public and the thinking public—I do not mean to be derogatory, but those who are concerned about the situation—and their knowledge and understanding of the situation? Is there enough information in the public domain for those interested to be able to form an opinion and to have a judgment, or has this all been rushed through behind closed doors?

Peter Jones: The process itself was certainly rushed through and came to certain proposals in the Smith commission which are flawed, in my view, and I have explained some of my thinking on that in the submission that I made. Since then, the UK Government has published draft legislation and an Explanatory Memorandum. That has been examined by the Finance Committee of the Scottish Parliament, with a degree of examination by the Commons, so there is plenty of information for anybody who wants to find it. My general experience is that the Scottish electorate or public should not be underestimated in their capacity to absorb quite complex information. The Smith commission itself received some 14,000 individual submissions and I think 250 from various organisations. I am certain that all those 14,000 people who submitted submissions will have followed the process as well. If

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005) you look at some of the blogs which are done by people of all sorts of descriptions, then there is a lot of animated discussion about the Smith commission proposals and how the UK Government is handling going on from there. I do not think there is any shortage of information. Whether the understanding is accurate or not is a different question and I could not give an assessment of that.

Q48 The Chairman: Your summary comes to rather a disappointing conclusion that in fact the arrangements could well weaken the UK, in terms of the devolution of income tax with greatly increased borrowing powers. Do you mean weaken it financially?

Peter Jones: Weaken it both financially and politically. Politically, I cannot see how near- complete devolution of income tax is compatible with implementing the EVEL principle, without creating the possibility of very severe tensions down the line. The difficulty is not just the political one of whether a UK Government also has a majority in England; it is also the problem of porosity of borders. England is 85% of the union or thereabouts and anything that it does has an effect on the other countries.

We have had very graphic examples already of how the Scottish Government has had to change proposals, with the introduction of the land and buildings transaction tax. When John Swinney first announced the proposals in October last year, the first innovation was to do away with the slab basis of the tax so that it became a much more marginal and progressive tax, which was a sensible innovation, but at certain points in the scale, particularly for properties worth above £350,000, the tax being raised by the new LBTT was significantly higher than the stamp duty that was raised. In December, in the Autumn Statement, Chancellor George Osborne changed stamp duty as far as land and buildings were concerned and made the charges somewhat lower for properties in what we would class broadly as middle-class households outside of central London—the £350,000-£550,000 range. Although properties are not moveable—you cannot shift a property around, unlike people—John Swinney, Finance Secretary, felt compelled to amend his proposals in January of this year and bring them much more into line with what George Osborne had proposed. He said this was specifically as a result of the amendments made by the Chancellor.

As I say, that is a tax on immoveable property. If you then introduce an income tax border as well as a property tax border, individuals are much more able to move. I think the scope for deviation, if you like, from the English norm under the English tax is extremely limited. I can see it only operating in a downwards direction as one or other country attempts to gain some kind of economic advantage. I cannot conceive of a circumstance where it would work with one jurisdiction moving it upwards and gaining some kind of advantage, either in human beings or working people or in economic gain. I cannot see it working that way; I do not see that it is a functional system.

The reason I think it was introduced is that it derives from the Strathclyde commission, set up by Ruth Davidson, the Scottish Conservative Party Leader, and chaired by Lord Strathclyde. Its clear purpose was to deal with the political problem that the Conservative Party has in Scotland, which is that it is not gaining any ground whatsoever and is gradually declining. The major problem identified was that they cannot offer what is one of the mainstays of the Conservative programme, which is lower taxes, essentially, and therefore by shifting the entire block—by devolving all Scottish income tax—that opens a window of

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005) political opportunity for the Conservative Party in Scotland. I think that is its main purpose. Looking at the membership of that committee, there are absolutely no economists on it. There is no evidence that it has sought any advice from economic sources. It looks to me to be purely a political solution, and I think it is a very bad one economically.

Q49 The Chairman: Your conclusion is that there is very limited scope for different tax rates. I just wanted to follow up with a question. Is it the fact that there is no serious movement available on taxes because they are constrained by Scotland being part of the UK?

Peter Jones: There is no practical, serious freedom there. I imagine if you change band rates for example, that may well have a marginal effect. Although the UK Government is retaining control of the threshold of British taxes, I do not see what is in the legislation that would prevent the Scottish Parliament from introducing a zero-rate band, for example, which would effectively raise the threshold at which tax would be paid. I also think there are macroeconomic problems, which are written about in the paper, so I do not need to go into detail, but I think they potentially damage the UK’s borrowing abilities in the longer term.

The Chairman: The possibility of greater borrowing powers is an invitation to increase borrowings to fund other programmes that which are covered by tax. Is that it?

Peter Jones: If you are going to devolve tax then you have to devolve borrowing powers, otherwise you leave the Scottish Parliament stuck with a balanced budget, which is bad economic management, by and large. It sounds good to the man or woman in the street, but it is economically very inefficient. Therefore, you have to devolve borrowing powers. Those have to be constrained, otherwise you end up with the mess that Spain got into when the central Government started reducing spending in order to meet the various European criteria and deal with a very serious deficit problem, the autonomous communities continued to borrow to fill the gaps and some of those communities got into the most horrendous difficulties and have had to be bailed out by the central Government. You do not want a position either where you can allow excessive borrowing to happen, which would impinge directly on taxpayers in the rest of the UK, because that is not the point of doing it.

Lord Lamont of Lerwick: So is your answer the sharing of tax revenue?

Peter Jones: Essentially it is.

Lord Lamont of Lerwick: You already have that with VAT, which they do not seem to like very much?

Peter Jones: Of course the Scottish Government does not like assigned taxes because it has no control over them, but to my mind there is an incentive there. If VAT is part of what you are getting, and particularly if indexation is introduced in some form or other as suggested by the Holtham commission, there is an incentive to grow the retail space or the buying power of the population so that you can recoup some of the VAT. I think it would be a very odd Government that did not see that there was some kind of incentive there that would give it benefit and the economy general benefit.

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

Q50 The Chairman: Ms Riddoch, welcome. Would you like give us your perspective on this and some comments on the twin principles of sticking with Barnett and the principle of no detriment? How do you see that working?

Lesley Riddoch: I should say first of all that I am not an economist and, unlike Peter, I have not made my trade the business of analysing economics. That was understood when I was asked here, which was at fairly short notice, so I have become an overnight expert on the business of Nordic devolution and the finance of that—while I know the generality of how some of the Nordic nations are funded, the specifics of it needed a bit of drilling down.

On the question of where we are at the moment in Scotland, I see Gordon Brown being quoted today as saying that the UK Government is falling short on delivery of the recommendations of Smith on Scottish devolution. I know that is not the question you asked, but from the point of view of where a lot of people are in Scotland, it really depends what your starting point is. I quite see that from the point of view of the British Government the status quo was a starting point; for 45% of the population of Scotland independence was a starting point; and possibly quite a few people in between had listened to comments about “near federalism”, which was how Gordon Brown put it at one point, and I think “home rule” has been quoted several times by Danny Alexander. In general terms, because that is how people will approach any proposition, there is a sort of expectation that it would be beefy— and this really ain’t beefy.

I think it also strikes people as being, if you like—and I exaggerate for effect—more of a lucky bag than a menu, because it does not look like a thought-through set of ingredients designed to create a wholesome meal. It looks more like a ragtag of heavily negotiated and bartered terms, which we know is the case because we heard what happened in the last stages of Smith. A bit like Russian dolls, each iteration of what is offered is slightly smaller than the last one. All of this does not leave anyone with great hope that we are getting towards something that is a generous settlement; rather that it is heavily caveated. That does not answer your Barnett point.

The Chairman: It is a very helpful perspective because we have heard in other sessions today serious misgivings about some of the ingredients of what is not a particularly beefy offer, the difficulty of reconciling the Barnett formula with the no-detriment principle and whether the powers are sufficient to allow the Scottish Parliament to have sufficient control to deliver economic prosperity and a different balance.

Lesley Riddoch: Or the different economic direction that the Scottish Parliament is trying to pursue in accordance with the will of the Scottish people. That is the problem. If we want to drive our car down that motorway slip road, we actually do not have the gears to do it. You have no doubt heard all of those worries about not having the minimum wage and not having job-creating powers. I do not know to whom you have spoken, but there were several comments that seemed to be fairly astute about this being something that could be very detrimental to the Scottish Parliament because basically it can only tax the middle classes. Not very many Governments see that as an appetising vote-winner. There is usually a range of things you might want to do before you start considering that. I think “transparent fiscal trap” was how one commentator put it and I think a lot of folk would agree.

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

The Chairman: For different reasons, there are those reservations in all quarters.

Lesley Riddoch: Maybe we will get on to this with the Nordic side of things, but it feels that there is not a direction of travel in which everyone has agreed they are going, founded on overarching principles from which some specifics are derived. It looks very much more that there were some specifics negotiated over and now the direction is not too clear. You ask one question—for example: “Is there a veto for Westminster over the creation of new benefit-raising powers?”—and you get two completely different stories from both Governments and from many experts. In terms of transparency, if the experts will not agree on such a critical question as that, and of course experts always have their agendas, we are not too sure as observers what the truth of it is.

Q51 The Chairman: From your quick study of the Nordic countries, what conclusions have you come to? What perspective does that give?

Lesley Riddoch: Particularly the Swedes, but to a lesser degree all of the different countries, have extraordinary tax-raising power at the very local level for everybody. By local I mean what seem to us tiny municipalities of an average of 14,000 to 20,000 people. The vast majority of taxes for Sweden are raised by those local government units, which have the power to vary local income tax rates. For Britain that is pretty mind-blowing. Sweden is at the other end of the spectrum, but when you come to individual islands, such as the Faroes or Greenland in particular, neither of those two regions is actually a member of the European Union despite the fact that Denmark is, and they were able to negotiate an opt- out mostly because of fishing—they did not want to be in the common fisheries policy. While Greenland entered with Denmark, they had a referendum soon after and voted to come out and special arrangements were found for them to be as they wanted to be. It seems that there is quite a lot of effort to be able to shape devolution. One thing which is also interesting is the way in which both Greenland and the Faroes in their agreements with Denmark have the ability to stage and phase the movement of powers according to the pace that both the Faroes and Greenland think is reasonable. The Greenland economic settlement which comes from Denmark is expected to reduce over the years as Greenland begins to make something of its huge potential for fossil fuel extraction. Again, what has been agreed will be at the pace of the Greenlanders. Again, to anyone looking at this it is quite an extraordinarily different world and a much less contested one.

Peter Jones: I am not sure how much the Greenland example is relevant, because one of reasons why the EU agreed that Greenland should not be part of the EU is that it is not actually part of the European continent.

Lesley Riddoch: I think the Faroes are though.

Peter Jones: The Faroes are, but they are a very small set of isolated islands. You cannot say the same about Scotland. Be that as it may, I think looking around the rest of the world, as Lesley said, the Nordic example is worth looking at, although they have a very high tax regime.

Lord Lamont of Lerwick: Local devolution is worth looking at.

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

Peter Jones: Local devolution is worth looking at and how it is managed as well, but I would direct the Committee’s attention to Canada, which operates as a federation. Moreover, if you are interested in maintaining the union and strengthening the union, then Canada as a union has managed to survive with the existence of Québec where there is a very strong separatist or sovereigntist party, as the Parti Québécois call themselves. It means an awful lot of complexity. I have set out, in the submission, some of the complexities of that. It does not look very appetising but the point is that it works, essentially.

Q52 Lord Lamont of Lerwick: I gather that you have been involved both in the community ownership of Rum and in the buy-out, if that is the right word, of Eigg. You have not thought about this devolution of tax to Orkney and Shetland, have you?

Lesley Riddoch: I appreciate, Norman, that you have a keen interest in this.

Lord Lamont of Lerwick: I never thought I would have the opportunity.

Lesley Riddoch: Particularly the Faroes, and to a lesser degree Greenland, have their own currency. It is pegged at a 1:1 rate with the Danish krone, but technically it is their own currency, so I suppose it is quite possible that we could at some incredibly advanced stage move towards that. As Peter is saying, there is an overall philosophy that certain areas have. Federal countries have made a decision that they are going to try to have very clearly separated and autonomous layers of government. Germany is the most successful economic powerhouse of Europe, which was probably created by British civil servants after the war who went in and decided to make sure that there was no way that one evil man could pull off all the goodies. Just deciding to lob a few powers to Orkney and Shetland, or indeed to lob some powers to Scotland, is not the same as a thought-through, coherent way of running something. That would be true hugely of the federal countries but also of the Nordics, most of which did not really have colonies so do not have the wider problem, although Denmark still has that. Norway, just while we are at it, has the Finnmark area, which has been basically handed to the Sami people—they have a 51% ownership of the Finnmark property, which owns a huge area half the size of Denmark. Again the population is negligible but if you are talking in terms of principle, these countries are all able to find ways to make something that works and seems to make sense to both ends.

Peter Jones: I would add that what I would have hoped to come out of the Smith commission and the UK Government’s response to it was a system that was capable of being extended to other parts of the UK, whether it is Wales, Northern Ireland or the north of England or Cornwall. This does not meet that criterion in any sense whatsoever.

Q53 Lord Kerr of Kinlochard: I agree strongly with that. I agree very strongly with the point about ragbag rather than ingredients to match a recipe. I think there are limits to what even the potentates of the House of Lords can do to change what is in the Bill for the present but, looking to the future, should we not be thinking of recommending institutional solutions that might produce further steps in devolution with a better rationale? If you travel across America, you pay a different sales tax rate state by state. People understand that and the sales tax is seen in the public mind as a way of financing local services. You pay the same rate of income tax whichever state of the United States you live in and that goes to the Internal Revenue in DC. There is a fundamental logic about that. This ragbag of taxes that we

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005) are playing with, particularly income tax—I had forgotten that Strathclyde is the guilty party—seems to me to lack all rationale and to make the situation worse, because it is not going to be easy for the man in the street to think, “This part of my taxes is going to finance these services and this part is going down there to London to finance defence and whatever”. There is not going to be any obvious link between the taxes that are devolved and the expenditure decisions that are devolved. Am I right? Is that the problem?

Peter Jones: Yes. I think that in Scotland, if the Smith commission proposals are legislated in the way set out, people will think, “Our income tax finances the Scottish Parliament and nothing of our income tax goes to the rest of the UK”. That weakens the connection between the electorate in Scotland and the UK Government. Depending on your point of view, you might think that was a good or a bad thing, but what are you left with? You are then left with VAT, which people do not think terribly much about, although half of it goes to the Scottish Government, and then corporation tax, which seems to be a dwindling revenue source, both as the UK Government reduces it and as companies find ways of avoiding paying it. The utility of corporate income taxes as revenue-raising seems to be in general decline, not just in the UK but elsewhere. I cannot see where people are going to think that they are paying taxes to finance the UK Government and its major activities, whether it is defence, foreign affairs, overseas aid and all these other things that Scottish taxpayers will be contributing to—the transparency of the contribution I think is going to be almost nil.

Lesley Riddoch: I agree with all that Peter has just said. The big difference between all the places that we have cited and the United Kingdom is that nearly all of them have a bottom-up approach to democracy, never mind tax paying and all the rest of it, but actually that flows from it. For example, if we were in Sweden, only people who earn more than £35,000 a year pay any tax at all to central government. Everybody else pays all their tax to their local municipality. Nobody is in any confusion about the idea, none the less, that they are financing central government through corporation tax and higher-rate earners. Here we have had a very top-down way of financing everything, so the average punter in Scotland sends all their income tax south to get a little bit, through gritted teeth, back to Edinburgh, to get another bit, through gritted teeth, back to councils, which are the largest in Europe and generally speaking nobody knows any of the people that are on them. We call that local democracy. We are already a bit stuffed and now we are trying to divvy something up in a modern way, but I would submit that we are not really working in a modern way altogether in terms of how we approach the direction of travel for cash and authority and democratic validity.

Q54 The Chairman: Given that we are where we are, given that there is the Smith commission and given that the legislation is going through, what changes could be made to address some of the misgivings that you both raise, obviously to meet the genuine concerns, which are likely to make it more difficult for it to work effectively as was intended?

Peter Jones: You have already mentioned the no-detriment principle and I mentioned the indexation principles that I understand are likely to apply to the VAT take. At the moment these are going to be negotiated behind closed doors between officials of the Treasury and the Scottish Government and eventually some sort of agreement will be reached and announced. Nobody will have the faintest idea of how the principles came to be.

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

Lord Kerr of Kinlochard: Immediately it is announced, it will be denounced.

Peter Jones: Yes, precisely. It will become a very hot political potato. The no-detriment principle is fine at the point of devolution, but to apply it thereafter to changes makes absolutely no sense. It is quite beyond the power of econometrics to work out whether a change in behaviour is due to a tax change or a shift in world trade or whatever. Therefore, it should apply only at the point of devolution. The other difficulty is in the indexation principle. If VAT revenues rise by 5% in Scotland and they rise by 6% in England through indexation, then the Scottish take for VAT will drop because we have not matched the retail growth in the rest of the UK. People simply will not understand that; it will look like a straight money-grab by the Treasury from the UK Government on the Scottish take. One change that I would make is that there should be some kind of body that works on an independent basis and is charged with dealing with both the no-detriment principle and the indexation issues. Rather than set up another body somewhere, a relatively efficient way of doing it would be that it should be a joint task force from the Office for Budget Responsibility and the Scottish Fiscal Commission which has been set up. Whatever arguments both Governments want to make, they feed into that body, that body then publishes its proposals and it will be for politicians to dispose of them.

The Chairman: But the facts would be in the public domain?

Peter Jones: The facts would be in the public domain.

Lesley Riddoch: I suppose coherence is the only thing you might hope for out of this. That will be hard to achieve and will not please either side particularly, I would imagine. Whatever is going to occur will be immediately, as you say, rebuffed, particularly by the Scottish Government and by an awful lot of Scottish people because, in much the same way as during the independence referendum, the attention and focus were quite rightly on the proposition that we could be independent, and huge scrutiny was put on that. Huge scrutiny will now be put on the offer, and while it is better than nothing, still people will pick holes in whatever there is that seems to be incoherent and gives rise to some of the problems that Peter has described. To do what? To not really address, most people would feel, the demand for home rule that Scotland seems to be clearly trying to state. I would not be hugely optimistic about what you can do from hereon in that is worth a candle.

Peter Jones: I have set out alternative propositions for how a devolved system might work based on the Canadian model. It is basically to do with the sharing of corporation tax and other similar duties and revenues on an assigned basis, which gives a greater balance to how a budget might move in the future. I would strongly urge the UK Government to go beyond Smith and consider some of those elements.

The Chairman: You refer to them here. Could you send us the work that you have done on that—you have written an article? That would be helpful.

Peter Jones: It is in my submission. It is set out on pages 7 and 8, with a table as to how it might work.

Q55 The Chairman: So in a sense are you both saying that this needs to be moved forward and that it needs to become much more compelling?

Lesley Riddoch and Peter Jones – Oral evidence (QQ 47-55) (DPF0005)

Peter Jones: You have to bear in mind—and it may not seem obvious to you because you spend most of your time in London, although I know that Lord Kerr comes up to Scotland an awful lot—that the broad mindset of the Scottish electorate is that Scotland has had a raw deal from the union essentially. That is why 45% voted yes in the referendum. The SNP in particular has fostered the view, and one of the reasons that it got so far as 45% was that its people and yes supporters said constantly, “Scotland is a wealthy country”. In the middle or just coming out of a recession, a lot people said, “Well, I’m not wealthy. Why is that? Where has all this wealth gone?” Answer: “It has gone down there somehow or other and it is in Westminster”. There were some quite ludicrous speeches by Alex Salmond in which he talked about money being stored in vast caverns in the Treasury but, none the less, people accepted and agreed with that because the general description of Scotland as a prosperous, wealthy country does not fit with their own circumstances. You can say that is true almost everywhere. You can find that in London. You would call London a wealthy city but you can find an awful lot of very poor people, but in London you do not have a nationalist party which is proposing independence for London; in Scotland you do.

The Chairman: I apologise profusely but we have to dash.

Lesley Riddoch: Can I just say one sentence to mitigate that slightly, because as someone who voted yes that is not my perception of it? My perception is that Scotland has the same inequalities of wealth as the rest of the United Kingdom but keeps voting for parties that want to minimise them, and that is the difference. Scotland wants to go, in a general sense, in a social democratic direction. It seems to have been voting for that for 100 years, with a few exceptions, and the difficulty is that there are no levers here to take that new route. I am not blaming England or London for too much—it is quits—but from hereon in I would like to be free to pursue a new direction, and we cannot with this.

The Chairman: That is very clear. Thank you very much. I am sorry this has been such a short session but we have a tram ride ahead of us—if we can find the tram, that is.

Socialist Health Association Cymru Wales – Written evidence (DPF0017)

SHA Cymru Wales: Evidence to House of Lords Committee re funding devolved administrations

1. Purpose

This short paper offers the views of Socialist Health Association Cymru Wales on the funding of devolved administrations as part of the Committee of Economic Affairs deliberations on this matter.

2. Background

2.1. We are fully aware of the history of the Barnett formula, its accidental starting point in 1978/9, and the intentional absence of any use of the concept of "need" within it. Most proposals to modify Barnett seem to assume that changes would be aimed at incorporating some needs based elements.

2.2. SHA Cymru Wales sees four inter-related aspects of such an approach which should be carefully studied.

2.3. First, there are political problems arising from any use of "need" as a key building block. Second, any machinery created to measure "need" would have to be carefully designed to make it credible and protected from any political interference; there are examples of such machinery in Australia and Canada.

Third, were a needs based formula to be used, this might have the perverse effect of fettering the freedom of the devolved Governments. Lastly by such a use; and finally whether there should be a further factor added to that of "need" which I have termed "convergence".

2.4 These four aspects are explored below.

3. "Need"

3.1."Need" is ultimately defined through a political process. For example, to what extent public and private services in Wales should cater for the wishes of Welsh speakers to do their business in Welsh (and other devolved bodies to support Gaelic) is a matter of judgment. In many federal or similar polities that have formulas governing the distribution of funds from central government to lower levels, the broad definitions of "need" are produced by a political process. The role of any expert body is then to measure the extent of relative needs in each polity and devise resource allocating formulae.

3.2. In the case of the UK, it would seem that any definition of need(s) would have to be applied across the four administrations. That definition will almost certainly be dominated by the attitudes to "need" that are held by various English interests as England is the largest country. (There might of course be pleading for special factors to be recognised - such as the post conflict needs of North Ireland). It is possible that, within England, its rural and post

Socialist Health Association Cymru Wales – Written evidence (DPF0017) industrial areas will have some affinity with like conditions in Wales and Scotland but it is also probable that, for many reasons, a London centric view of England's needs will prevail.

3.3.It this is so, Wales may find it difficult to ensure its view of need commands sufficient support across the UK.

4. Fettering the discretion of devolved Governments

4.1. Despite the problems of agreeing "needs", if a clear formula emerges, there is then the possibility that the interest groups whose needs are recognised by the formula will seek to ensure that the funds delivered to Wales are applied directly for that purpose.

4.2. At the moment it is relatively easy for devolved administrations to argue that, because Barnett is imperfect, they can manage the total resource at the total block level. However, once a refined needs - based approach is both crafted and made publicly explicit, using the funds derived from recognising one "need" to boost another area of Government will be come increasingly difficult. The current freedoms to transfer funds derived from, say, spending on local government in England to devolved NHS services will be open to greater informed challenge by the interests who feel cheated.

4.3. Should this occur, the devolved administrations could become merely a conduit through which money allocated through a formula designed elsewhere reaches its intended needy location/ interest group.

5. Who measures need - and how?

5.1. Whether a UK wide political process determines "need" and then uses an expert group to measure the level of need in each of the four countries, or whether such an expert group is used to both define need and then measure it, clearly there will need to be some new and independent machinery.

5.2. Australia and Canada tackle this problem with one central, independent, body that regularly computes the sums due to the devolved level.

5.3. In the UK context, setting up a body that is trusted to assess "need" seems to me to run counter to our long standing democratic traditions. Hence it is likely that any expert body will be restricted to: a) measuring, as best it can, how the relative needs (as defined politically) of the four polities (or even the regions within England) relate one to another and b) devising methods by which these are met in financial terms.

5.4. The skills and data needed to do this - and the constitutional protections it will need to preserve its independence - deserve great thought.

6. Convergence

Socialist Health Association Cymru Wales – Written evidence (DPF0017)

6.1. In addition to the challenges involved in measuring need and employing that notion fairly to share funds among the four UK countries, there is a further important factor to consider.

6.2. This is the extent to which any sharing of funds must take account not only of need, but should also be weighted to seek to bring over time the four countries (and in England its different regions) towards convergence (in wealth, health outcomes, etc). Again, this is a political judgement but there is some evidence to suggests that not only has the UK become increasingly "unbalanced" but that level of imbalance has become unhealthy.

6.3. Applying such a convergence factor might be done merely by a "weighting" factor to be applied to the shares that derive from any needs assessment but there is a case for trying to compute what financial resources should be moved within the UK to fund activities that are likely to reduce the inequalities within the UK.

7. Conclusions

Perhaps the best way forward is not to spend time seeking to devise a "needs based" formula as such. Rather, better and swifter progress might be made by retaining the current imperfect Barnett formula but applying some weighting factor to speed the convergence of the economies and societies of the component parts of the UK.

17 August 2015

Professor Adam Tomkins, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002) Professor Adam Tomkins, University of Glasgow; Professor Ronald MacDonald, University of Glasgow; Professor John McLaren, University of Glasgow – Oral evidence (14-27) (DPFOE0002)

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

House of Lords Economic Affairs Committee

Inquiry into The devolution of public finances in the United Kingdom

MEMORANDUM BY ALAN TRENCH*

1. This memorandum is intended to assist the Committee in relation to my oral evidence on 21 June 2015.

2. My work on devolution and particularly its financial framework has had a significant impact on many of the present proposals for devolution. I worked with the Institute for Public Policy Research on its ‘Devo More’ project in 2012-14, which laid out the key proposals that informed the work of the Scottish Labour and Conservative parties’ commissions on further devolution, and the work of the Smith Commission. That project produced two substantial papers, on fiscal devolution (Funding Devo More: Fiscal options for strengthening the union, January 2013) and welfare issues (Devo More and Welfare: Devolving benefits and policy for a stronger union, March 2014), which are available from the IPPR website.99 More recently, I have worked with the Bingham Centre for the Rule of Law on its devolution review chaired by Sir Jeffrey Jowell QC, published as A Constitutional Crossroads: Ways Forward for the United Kingdom in May 2015, particularly on the financial issues addressed in the report.100

Tax devolution and its implications

3. The package of tax devolution adopted by the Smith Commission – based on devolution of all personal income tax and assigning a share of VAT receipts, along with land taxes – was first proposed in Funding Devo More. This package was designed to bring about a closer relationship between devolved spending and tax revenues, and to put in the hands of devolved governments those taxes bests suited for exercise at a more local level. This package was also designed to minimise the scope for potentially damaging spill-overs, so that devolved tax decisions taken in one part of the UK would have the least impact possible on other parts of the UK. In doing so, it took into account the lessons that can usefully be learned from federal and decentralised countries overseas, which offer a wide range of models of fiscal devolution and experiences of it.

* Research fellow, Bingham Centre for the Rule of Law; honorary senior research associate, The Constitution Unit, University College London; specialist adviser to the House of Commons Welsh Affairs Committee, 2010-15. 99 Funding Devo More is at http://www.ippr.org/publications/funding-devo-more-fiscal-options-for-strengthening-the- union. Devo More and Welfare is at http://www.ippr.org/publications/devo-more-and-welfare 100 The Bingham Centre report is available at http://www.biicl.org/documents/595_a_constitutional_crossroads.pdf

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

4. The Scottish proposals are the most far-reaching but not the only ones that have to be taken into account. Partial devolution of income tax for Wales was recommended by the Silk Commission and enacted by the Wales Act 2014, to come into effect following a referendum. The Stormont House Agreement of December 2014 endorsed a range of financial changes for Northern Ireland, including civil service and welfare reform, and for devolution of corporation tax subject to other changes taking place. Corporation tax devolution was enacted in the Corporation Tax (Northern Ireland) Act 2015. While it is questionable whether either of these provisions will in fact come into effect, they may well do so – and further measures of fiscal devolution may follow subsequently.

5. Fiscal devolution offers other advantages to a devolved UK, beyond the principle of ‘financial accountability’. It enables devolved governments to use tax levers as well as other levers in policy areas for which they are responsible. It enables devolved governments to make their own choices, for which they are accountable to their own electors; if they want to spend more generously on public services, they must justify the higher taxes needed to do so, and if they want to cut spending, they can also offer a reduction in tax levels. (The gearing of devolved taxation means that this only becomes a realistic prospect if substantial tax capacity is devolved; that is why such measures as the Scottish variable rate enacted in 1998, or the 10-pence tax power in the Scotland Act 2012, are insufficient to deliver meaningful scope for policy choice.) For Scotland, this will mean that the taxes under the control of the Scottish Parliament would amount to 36-46 per cent of its spending in 2012-13, and devolved and assigned taxes would have accounted for 48-60 per cent of devolved spending in that year. (The range is due to different ways of accounting for the total range of devolved spending.)

6. The ‘devo more’ model was also intended to work for other devolved governments than Scotland, if there were support in Wales or Northern Ireland for it to do so. The different economic circumstances of those parts of the UK mean, however, that much greater attention is needed to the workings of the grant element of funding devolved administrations than is the case for Scotland. I argue below that this attempt to use the existing grant arrangements for Scotland may appear more straightforward than a wholesale reconstruction of it, but that it is itself deeply flawed.

7. On this basis, I broadly support the general thrust of the recommendations made by the Smith Commission and set out in the current Scotland bill. However, there are many difficulties with the precise means of doing so proposed by the UK Government, though these relate more to the implementation of the proposals as a matter of practice than the contents of the current Scotland bill.

Grant issues

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

8. In A Constitutional Crossroads, the Bingham Centre calls for the replacement of the system of block grant funding used at present, known as ‘the Barnett formula’ by way of shorthand. This is not to say that a grant element will not be needed, nor that in some respects such a grant will continue to work in ways similar to the present Barnett formula arrangements. The changes needed to those present arrangements to make them appropriate for the new constitutional and financial dispensation are so extensive, however, as to mean that using the same name would wrongly imply any continuity between the arrangements as they should be.

9. The most significant issue in relation to grant is to work out what level of services it is meant to fund. The Barnett formula system implicitly ties devolved governments to the same overall package of public services as applies in England.101 This was appropriate for the circumstances for which Barnett was designed in the late 1970s, to allocate (some) changes in spending on functions in England to the territorial departments responsible for Scotland, Wales and Northern Ireland which were run by ministers in the same, UK- wide government with a shared political mandate and cabinet collective responsibility. The creation of distinct devolved legislatures meant that that this shared accountability no longer existed.

10. Although devolved governments are free to allocate the block grant as they see fit, the amount of the block grant depends on changes made for England. The significance of this is veiled by the fact that the formula only applies to incremental changes, but if the UK Government makes a large enough spending decision affecting ‘comparable functions’ in England, devolved governments will have to adjust to that decision. Their options for doing so are to cut their spending (either on that function, or on other functions in order to protect a favoured one), to raise more revenue (if they have sufficient tax powers) or to follow the UK Government decision. Minor spending decisions will not have this effect, but a change like the cut in the teaching grant for universities in England announced following the Browne review of university tuition fees in 2010 and taking effect from 2012 was large enough to do so. The problems that this creates are all the more serious if devolved governments are not involved in the making those decisions. They are also aggravated when changes and particularly cuts in comparable spending are made in the middle of a financial year, as has now happened on several occasions.

11. The impact of this link with English levels of spending has been limited to date, for two reasons. One is that the bulk of devolved spending is on health and education functions,

101 The working of the Barnett formula is set out in HM Treasury Funding the Scottish Parliament, National Assembly for W ales and Northern Ireland Assembly: A Statement of Funding Policy Sixth edition, 2010. For a detailed discussion, the report of the House of Lords Select Committee on the Barnett Formula The Barnett Formula (1st report of 2008-09), HL 139, may be useful. (I was specialist adviser to that committee.)

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

and the protection of health and schools spending for England since 2010 has cushioned the bulk of devolved budgets. The other is that Scotland and Northern Ireland are, so far as we can tell, generously funded compared to the levels of relative needs there.102 (Data difficulties make it hard to come up with precise figures, but the general issue is clear.) That means Scotland and Northern Ireland have a degree of room for manoeuvre that Wales does not, and which they would not have if they did in fact receive grant related to relative need.

12. There has been a good deal of talk about a ‘baseline review’ of the block grant, to ensure that the underlying levels of grant funding correspond to relative need (or correspond more closely). This no long appears to be necessary for Wales, which was ‘under-funded’ relative to need in the later 2000s. Changes since then, notably the protection of health and education spending since 2010, mean that is no longer an issue. Wales appears no longer to be ‘under-funded’, but funded within the range of its relative needs. The issue for Wales is convergence. This is an arithmetical property of the Barnett formula. Over time, if nominal levels of public spending increase and the population numbers used are accurate, the grant for all three devolved governments should converge on the English level of public spending. That in itself should mean that a baseline review is less pressing, at least when public spending increases even in nominal (not real) terms.

13. What remains a puzzle is why convergence in the amounts allocated by the block grant did not occur for Scotland during the 2000s. The sustained and significant increase in public spending then should have meant it happened.

14. These general problems of the amounts of money allocated through the block grant system are not the only reasons why it is no longer fit for purpose. A second set relate to the ‘no detriment’ principle, which has been used by the UK Government in its proposals for implementing the Smith Commission recommendations. ‘No detriment’ is meant to ensure that tax devolution is revenue-neutral in principle (if the Scottish Parliament were to set the same rates of tax as the UK Government does, it would have the same resources), by providing for an indexed reduction in the block grant which should ‘dynamically and mechanically reflect changes in tax foregone by the UK Government over time’.103 It is also intended to provide that a government which takes a tax decision

102 The criterion of ‘relative need’ has long been used to underpin the principle of resource allocation, particularly for local government and health. Its application has been imperfect in practice, though: see House of Commons Committee of Public Accounts, Formula Funding of Local Public Services, Fifty-fifth Report of Session 2010–2012, HC 1502 (London: The Stationery Office Limited, 2011), and has now broken down further with changes to local government and schools funding and health service reforms. The only substantial attempt to relative need for the UK’s devolved governments was carried out by the Independent Commission on Funding and Finance for Wales, appointed by the Welsh Government and usually known as the Holtham Commission, which published its final report in 2010. Holtham concluded that relative needs for Scotland (compared with England) were around 104-5 per cent, for Northern Ireland 121 per cent, and for Wales between 114 and 117 per cent. See Independent Commission on Funding and Finance for Wales Final report – Fairness and Accountability: A New Funding Settlement for Wales (Cardiff: 2010). 103 HM Government Scotland in the United Kingdom: An enduring settlement Cm 8990, January 2015, paragraph 2.4.7.

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

which affects the revenues of another will compensate that other government accordingly.104 (In addition, a third version of ‘no detriment’ is meant to relate to spending devolution of welfare functions.)

15. The first of these issues raises the question of how the block grant should be adjusted to allow for tax devolution, an issue which has been the subject of considerable debate since the first measure of tax devolution was proposed by the Calman Commission in 2009. It presents considerable practical difficulties which have not been effectively addressed to date. (This difficulty has been particularly great in a Welsh context, but have been significant in Scottish and Northern Ireland contexts too.) Such questions will inevitably become highly charged politically. Addressing such a mechanism by making adjustments to the Barnett formula is in my view the wrong way to address the problem, and in Funding Devo More I outlined an alternative approach. (See particularly chapters 5 and 6.) Trusting HM Treasury to make such adjustments without institutional changes is to invite grave intergovernmental difficulties.

16. The problems presented by the second version of ‘no detriment’ are, if anything, greater. This principle will be impossible to accomplish in practice, if only because of the dynamic effects of tax devolution. Placing such emphasis on such a vague principle, without adequate machinery to implement it, simply invites a sequence of poorly explained, highly contentious ad hoc adjustments to the block grant that will be based on questionable evidence and so will be highly subjective in nature. This will be the opposite of a ‘dynamic and mechanical’ adjustment to the block grant.

17. In these respects, therefore, it is impossible to say that the UK Government’s proposals in Scotland in the United Kingdom: An enduring settlement in fact create the basis for an enduring financial settlement.

Institutional arrangements for a fiscally decentralised Union

18. All reviews of the institutional arrangements for devolution finance since 1999 have been critical of what has been put in place, and in particular the huge discretion given to HM Treasury. It is clear that significant fiscal devolution will put further strain on these arrangements. It is hard to see how that level of discretion can continue; the Treasury cannot be trusted not only to be judge and jury in its own cause, but also responsible for gathering the evidence and applying the sanctions it determines.

19. Two new institutions are clearly needed. First, there needs to be an independent, non- political expert body responsible for giving authoritative advice on amounts of grant

104 Ibid, paragraph 2.4.14.

Professor Alan Trench (University of Ulster) – Written evidence (DPF002)

payable to devolved governments, reduction from that grant to allow for devolved tax capacity, and a range of other technical issues. An institutional model for this is the Commonwealth Grants Commission in Australia, as recommended by the Select Committee on the Barnett Formula in 2009. (There is further discussion of this in A Constitutional Crossroads, particularly section 6.7.) Second, there needs to be an independent body to resolve disputes and disagreements that might arise (not necessarily limited to financial ones). Without such changes, it is hard to see how the public at large, or the governments involved, can have confidence in the system.

20. Going beyond institutional changes, there also needs to be greater disentanglement of public finances so that devolved finances are not so dependent on UK ones. This applies to fiscal devolution (including the calculation of devolved tax capacity, the determination of tax bases and collection arrangements), in grant (particularly transparency about how the block grant is calculated and varied following spending changes in England) and to administrative arrangements (including the Budget Exchange arrangements that replace end year flexibility, and the way that decisions about spending for England drive changes for devolved governments as well). Otherwise, it is hard to see how the financial structure of the UK will not conflict with its devolved constitutional structure.

Alan Trench 18 July 2015

Professor Alan Trench, University of Ulster; Professor David Heald, University of Aberdeen Business School; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001) Professor Alan Trench, University of Ulster; Professor David Heald, University of Aberdeen Business School; Professor Jim Gallagher, University of Glasgow; Dr Angus Armstrong, NIESR – Oral evidence (QQ 1 – 13) (DPFOE0001)

The Weir Group PLC – Written evidence (DPF0012)

Written evidence from The Weir Group PLC to the House of Lords Select Committee on Economic Affairs inquiry into the devolution of public finances in the United Kingdom

August 2015

Introduction

1. The Weir Group PLC is a global engineering business based in Glasgow, Scotland. Founded in 1871, the Group has grown to operate in more than 70 countries, providing highly engineered equipment to mining, oil and gas, and power customers. In 2014, the Group generated £2.4bn in revenues and currently employs approximately 15,000 people, including around 600 in Scotland and 900 in England.

2. Weir welcomes the opportunity to contribute to the Committee’s inquiry. We have chosen to only answer those questions where we think it most appropriate to do so.

Fiscal framework

Should devolved governments receive further borrowing powers? What form of contract between the UK government and the devolved nations will prevent bailouts if government’s do not stick to their borrowing limits?

3. In order for the new fiscal framework to be stable and therefore to promote business confidence, it would be beneficial for the Scottish Parliament to be granted additional borrowing powers with access to the bond markets.

4. This would give the administration at Holyrood greater flexibility across the economic cycle, while at the same time exposing it to the discipline and transparency imposed by market dynamics. To allow the powers to be sufficiently meaningful, the fiscal framework agreement between the Scottish Parliament and rest of the UK could adopt the 3% of Gross Domestic Product (GDP) criterion currently in place in the Eurozone. Using the Scottish government’s latest GDP estimate for Scotland of approximately £153bn105 (including a geographical share of extra-regio activity), would result in the Scottish Parliament receiving a maximum borrowing limit of £4.6bn. To give context, the UK’s public sector net borrowing for the month of June was £9.2bn106. This additional flexibility would also reduce the focus on the Barnet Formula which often dominates discussion of Scotland’s public finances.

5. In order to maintain confidence, there would need to be a robust agreement in place between the Scottish Parliament and the rest of the UK, which may need to be backed by legislation. It would also be beneficial to extend the remit of the Office for Budget Responsibility to Holyrood, thereby giving the public access to external

105 http://www.gov.scot/topics/statistics/browse/economy/QNA2015Q1 106 http://budgetresponsibility.org.uk/wordpress/docs/July-2015-PSF-commentary.pdf

The Weir Group PLC – Written evidence (DPF0012)

analysis of Scotland’s public finances and helping parliamentarians provide an effective set of checks and balances to the executive power of the Scottish government.

What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?

6. Full fiscal autonomy, if defined as the devolution of all powers except those in relation to defence and foreign affairs, would have the effect of potentially undermining the economic union and creating a far more complex fiscal environment for businesses and individuals in the UK. From a business perspective, the full devolution of all corporate taxes and regulation would almost inevitably lead to divergence. While this could include positive aspects for business, it would also involve increased costs and complexity for businesses such as Weir, which operate across the UK’s borders, which would be negative. The UK tax system is currently perceived as relatively complex, full fiscal autonomy for Scotland would only add to that complexity. Recent estimates107 suggest Scotland’s deficit under full fiscal autonomy would be substantial necessitating, as the Institute of Fiscal Studies noted, “substantial spending cuts or tax rises in Scotland”. If any additional tax burdens were to fall on businesses based in Scotland, it would make the operating environment less favourable.

Tax Powers

What are the implications for devolving corporation tax to Northern Ireland? Will it have an effect on business in the rest of the UK?

7. The most obvious implication of devolving corporation tax to Northern Ireland is to break the current UK-wide system of corporate taxation. Weir does not have any operations in Northern Ireland and therefore cannot comment on its implementation there. However, by devolving corporation tax to one constituent part of the United Kingdom, we will see the impacts of differentiated rates if the administration at Stormont decides to vary the corporate tax rate from the rest of the UK.

With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)?

8. From the perspective of a Scotland-based company with operations in England, if corporation tax were to be devolved to Scotland, it would introduce complexity and potentially end the current UK-wide system of group-relief which allows Weir to offset losses made in Scotland against profits made in England. Weir’s losses in Scotland are as a direct result of its head office functions being based there. As a business operating across a number of tax jurisdictions, Weir sees the added complexity created by transfer pricing and cross border tax issues. The UK’s corporate taxation regime is already very competitive and therefore the Group does not see the merits of devolving corporation tax to Scotland and potentially importing

107 http://www.ifs.org.uk/publications/7722

The Weir Group PLC – Written evidence (DPF0012)

additional complexity and consequent costs. It is also worth noting that corporation tax rates are only one consideration when companies make investment decisions alongside stability, infrastructure and labour availability.

Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?

9. Any reforms which make the UK and its constituent parts more attractive to investment are to be welcomed. However, if a scenario were to emerge where Scotland, for instance, were to increase income tax above the rate levied in the rest of the UK, this would have a negative impact on business’ ability to recruit and retain senior managers, undermining Scotland’s attractiveness as a head office location. From Weir’s perspective, we have already seen potential candidates for senior posts question the future tax environment in Scotland and take that into consideration when considering relocating from other parts of the UK. Any tax divergence which made Scotland or any other part of the UK less attractive as a business location would not be welcomed by the Weir Group.

Conclusion

10. The Weir Group PLC welcomes the opportunity to contribute to the Committee’s deliberations and looks forward to its recommendations.

25 August 2015

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Evidence Session No. 8 Heard in Public Questions 98 - 107

TUESDAY 20 OCTOBER 2015

Examination of Witnesses

Keith Cochrane, Chief Executive, The Weir Group, Professor John Kay, Visiting Professor of Economics, London School of Economics, and Professor Noel Lloyd, Member, Silk Commission, and former Vice Chancellor of Aberystwyth University

Q98 The Chairman: I welcome you all to the Committee. Thank you for your forbearance. We had to pop downstairs and meet the President of China, who made some very nice remarks about the great links between our countries. He seemed to be looking forward to his fish and chip dinner in a pub. That all went down very well. I am conscious of the fact that by moving this session we have a very tight timetable, so we will stick strictly to one hour.

Could I start by asking you to what extent you think the choices of taxes that are being devolved have been governed by any principles? As a follow-up, should corporation tax have been devolved to Scotland and Wales? Who would like to start?

Keith Cochrane: Perhaps, my Lord Chairman, I could start. For me, the fundamental principle is driven by the desire and, indeed, the need to give more accountability and more responsibility to the Scottish Parliament. Against that context, devolution of income tax is in reality the most practical and sensible choice to enable that to take place. Clearly, it does not result in a straightforward system going forward. There will be some complexities, no doubt. Our own thinking had been that, while the tax rates themselves could be devolved, perhaps the bands and the underlying legislative processes would remain consistent across the UK. The latter piece is certainly the case, but the former is not. There is a risk of more complexity given the approach that has been taken.

In terms of your second question about corporation tax, I and my company, the Weir Group, have been very consistent in saying that one of the most important benefits of the union has been the maintenance of a free market—the ability to trade freely right across the United Kingdom—and the challenge in doing anything with corporation tax is that it risks putting a question mark against that ability, and indeed introducing a lot of complexity for business. It was wise not to devolve corporation tax.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Professor Kay: If one looks at what taxes it is sensible to devolve, the first question to ask is how easy it is to attach a location to the thing you are trying to tax. Of the three big taxes in the UK, which are income tax, VAT and national insurance, VAT is a transactions-based tax that we cannot devolve for EU reasons; income tax is basically about residence; and national insurance is about workplace. Either of those are not bad from the point of view of attaching a location, but there is a good reason for not choosing income tax rather than national insurance, which is that national insurance is tied up with the benefits system, which you are not devolving very far. That is a sensible choice. If you go down the list of large taxes, the next one you come to is corporation tax, which is probably the hardest of all taxes to attach a location to. It is, basically, not working globally at the moment because of the difficulty of making that attachment. You then get down to the next group, which in order of size are fuel duties—really problematic to put a location on by the very nature of the tax—and business rates and council tax, which are, sensibly, devolved. In terms of underlying principles, the choice of devolved tax has been quite sensible.

Professor Lloyd: Going back to the work that we did in the Silk commission—my interest in this—on the devolution of financial issues to Wales, we initially established a set of priorities and criteria in terms of accountability, empowerment, incentivisation and stability. We checked, in a sense, every possible tax against those principles and came up with a very similar list, in that it needed transparency and stability for income tax and the smaller taxes, which in those days was stamp duty land tax. It is interesting that, working from those principles, we came up with a similar list of taxes to be devolved as is happening in Scotland. We looked very closely at corporation tax and, indeed, spoke to colleagues in Scotland and Northern Ireland. We came to the conclusion that it would not be sensible to devolve corporation tax. It is volatile to start with, it is unpredictable in some ways in terms of location, and it is a very complicated tax to operate. Against our principles, we were quite firmly of the view that, unless and until it was devolved to Scotland and Northern Ireland as well, we did not think it was useful to devolve corporation tax to Wales.

The Chairman: Did the commission look at the merits or otherwise of devolving tax on oil and gas from the Scottish part of the North Sea?

Professor Lloyd: We were not looking in particular at the Scottish element of it, obviously, but for other taxes we did a survey of the others and felt that in terms of Wales it would not make sense to have devolution. One of our principles was that, just because it was happening in Scotland, it did not necessarily mean that it would be good for Wales. One has to address the conditions in Wales, which may on some occasions be different from those in Scotland.

Lord Forsyth of Drumlean: I would like to comment on the principle of using income tax. Perhaps this is a problem that I have. I live in Scotland and I end up paying my income tax, which goes towards running the Scottish Parliament. On the question of accountability, if all my income tax is going to that purpose, I have no real interest, do I, in what is spent on defence and non-devolved issues? Is it not rather unusual—I cannot think of even a federal system—that all the revenue comes from income tax? Normally, you have a proportion that is then allocated in a particular way. It may be convenient, but it is not clear to me that the principle is right.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Professor Kay: Your VAT is going on defence and other non-devolved functions.

Lord Forsyth of Drumlean: I understand that.

Professor Kay: If there were freedom on VAT, one might well wish to do rather more. Clearly, the compromise by which part of the VAT is allocated to Scotland is a rather unsatisfactory one. Equally, there is probably more difficulty in pinning down the location of VAT.

Lord Forsyth of Drumlean: Of course, VAT is not a progressive tax. It is regressive.

Professor Kay: Yes. That is an interesting question. Given that we are in a United Kingdom, do we want there to be more progressivity, or an opportunity to have more or different progressivity at the devolved level? That is an issue about which you can argue, and one of the key moves in the Smith commission is to change that, to give some opportunity for Scotland, if it wants to have a more progressive tax system, or less.

The Chairman: But is there not a contradiction? Devolution—let us call it devo-max—or a significant amount of devolution is in order to provide the devolved part of the United Kingdom with the levers to improve their own economy, to improve their productivity. Many countries have used tax to do that. It seems to me that this is a natural direction of travel for the devolved Scottish Parliament.

Professor Kay: Yes, I think that is right. Lord Forsyth, to my mind, raised the question of what is the object of devolution in the first place, which is really the question from which you ought to begin all discussion. One of the problems of this discussion is that that is not where it began.

Q99 Lord Turnbull: We have a mixture of devolved taxes, shared taxes and direct grant. I get the impression that if you take the big picture you seem to be reasonably satisfied that it is better than the status quo, and in particular that one of the festering sores of all this in the Barnett formula, the direct grant bit of it, is now substantially reduced. Are you roughly satisfied, and if you had actually been on the Smith commission yourself is there anything significantly different that you would have done?

Professor Kay: Given the direction that the Smith commission was forced to go in, in effect by the political situation, I do not think I would have wanted to do anything radically different. I agree with Mr Cochrane that the primary purpose had to be to try to raise the tax-raising powers of the Scottish Parliament to something rather more commensurate with its expenditure levels than the status quo allowed.

Lord Turnbull: We have had in the past a Scottish income tax power, never used. Do you think this income tax power is going to be significantly used?

Keith Cochrane: That is a very interesting question. One of the challenges will be for the Scottish Parliament to move itself from a debate only about outputs to considering the inputs necessary to deliver those outputs, which again gets to the heart of what is to be achieved in terms of providing, if I might say it, a sensible dose of reality to some of those discussions and understanding the consequences. There will have to be trade-offs. We are

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) already hearing that in terms of some of the comments from political parties. Frankly, I am of the view that the sooner those powers are transferred and active in Scotland the better, because it will change the debate. It will ensure that at the next Scottish parliamentary election, which takes place next year, this will become a very real issue and start to inform the debate that the electorate of Scotland can opine upon.

Professor Lloyd: Although in Wales we are coming from a slightly different position in terms of quantum, the principle that Mr Cochrane mentioned, of ensuring that the Welsh Government have responsibility for raising taxes as well as spending taxes, is roughly what we mean by accountability, but also in terms of giving the Welsh Government an opportunity to develop the economy in terms of incentivisation. One of the cornerstones of the recommendations of the Silk commission is that the Welsh Government should have that opportunity to develop the economy of Wales by having those responsibilities. We were very keen on that. To answer the question about those powers not being used in Scotland to date, that is why the Silk commission was very keen to ensure that the bands of income tax could be changed independently—the lockstep issue—rather than tied to each other. We felt that perhaps the reason for not using it in the past was that you did not have that flexibility and that if you changed the standard rate you had to change the higher rates in the same way. Although having that independence was initially turned down by the Government of the time, it was changed. In the Wales Act 2014, that independence on possible changes was agreed. You might see a very different situation in the future given that that lockstep has been removed.

Lord Turnbull: Is it right that the only thing that is common is the first band, where the basic personal allowance is common?

Professor Kay: And the base of course. It is not as simple as saying that the personal allowance is common, because there would be nothing to stop you having a zero rate on, say, the first £1,000 of taxable income, or there is nothing that I can see that would stop that. It might possibly be something the Scottish Government would consider doing, because from where the Scottish Government are now they absolutely have to do something; the business of not doing anything, which has been true up to now, is now impossible. Having made a great song and dance about the need for more powers, you cannot then say, “Now we have got them, we are not going to exercise them”. But then what is discovered is that the amount of money that comes from tinkering with the income tax structure is quite a lot less than people believed. I have sketched out what really would be the most draconian sets of innovations and adjustments you could make without prompting mass migration from Scotland. That might raise an extra two to three billion.

Lord Turnbull: What was the size of your threshold?

Professor Kay: I was going to leave the threshold, and I was going to knock all the rates of tax up by five points, so it would be a basic 25% rate of income tax in Scotland. It is only from the basic rate that large amounts of money come.

Lord Turnbull: First of all, what revenue would it raise, and do you think that would have people scurrying for the border?

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Professor Kay: That package would raise £2.5 billion or so, which is about 6% of total Scottish Government expenditure—less, rather paradoxically, than the amount per capita by which public expenditure in Scotland currently exceeds the UK level.

Lord Turnbull: Right. I think that others will take that. Let me ask one last question about Wales. Having seen the Smith package, are there any bits of it that you would significantly not want to adopt or do so to a lesser extent?

Professor Kay: There is the big question, to which I am sure we are going to come.

Professor Lloyd: In general terms, the Smith recommendations were not very different from the ones that we had recommended. Going back to the mixed economy of a smaller proportion of income tax being devolved than is now proposed in Scotland, it is right for Wales, because it is a very different situation in terms of what is sometimes called the porousness of the border, with 90% of the working population of Wales living within 50 miles of the border. You have a different situation to take into account in terms of migration. Our feeling was that a mixture of shared income tax base would be appropriate for Wales. Perhaps the argument in Scotland is slightly different.

Q100 Baroness Blackstone: How easy is it going to be to identify Scottish income taxpayers? Are we being too ambitious in aiming for 2017-18 for the introduction of the new powers? Is it going to put the tax authorities under so much pressure that they will not be able to complete this adequately?

Professor Kay: I do not have particular knowledge of the administrative side of this. In the case of most people, it is not very difficult to determine where their residence is. The trouble in this case, or perhaps in any case, is that the people for whom it is more difficult tend to be the people who have the money. If you look at who the additional rate taxpayers are, there are something like 15,000 of them in Scotland. Most of them, one suspects, work in Edinburgh in financial services or in activities related to it. I suspect that a high proportion of those people have some base in England as well. That is the difficulty, and that is why I am sceptical about how much of any revenue would be raised by adjusting the additional rate of income tax, which is the one commitment that all the parties in Scotland seem to have made so far.

Lord Forsyth of Drumlean: There is also the point that dividend income will be taxed on a UK basis. If you have more than one job, you simply set up a company and pay yourself in dividends.

The Chairman: I think we should try to avoid giving tax advice.

Lord Forsyth of Drumlean: I was not giving advice. I was pointing out that there is a big hole in the bucket.

Q101 Baroness Wheatcroft: The Barnett formula is something that even the late Joel Barnett thought had outlived its usefulness, but it is pivotal to what is going on here. Do you think that that is a sensible way forward, or should there have been an adjustment based on needs? Should it be far more needs based than what we are looking at at the moment?

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Keith Cochrane: I cannot claim any specialist knowledge on Barnett. My own perspective—it may be very simple—is that, given the complexities that are clearly inherent in the way the current formula works and given the substantial change that is taking place, can we not just draw a line and say, “This is the amount of block grant. It was set many years ago, subject to many different factors, which everyone would recognise have moved on, potentially to date. Is it possible to make a fresh start?” The biggest challenge with Barnett, and the challenge we have going forward, particularly against a means for adjustment, is that it becomes a perpetual debating ground. I would be very keen, but I will let my learned colleagues here comment upon whether it is possible. In my own view, if you could come up with a transparent, straightforward, visible—I am not going to say understandable, because I doubt it will be understandable to the average layman; but at least visible—and objective means by which—

Baroness Wheatcroft: It might be more understandable.

Keith Cochrane: It might. I completely agree. That would create a far better platform. My fear is that, if we do not address it appropriately, all we are going to do is create problems down the way, because there will inevitably be debate and indeed dispute about the adjustments that are going to be made. Having clarity, transparency and objectivity, perhaps involving an independent body in some form of review mechanism, from my perspective, as a businessman and certainly not an economist, would be the right thing to do.

Baroness Wheatcroft: Professor Kay, is it an opportunity wasted?

Professor Kay: Yes and no. If you were starting again, you certainly would not start from here. That is for sure. The core problem, which people do not want to talk about too much, is that if we move to a more objectively based system, unless you decide that the oil is Scotland’s, and at current prices even if you do decide that the oil is Scotland’s, Scotland gets too much. That is a fundamental problem in moving to a more sensible basis for the formula, and is why no one has been anxious to reopen this on either side.

Professor Lloyd: The Barnett formula is something that excites a lot of people in Wales, because there is a feeling that Wales is underfunded as a result of the formula. In terms of the commission, it was outside our terms of reference, although in our evidence gathering we received a large amount of evidence on the problems of the Barnett formula. One thing I would say, and of course everybody agrees, is that we would not start from here. Transparency is important. There are mechanisms for establishing a formula on some kind of needs basis. One of our predecessor commissions in Wales—the Holtham commission, which reported to the Welsh Government, not to the Westminster Government—proposed a mechanism by which that could be done. It was quite complicated, and in terms of public understanding there would be a challenge, but it is possible to do it, and it is done elsewhere, of course. Internationally, there are other examples of attempting to do it. Ideally, I suspect that most people in Wales would say that, yes, there should be a needs- based formula, but the political situation is such that it is not very easy to achieve, although with the changed scene in Scotland, with considerably more tax being devolved, there might be an opportunity. I emphasise that it was outside our terms of reference, but transparency and simplicity are what is required.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Baroness Wheatcroft: Added to that, Mr Cochrane suggested an independent body to determine what the grant should be. Is that something that you think would be an advantage, Professor?

Professor Lloyd: There are examples of that. Australia is one example, is it not? Certainly one needs a transparent mechanism, which might be intergovernmental or independent, to try to establish that, but that is a political decision.

Professor Kay: The independent commission route is clearly the sensible route ahead. The Australian system seems to work pretty well, although there is almost no example—I do not think there is any example—of a system of this kind where one of the units you are talking about is 85% of the total. That is a particular difficulty here. As the Australian story will tell you, it achieves objectivity and it is widely admired for that. On the other hand, everyone wants to introduce in taxation areas simplicity, transparency and so on. The trouble is that it is too hard to get simple, transparent systems. A system that achieves the variety of objectives you have is almost inevitably complicated. There is no simple interpretation of what one means by needs when one talks about a needs-based formula. That opens the debate rather than closes it.

Q102 Lord Griffiths of Fforestfach: I have a question for Professor Kay. Do you think that the OBR would be sufficiently independent to be an “independent commission”, or do you think we need to create another bureaucracy?

Professor Kay: It is possible that the OBR could do the job. It will create enough bureaucracy anyway, even if it is part of the OBR. It is a possible role for the OBR as a possible carrier of this particular load..

Lord Kerr of Kinlochard: Going back to Professor Kay, you say it is too incomprehensible to be transparent. If it is too incomprehensible to be transparent, it is unacceptable. It cannot be a firm continuing basis. We are stuck with it, I agree, because of the vow and all that, but should we not be using this Parliament to think of a long-term solution? I do not really buy your argument, Professor, that we are stuck with it because any needs-based alternative would be less good for the Scots, so they will not agree. Surely, that entirely depends on what weight you put on the factors in assessing needs. If you think it costs more to provide education, health or whatever at an acceptable, common UK level in the highlands and islands of Scotland, it is conceivable that you might produce a system out of which the Scots did better. It would certainly be easier to comprehend. If it is incomprehensible, surely it is unsatisfactory.

Professor Kay: I agree entirely that it is unsatisfactory, and I agree that the Barnett formula with the adjustments that have been put in place is not sustainable on a long-term, or possibly even quite a short-term, basis. It is going to be a starting point for contentious argument. The issue I would disagree with you on is that while it is true that it costs more to provide health and education in the highlands of Scotland, it does not cost so much more. Actually, the highlands and islands of Scotland are not where most of the Scottish population live. If you say how much would be justified on a needs basis in relation to health and education, you can justify a bit more for Scotland but you cannot justify the amount more that Scotland currently gets.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Lord Forsyth of Drumlean: When I was Secretary of State, my officials always told me when I went to negotiate budgets for the Treasury, “Under no circumstances agree to any kind of needs-based assessment because it will cost us £4.5 billion”. I do not know what the number is now. Are we not making a big meal of this needs assessment difficulty, because at the end of the day, both in Wales and in Scotland, the money that comes as a block grant is distributed using a needs-based system? The money goes to health and local authorities using a needs-based system which takes account of demography, sparsity and all the rest. What is the big deal about applying the same principles that you use to dish out the money to determine what the total should be?

Professor Kay: The big deal is that Scotland would get less than it gets at the moment.

Lord Forsyth of Drumlean: Exactly. But if that is the problem, the way to deal with it, is it not, would be some kind of transitional relief that would allow for equilibrium to be established over a period of time?

Professor Kay: That is right, yes.

Professor Lloyd: Just a comment. We have been talking about simplicity and transparency. Any needs-based system can be quite complex, so it may not be simple but it can be transparent.

Q103 Lord Monks: As you were answering that question, I was reflecting on what sort of person might be called upon to lead this independent commission. I have a vision that he or she might make the South African referee look quite popular. The pressures coming from all angles on the particular Solomon who gets chosen for that job will, I fear, make it about the worst job in British public life. My question is in the same general area, and that is the block grant adjustment. Should it reflect the devolved powers of taxation in some way? James Cuthbert has criticised the proposal to index the adjustment to revenues in the rest of the UK because if Scotland has a lower growth rate it would be disadvantaged and it would have limited powers to grow its own economy. What are your views on that particular aspect?

Professor Kay: Given that the Barnett formula is going to survive for at least the immediate future, you have to do something like that, but it is not sufficiently clear what it means or how it works for you to have any confidence that it is a sustainable solution.

Lord Monks: Are there any other observations on that?

Keith Cochrane: I really cannot comment on the specifics of the block grant adjustment mechanism, other than to say that what both Governments should seek to do is establish a clear base line for assessment. Once we have that clear base line, that clear starting point, it is then a matter of understanding the parameters. It goes back to part of the earlier discussion. My own sense is that we could get lost in the mists of time around Barnett. There is going to be a one-off adjustment as a result of the transfer of taxation powers to Scotland, and potentially Wales in due course. Once that is made, and perhaps there need to be some transitional arrangements, the key, starting from that new base line, is how do you adjust it? If we try to treat it and think about it as Barnett, we could just compound the challenges that we have. Let us look at it afresh. Let us say, “This is the base line”. It does not necessarily mean any change in funding, so no one is any different from the day before to the day after,

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) but we then have a clear adjustment mechanism based on the changes or the impact of those changes going forward.

Lord Sharkey: How do you decide on the adjustment mechanism? Do you not need an underlying principle, or at least an objective, to devise any kind of mechanism that has a chance of fairness or stability?

Professor Kay: That is right; it is because there is no principle underlying the Barnett formula that you cannot find a sensible principle for adjusting it going forward.

The Chairman: It is worse than that. There is no underlying principle. It is fairly opaque. Parliamentarians, both north and south of the border, are being asked to vote on new arrangements when there are no details of how it is all going to work. Is that satisfactory in your view?

Professor Kay: I was surprised when Professor Lloyd said that people in Wales were excited by the Barnett formula. It is the first time I have ever heard anyone say that.

The Chairman: There is a complete lack of information in the public domain and for parliamentarians to come to a reasoned decision on whether they should support this legislation or not.

Lord Sharkey: Was there not a principle underlying Barnett in the first place, which was the expectation of convergence? That is a coherent principle, but it seems to me that clearly it has failed. Since no principle has been substituted for that, it is hard to see how you choose one mechanism over another.

Professor Kay: What prevented convergence was the mixture of politics and the slower growth of the Scottish population than the UK population. That is what created the position we are in now.

Lord Forsyth of Drumlean: Guilty as charged.

Q104 Lord Griffiths of Fforestfach: I would like to come on to the “no detriment” principle of the Smith commission, and particularly the second part of it, which is that there should be no detriment as a result of post-devolution policies either by the UK Government or by the devolved Government. Will this ever fly? Is it in any way practical?

Professor Lloyd: The initial adjustment to the block grant following devolution is the easy bit to decide on. It is what happens thereafter, and this is what your question refers to. Going back to the Silk commission and its predecessor, the Holtham commission, the recommendation we made was that the concept of indexed deductions should be embedded. It is important to know in advance, though, how the block grant will be adjusted following devolution of responsibility to reflect the changes. I can see that the whole purpose of “no detriment” is that policies implemented on one side or the other of the border should not adversely influence the other side. I think that most people would accept that something along those lines is necessary. The detail needs to be worked out before anything takes place, not afterwards; that is part of the whole picture. My plea is that it is given thought well in advance.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Lord Griffiths of Fforestfach: What if you had substantial asymmetric shocks on both sides, or you had a change of Government, let us say in England, with a much more radical approach to something or other than the Scottish devolved Government, so we are not talking about something incremental but a major knock-on issue? People have argued that you can apply this principle at a very high level, but I never know how high is high. With smaller changes you can see that it would work, but when you have something more significant it seems to me that it is a real problem.

Professor Kay: I do not even see how you can make it work with small changes. I can see how you could make it work in one or two extreme cases: for example, in the discussion of Northern Ireland corporation tax. If you get people brass-plating their activities in Northern Ireland, you can estimate how much that is and compensate for it. Suppose you reduce health expenditure in England and make people pay for it, with the result that ill people are more inclined to go to Scotland and healthy people are more inclined to go to England. Does anyone really imagine that you are going to pay compensation between the two jurisdictions to reflect that? It just does not seem real to me. Every possible case where you might cite the “no detriment” principle is again going to be a matter of argument. It is an easy and attractive principle to write down but a hopeless one to apply.

Lord Forsyth of Drumlean: We took some evidence from Sir Danny Alexander earlier, and I put to him an example similar to one that was included in your FT article, which I thought was excellent, that when we were in government we privatised water in England but we did not do so in Scotland. The result of that was that the Barnett consequences of the money that we spent on water did not go to the Scottish block, and I had to find savings elsewhere. I understood the “no detriment” principle to mean, in this new world, that if something like that happened the English would send a cheque to the Scots to compensate them for the loss of revenue. He said no, it does not work like that at all; that is not how it would work. What is your understanding of how it would work, because if that is not how it works I do not know what “no detriment” means.

Professor Kay: It ought to work in the way you describe. I do not think that anyone knows how it is going to work.

Lord Forsyth of Drumlean: Is it not absolutely impractical to say to people in England, “You are all going to have to pay for your water because we want to save public expenditure. By the way, we are going to send some money to the Scots, who won’t have to pay for their water, to compensate them for the difference”? That seems to me to be difficult.

Professor Kay: This is just the tip of an iceberg, a set of unanswered questions, about how adjustments to the block grant are made once there start to be any material differences in policies between England and Scotland. You can multiply the examples endlessly. Indeed, in the absence of hypothecation between rest of the UK expenditures and rest of the UK taxes, you are going to have the kind of argument that you have just described all the time, and we are not going to have that kind of hypothecation.

Lord Forsyth of Drumlean: While you are having that argument, if you have English votes for English laws, is that not going to create a further difficulty?

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Professor Kay: As you know, in the article I said that I could not think of any English law on which there would be an English vote, given that we have this kind of funding formula.

Lord Kerr of Kinlochard: Because any English Act that had expenditure implications only for England would under this deal, the “no detriment” promise, have an implication on transfer to or from Edinburgh.

Professor Kay: Yes.

Lord Kerr of Kinlochard: Also any change to UK revenue-raising powers, even if it only applied to England, would also have expenditure implications, so “no detriment” comes in whichever side of the budget you are talking about. How can it work?

Professor Kay: That is a rhetorical question.

The Chairman: Lord Sharkey.

Q105 Lord Sharkey: Following the Smith commission proposals, what additional borrowing powers should Scotland receive? What principle should determine the size of the permitted additional borrowing?

Keith Cochrane: There is a strong case for allowing the Scottish Parliament access to capital markets, the bond markets. Our submission to the Smith commission proposed that the Scottish Government have the ability to borrow up to 3% of GDP, perhaps averaged over a year or two previously. There is no science for the 3% other than the eurozone criteria that have been established. My understanding is that that would give Scotland a borrowing limit of around £4.5 billion, available both for opex, and indeed capex. From my perspective, that gives rise to a few benefits. One is that perhaps it helps to smooth out some of the volatility in terms of revenue raising. Secondly, it gives the Scottish Government the ability to have direct exposure to the markets, and accountability in understanding the market reaction to some of their policies is no bad thing. Thirdly, it enables choice to be made about opex and capex, and reduces dependence on Barnett by taking another chunk of revenue out of Barnett and being supported by different means.

Lord Turnbull: You talked about a 3% annual borrowing limit, and then you talked about it being spread over a number of years.

Keith Cochrane: I think that 3% of Scottish GDP is around £150 million per year, or perhaps you could average it over the two prior years. There are a number of variations on that principle.

Lord Turnbull: When it has been running, is there then a debt ceiling?

Keith Cochrane: The reality, as I said earlier, is that that is around £4.5 billion. Let us keep this in context. I am not sure that you need to worry about debt ceilings. UK public debt is £1.5 trillion at this point, so building up £4.5 billion to £5 billion a year, it is going to be a long time before that becomes anything like material in the context. It raises the interesting potential dichotomy in the future—

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Lord Turnbull: It may be material to the UK finances, but it could become material to the Scottish Government’s finances.

Keith Cochrane: It could, but then that becomes a call for the Scottish Government as to how they manage their financial affairs in terms of ability to repay and fund the interest. One would imagine that if the markets were working effectively, as that debt burden grew, interest costs would go up.

Lord Turnbull: I do not know whether someone was going to ask the obvious next question about bail-out. Should there be a prohibition? Lord Sharkey, were you going to follow that up? I do not want to steal your thunder.

Lord Sharkey: Professor Kay and Professor Lloyd may want to comment.

Professor Kay: It depends on what the objectives of devolution are, once again. Where we are at the moment is that the UK Treasury is absolutely determined to maintain overall control of macro-economic policy, and therefore it will not devolve significant borrowing power. It is a political decision for you in this building to decide whether you want to maintain that objective or not. Personally, I do not have a very strong view on it either way. One thing that is a bad idea is the situation we are in at the moment where the Scottish Government have no real borrowing power but have made quite vigorous use of PFI-type initiatives to do more balance-sheet financing.

Professor Lloyd: The position in Wales is slightly different. Obviously, the area is much smaller. Interestingly, there has not been much exposure to PFI in Wales compared with Scotland. The Silk commission recommended that there should be borrowing powers, and that has been accepted, for the Welsh Government. The only principle I suggest is that the quantum should be related in some way, perhaps not directly in proportion, to the amount of tax-raising powers that the Welsh Government have. The more taxation they can raise for themselves, the higher the borrowing should be. That linkage seems reasonable in terms of quantum. Again, it is really important for empowerment for the Welsh Government that they have some borrowing powers.

Lord Kerr of Kinlochard: Can I assume that nobody thinks it would be desirable or credible to legislate for a no bail-out rule? I see no point in it. It did not work terribly well in the European Union and it seems to me that it would be incredible in the markets that, while the United Kingdom remained a single country, a no bail-out rule would be applied.

Professor Kay: It sort of works in the United States.

Keith Cochrane: There is a difference between explicitly legislating for no bail-out and explicitly guaranteeing the debt. My own sense is that a debt issued by a Scottish Government should not be guaranteed from the United Kingdom. In that sense, they should stand on their own feet. That is a slightly different answer to your question. It comes back to the principles of devolution and what the Smith commission are seeking to do. If the objective is to make the Scottish Government accountable and more responsive to the marketplace, to their sources of revenues, and to take account of those in the spending decisions they make, the ability to get direct exposure to the markets, which over time builds, I accept, a growing pool of debt, is frankly no bad thing.

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008)

Lord Griffiths of Fforestfach: You say it is no bad thing, but I well remember 1976 when we had to go to the IMF. Let us assume you get some Government in Scotland and inflation really takes off, and interest rates rise through the roof, and the austerity which is then necessary is very significant. Then you are asked, “Do we just let the debt go?” It would be very hard, if we are part of a United Kingdom, to say that we do not have some moral responsibility to help.

Keith Cochrane: I take that point. Perhaps one way would be to create some sort of cumulative cap that over an extended period of time seeks to address that concern. There is no point in the Scottish Government just issuing debt that is automatically guaranteed by the Westminster Government. It really does not do anything, from my perspective, to enhance their accountability, exposing their decisions to the markets per se.

Professor Kay: While that is true, it does not answer the question of whether a no bail-out rule is credible. The argument that in a United Kingdom it is very difficult to make it credible is hard to disagree with. I mentioned the United States, which seems to me to be at least a partial exception to that. No one is confident that the federal government would bail out California or Illinois, but the United States has a history as a looser federation than we are talking about. It therefore also has a history, even if it was quite a long time ago, of states going bust and defaulting on their debt.

Lord Kerr of Kinlochard: You looked incredulous at my saying that surely this “no detriment” system just cannot work. You thought how naive I was just to realise that now. If you go back in the literature and look at the Smith Commission and what the two Governments said immediately after the Smith Commission, you will find the philosopher’s stone. You will find something called the fiscal framework, which is going to be crucial. I keep looking in the current documents for the fiscal framework, say when the Bill goes through the House of Commons, but it does not seem to be there. What do you think is going to be in the fiscal framework? Is it satisfactory to pass this Bill without knowing what is in the fiscal framework, and what would you put in the fiscal framework to try to reduce the problems we are talking about in the working of the system over time?

Professor Kay: It seems to me that this discussion has pointed to what would be the only rational basis, which would be some kind of grants commission, to have something that people have described as a needs-based formula. Saying we have a needs-based formula raises an awful lot of questions that need to be answered about what you mean by assessing needs for these purposes. Having done that, you need an independent commission to implement it and you need transitional arrangements. Something like that is the only structure that stands a chance of being defensible in the long run.

Q106 Lord Forsyth of Drumlean: Do you think that on both sides of the border, ordinary folk, not political anoraks, have a clue about what is involved and what is going on? If you do not think so, what can we do about it? I have a horrible feeling that folk think that all this is going to mean more money, not less money, and more control. Every time I look at it, it seems that it could turn out to be the reverse. That is one thing about public information. Secondly, on information that is available to people who are making policy, or who are commenting on policy like yourselves, do you think we have the information about the

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) nature of the tax base in Scotland, the revenues and the rest, in any degree of certainty or accuracy that would enable us to predict what is likely to happen?

Professor Kay: Do people have much idea? No, although you have the apparent inconsistency that people do not quite realise, on the one hand, that the issue of the formula at the moment is that Scotland gets rather a lot, yet people are also worried about whether Scotland could be viable as an independent country. There is an obvious contradiction between those two kinds of thought, which does not seem to be in a great many people’s minds. Could we make it clearer? Only by the kind of mechanisms that we have been describing—having some kind of determination based on a principled structure of how grants should be determined.

Lord Forsyth of Drumlean: On the issue of the reliability of tax and expenditure data on a regional basis, do you think that we have enough information?

Professor Kay: It is not that bad. In most statistical areas, Scotland turns out to look rather like the UK as a whole, although part of the reason is that we are not clear enough about the data. You discover that sometimes the data are 8.5% of the UK figure.

The Chairman: Professor Kay, you said earlier that retaining the Barnett formula was a starting point for contentious argument. We can add to that that we are going into this slightly blind-sided, if I can describe it in that way. You also made the point that any rapid change in the current arrangements would leave Scotland rather worse off, which would politically be probably unacceptable and unattractive. We are in rather an awkward position. You were implying earlier that we are heading towards a crisis point—my word, not yours. Is there a way of resolving this, a transitional arrangement, which can get us to a more sustainable solution, or are you saying, and I would be interested in the view of all of you, that we have to allow this to work its way through, and there will be a crisis and that only in a crisis can the situation be put on a more sustainable and transparent footing?

Professor Kay: We probably are boiling towards a crisis. My worry is that this drifts towards Scottish independence not so much because it is wanted but because it is the only way of resolving the problems that have been created. I am saying that without prejudice to whether I think that would be a good or a bad outcome, but we might drift there because we have not found a mechanism for resolving the problems which were created, in large part, by panicky promises round about the referendum.

Professor Lloyd: I would like to make a comment about gathering information. We felt that there is certainly a need to ensure improved quality of information, both economic and in other areas, in particular comparative information from different parts of the UK. Sometimes, not so much in the economic sphere perhaps, but in others—the health service, for example—information is gathered on a slightly different basis in different places, whereas it is presented as if it were on the same basis. That is really quite dangerous. There is a job to be done there.

Q107 Lord Forsyth of Drumlean: I have a question about information and people knowing what is going on, which is really directed to Keith Cochrane. I notice that Standard Life have moved their domicile, their registration as a company, from Scotland to England. That was reported in the newspapers. Do you have a view from the business community—I am trying

The Weir Group PLC; Professor John Kay, London School of Economics (LSE); Professor Noel Lloyd CBE, Silk Commission – Oral evidence (QQ 98-107) (DPFOE0008) not to lead the witness—as to what extent uncertainty about these issues is actually creating either an acceleration or deceleration of business issues, or are people so unaware of what is going on that it is not an issue?

Keith Cochrane: There is underlying concern across the Scottish business community that there remains considerable uncertainty both as to the outcome of the Smith commission settlement and the legislation that is developing now, and more generally the direction of travel of Scotland. Is that translating into real business decisions today not to invest in Scotland, to put it as bluntly as that? I do not think so. It is something at the back of people’s minds that they are very conscious of, without necessarily knowing all the detail. I guess the worry is that, if uncertainty compounds upon uncertainty, it starts to be a factor. Where we ourselves have seen it as more of an issue is probably in our ability to attract talent— people—from south of the border to come and work in Scotland, particularly against the backcloth of the potential taxation changes where people are aware of what is happening. They may be aware at a very superficial level of some of the statements that have been made about raising tax rates in Scotland. Against the backcloth of individuals having a choice, do they consciously decide to move? Scotland has very many capable and highly talented people, but, equally, occasionally you want to look in a broader pool and source individuals from elsewhere. That has the potential to be more of a challenge in terms of attracting top talent, as uncertainty impacts on individuals, particularly around the taxation question. Finally, on information, there is a superficial understanding of what is going on, but it is superficial, right across the Scottish population.

For all the complexity, the ideal is that you get the tax changes, because there is an unstoppable momentum in terms of the taxation powers; that train has already left the station. I do not disagree with Professor Kay’s comments about some of the challenges that that brings, but against that backcloth, how you change the debate and how you make it real for individuals in Scotland is when the political parties have to start talking about what they are going to do to tax rates. What are the choices they are going to make around raising taxes? Do they transfer that additional income, if additional income is raised, to welfare or to other activities? That is when you make it very real—when you bring it home and that debate takes off. That is why, if we are in a position to have that debate as part of the next Scottish parliamentary elections in May next year, you fundamentally change people’s understanding and knowledge, because it becomes a very real issue that starts to impact on people personally.

Professor Kay: Chairman, I think you have been told that I have to give a lecture, so unless you have any further questions for me—

The Chairman: You took the words out of my mouth. That brings this session to an end. Thank you very much indeed for your contributions. It has been very helpful.

Welsh Government – Written evidence (DPF0011)

The Lord Hollick House of Lords London SW1A 0PW

11 August 2015

Dear Clive,

Thank you for your letter of 14 July, inviting written evidence in response to the inquiry by the Select Committee on Economic Affairs into 'The devolution of public finances in the United Kingdom'. I am also writing in reply to your similar letters of 14 July to the First Minister and to the Minister for Economy, Science and Transport.

The Welsh Government welcomes the opportunity to contribute to the Committee's work. The pace of financial reform across the UK has stepped up in recent years, and looks set to continue in the medium term at least, with the new taxes and other measures being devolved to Wales, Scotland and Northern Ireland.

These developments, provided they reflect the will of each country, are very welcome - strengthening the ability of each administration to develop policies in ways that can meet the particular needs of its communities and businesses, while continuing to maintain a strong Union.

The enclosed paper responds to the Committee's questions from the perspective of devolved Government in Wales. It is not a matter for the Welsh Government to comment on the arrangements in place or under discussion for Scotland and Northern Ireland, except in so much as they may impact indirectly on Wales.

I wish you well with your study and look forward to reading your conclusions.

I am copying this letter to the First Minister and the Minister for Economy, Science and Transport.

Yours sincerely,

Jane Hutt AC / AM Y Gweinidog Cyllid a Busnes y Llywodraeth Minister for Finance and Government Business

Enc.

Welsh Government – Written evidence (DPF0011)

House of Lords Select Committee on Economic Affairs

The devolution of public finances in the United Kingdom

Call for evidence

Fiscal framework

What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

1. Multiple independent studies - including a House of Lords Select Committee and the Independent Commission on Funding and Finance for Wales ('Holtham Commission') - have proved that the Barnett formula does not apportion spending fairly. It is the Welsh Government's view that public spending should be determined by needs, and therefore a needs-based allocation formula is ultimately the most sensible way to deliver fairness across the UK.

2. In the meantime, there remains a particular issue for devolved spending in Wales. The Holtham Commission has shown conclusively that the design of the Barnett formula works to depress relative funding per head in Wales to the same level as the average for England (convergence) - regardless of the very different levels of need for public spending in the two countries. In order to address this concern, the Welsh Government has argued for a 'funding floor' to be applied to ensure that there is no further convergence. The UK Government has announced that it will do so, although critically it has not yet provided details about how or when this will happen.

3. The test for any process is how successfully it handles disputes, and to that extent the current framework has been shown to be ineffective. Where there has been disagreement, HM Treasury serves as both judge and jury.

4. The Welsh Government would favour greater scrutiny and a more open and transparent approach to the calculation of funding for Wales. The Holtham Commission recommended the establishment of an independent advisory body. Alternatively, the Silk Commission suggested that the Office for Budget Responsibility or the National Audit Office could review and audit technical aspects of the funding regime. Either of these approaches would enable the Devolved Administrations to have more confidence in the framework.

Welsh Government – Written evidence (DPF0011)

How should block grant funding reflect devolved tax and welfare powers? How should future changes to the block grant be decided? How should the Smith Commission proposal of "no detriment" apply over time?

5. The Welsh Government's position is that it should bear the risk for the decisions it takes with regard to devolved tax policy, but not for the actions of the UK Government, nor the economic cycle. The Holtham Commission gave great thought to the appropriate block grant offset mechanism for devolved taxes in Wales. This work will form the starting point for negotiations with the UK Government for the right block grant offset mechanism for devolved taxes in Wales.

6. The Welsh Government is not seeking the devolution of welfare provisions and does not have a view on how this should be applied to other devolved administrations.

7. The Welsh Government believes there is a very good case for Wales to have enhanced capital borrowing powers. That would enable us to invest in Welsh infrastructure and support the economic recovery.

8. Based on the current borrowing rules for Scotland, and our low PFI debts, the Welsh Government believes Wales could comfortably handle a borrowing ceiling of around £1.3 billion - higher than is contained in the Wales Act 2014.

9. The Smith Commission recommended that the Scottish and UK Governments should explore whether a prudential borrowing regime would be appropriate to support devolved capital investment, and the UK Government confirmed in its response that it would consider this approach. This is an approach that would interest the Welsh Government - it seems to have worked well for Local Government. Should progress be made on that front, the Welsh Government would expect a similar offer to be made for Wales.

What would the implications be of full fiscal autonomy for Scotland? How would Scotland shrink any fiscal gap?

10. The Welsh Government has no view on the funding arrangements for Scotland. This is a matter for the Scottish Government and the UK Government.

What implications will the renegotiation of the fiscal framework for Scotland have on Wales and Northern Ireland?

11. Devolution is likely to continue to proceed in each country at a different pace and in different ways. Inevitably this will impact on the fiscal frameworks, and increasingly we must expect differences in the arrangements. There can be no question of a 'one size fits all' approach.

Welsh Government – Written evidence (DPF0011)

12. However, it is important that there are clear and agreed principles underlining the arrangements for all countries. It will remain essential that we ensure consistency and fairness in the fiscal framework.

13. The Welsh Government therefore does not expect the changes agreed for Scotland to have any material impact on those for Wales. Nevertheless, we expect the circumstances of Wales - including our particular mix of devolved powers and fair funding - to be reflected in our fiscal framework.

Tax powers

What is the rationale behind the choice of taxes proposed to be devolved in the Scotland Bill?

14. There is no question that some taxes are more suitable for devolution than others. For example, the Welsh Government has consistently argued that devolving corporation tax to the countries and regions of the UK could lead to a 'race to the bottom' in tax rates, which might harm the tax base while delivering few net benefits to any part of the UK. To assist in identifying appropriate taxes for devolution, the Holtham Commission produced an assessment taxes against the following criteria:108

 accountability - the tax should enhance the accountability of a Government to its citizens;

 economic efficiency - the tax should not provide individuals or firms with strong incentives to alter their behaviour solely in order to reduce their tax burden;

 administrative efficiency - the tax should not impose substantial additional administrative burdens on citizens or firms, nor increase the cost of collection unreasonably;

 policy relevance - the tax should provide a tool that helps achieve devolved policy goals;

 legal constraints - the tax should be consistent with European law;

 impact on the UK tax base - the tax should limit the risks to the UK tax base.

15. That said, the Welsh Government has no view on the rationale for the devolution of taxation powers to the Scottish Government through the Scotland Bill. That must remain a matter for the Scottish Government and the UK Government.

108 Further details are provided in 'Fairness and accountability: a new funding settlement for Wales', Independent Commission on Funding & Finance for Wales ('Holtham Commission'), July 2010.

Welsh Government – Written evidence (DPF0011)

16. However, the Welsh Government believes that Wales should be offered similar arrangements to those being made available to the other Devolved Administrations. In practice, what is appropriate for Scotland or Northern Ireland - or indeed areas of England - may not be right for Wales, but it should be for the Welsh Government to decide what is appropriate.

What is the rationale behind the choice of taxes devolved by the Wales Act 2014?

17. The Wales Act 2014 devolved a package of fiscal powers to the Welsh Government based on the recommendations from the UK Government’s Commission on Devolution in Wales (the Silk Commission). The Silk Commission recommended a range of tax powers to be devolved that would help to strengthen the financial accountability and empowerment of the National Assembly for Wales. The Welsh Government supports the Silk recommendations in full and the Welsh Government is pleased that the vast majority of the recommendations were accepted by the UK Government in the Wales Act 2014.

18. The Welsh Government agrees with the devolution of taxation powers in areas of devolved responsibility. Devolving non-domestic rates to Wales is a useful lever that we can use to help to boost jobs and the economy, and it will give Welsh Ministers the flexibilities needed to set non-domestic rates that meet priorities in Wales. The devolution of Stamp Duty Land Tax and Landfill tax will also enable Welsh Ministers to develop taxation policy in the two key areas of devolved policy housing and the environment respectively. The Welsh Government welcomes the powers to introduce new taxes in areas of devolved responsibility. This provides a useful new tool to help achieve policy priorities if, after careful consideration, taxation is deemed the best way for those priorities to be met.

19. It is important to recognise that the Wales Act 2014 does not implement all the recommendations from the Silk Commission’s first report. Importantly, the Wales Act does not devolve powers over Air Passenger Duty. APD is already devolved to Northern Ireland for direct long-haul routes and will be devolved to Scotland through the Scotland Bill. The Silk Commission outlined the strong arguments in favour of devolving APD to Wales. Devolution would help to rebalance the UK economy away from airports which are close to capacity and it would strengthen the financial accountability of the National Assembly for Wales.

20. The Welsh Government believes that the devolution of income tax, as recommended by the Silk Commission, is a logical next step enabling Welsh Ministers to choose between the level of taxation and corresponding level of public services that best meets the preferences of the citizens of Wales.

21. The Welsh Government also fully supports the recommendation from the Silk Commission that the transfer of income tax powers should be conditional upon resolving the issue of fair funding in a way that is agreed by both the Welsh and UK Governments. With the income tax powers in the Wales Act 2014 the block grant will still be responsible for 80 per cent of the Welsh Government’s resources and it is

Welsh Government – Written evidence (DPF0011)

essential that this is put in a fair and sustainable basis before the income tax powers in the Wales Act are enabled.

What are the implications of devolving corporation tax to Northern Ireland? Will it have an effect on businesses in the rest of the UK?

22. In general the Welsh Government believes there is a good case for corporation tax to be retained as a single cross-UK tax. The Welsh Government maintains that there is a risk of 'a race to the bottom' with powers over corporation tax devolved within the UK. However, the Welsh Government recognises that Northern Ireland is in a unique position because of its land border with the Irish Republic.

With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales?)

23. The fiscal framework for the UK should strike a balance between funding through devolved taxation and via a block grant. Underpinning this should be the principles that:

a) in all parts of the UK, an equivalent level of services should be provided for an equivalent tax, and

b) there should be a sufficient level of tax devolution to allow Devolved Administrations to make meaningful decisions between levels of taxation and of spending in order to meet the preferences of their citizens.

24. The Welsh Government believes that the fiscal provisions in the Wales Act 2014 are broadly the right taxation powers for Wales. However, as stated above, the Welsh Government believes that powers over APD should also be devolved. This would provide a useful policy tool which, as part of a suite of interventions, could help to unlock the full potential of Cardiff and other airports across Wales.

25. The UK Government has published a review on options for supporting English regional airports from the impacts of APD devolution. However, devolution of APD to Wales is consistent with the UK Aviation Policy Framework109. Devolution of APD to Wales would help to reduce airport congestion in the South East of England, by making more efficient use of the existing runway and airport capacity across the UK. Cardiff airport is an underutilised economic asset and the airport has the potential to attract the growth in UK air passengers to ease capacity constraints at other UK airports. The devolution of APD would also increase transport choices for businesses and citizens in Wales and the South West of England.

26. The Silk Commission concluded that direct long haul should be devolved to Wales, with the potential to extend to full devolution at a later stage. Direct long haul APD

109 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/153776/aviation-policy- framework.pdf

Welsh Government – Written evidence (DPF0011)

has already been devolved to Northern Ireland, and APD is being devolved in full to Scotland. The lack of progress for Wales is striking in contrast.

27. In theory, corporation tax could give the Welsh Government a powerful tool to promote economic development but, as discussed above, this involves significant risks and may in practice deliver few, if any, net benefits to Wales. Corporation tax receipts are highly volatile and the consequences to the Welsh budget could be substantial, and there would be many practical and legal issues to overcome before devolution of corporation tax could be put into effect. However it could be a bigger risk if corporation tax was devolved to other areas and not to Wales. The Silk Commission concluded that corporation tax should be devolved to Wales if it was devolved to both Northern Ireland and Scotland. As corporation tax is not being devolved to Scotland, the Welsh Government is not seeking devolution to Wales at this time, but if that situation changed, we would expect the same powers to be offered to Wales.

28. The Welsh Government also agrees with the recommendation from the Silk Commission that if a new tax is introduced at the UK level, which is in a devolved area, an assessment should be undertaken as to whether powers over the tax should be devolved to the Welsh Government.

Will devolution of tax powers lead to competition between Northern Ireland, Scotland, Wales and England? Would competition be welcome?

29. The Welsh Government is committed to developing tax policy in Wales that will:  be fair to businesses or individuals who pay taxes;

 be simple with clear rules which seek to minimise compliance and administration costs;

 support growth and jobs, which will in turn help tackle poverty; and

 provide stability and certainty to tax payers, with changes subject to proper consultation with stakeholders.

30. The Welsh Government recognises that tax revenue funds the vital public services that many in society depend on. The Welsh Government does not welcome tax competition that would lead to a deterioration of the UK tax base.

11 August 2015

Welsh Liberal Democrats – Written evidence (DPF0009)

The devolution of public finances in the United Kingdom Submission from the Welsh Liberal Democrats to the House of Lords Select committee on Economic Affairs

Introduction

1.1 The Welsh Liberal Democrats are the state party of the Liberal Democrats in Wales.

1.2 We are glad that the Coalition Government in Westminster established the independent Commission on Devolution in Wales (the ‘Silk’ Commission) to review the present financial and constitutional arrangements in Wales.

1.3 We also welcomed the Wales Act 2014, which has devolved taxation powers to the National Assembly for Wales for the first time. This was sponsored by Welsh Liberal Democrat Baroness Randerson, while she was a Minister in the Wales Office.

1.4 The St. David’s Day Command Paper was also a welcome step forward in the devolution settlement for Wales, including its proposals for a reserved powers model, and devolving the responsibility for all energy planning development consents for projects up to 350 MW onshore and in Welsh territorial waters; licensing of onshore oil and gas extraction in Wales; speed limits, bus and taxi regulations, and the functions of the Traffic Commissioner; port development; powers relating to Assembly and local government elections; and competence over equality duties for devolved public sector. We await the devolution of these powers in a future Wales Bill. We believe that we must go further in securing Home Rule for Wales, the goal of Liberals for over a century.

1.5 Liberal Democrats, in Wales and across the UK, believe that power and authority derive and flow upwards from the people and that power must be exercised at the most appropriate local level. We have long supported a federal system as part of our vision for the UK’s constitutional future.

1.6 We are submitting this evidence for your consideration in order to voice our views on the further devolution of public finances in the UK. .

Welsh Liberal Democrats – Written evidence (DPF0009)

Fiscal Framework

What principles should govern the way devolved nations are funded? For example, is a new needs assessment required and if so, what should it take into account?

2.1 The nations of the United Kingdom have long had different needs with regard to funding. The Barnett Formula is the mechanism used to adjust spending allocations across the UK.

2.2 We believe that the Barnett Formula underfunds Wales. We recognise the findings of the Holtham Commission that the current formula underfunds Wales and would commission work to update this analysis. Liberal Democrats would address the imbalance by immediately entrenching a Barnett floor set at a level that reflects the need for Wales to be funded fairly, and seek over a Parliament to increase the Welsh block grant to an equitable level.

2.3 While we will need a higher level of tax autonomy to improve autonomy, accountability and incentives for devolved governments, we also need to ensure that all the people of Wales are treated fairly. Any funding formula for a federal UK should ensure that, should the prosperity of Wales increase relative to the prosperity of other nations and regions in the UK, this will not cancelled out by a consequent reduction in equalisation funding. The reduction in the grant should not be more than the increase in tax revenue as this would act as a disincentive to the Welsh Government to pursue economic growth. The quest for a better whole should not prevent us from seeking to improve component parts meanwhile. In the absence of a full Convention and a written constitution based on a federal UK with home rule for Wales, Welsh Liberal Democrats will continue to push for progress through incremental reforms wherever these can be achieved.

2.4 We would encourage the Select Committee to work with the UK Government to ensure that the needs of Wales are met in future fiscal settlements.

3.1 In Government, the Liberal Democrats delivered borrowing powers for the National Assembly so it could better deliver for the people of Wales. The Wales Act allows the Welsh Government to borrow up to £500m for capital investment.

3.2 We addressed the historic inequality where many other public institutions, such as community councils, were able to borrow, but not the Welsh Government. We ended this anomaly.

3.3 We believe that we should increase the borrowing powers to be proportional with Scotland, by increasing the borrowing limit to around £1 billion. This increase in power would mean Wales would be able to invest in projects that could help build a stronger

Welsh Liberal Democrats – Written evidence (DPF0009)

economy – more jobs, improved infrastructure AND also a fairer society – by building schools and hospitals.

3.4 The Silk Commission's report said: “We do not believe that Wales should get a proportionally lower capital limit than is in place for Scotland. This would mean for Wales a limit of £130 million a year based on 2011-12 spending, around 10 per cent of the Welsh Government's current annual capital DEL, and an overall capital stock limit of £1.3 billion.”

3.5 The Scotland Act 2012 provides a range of new borrowing powers to the Scottish Government which will be able to borrow up to a stock of £2.2 billion for capital purposes, with an annual limit of 10 per cent of the Scottish annual capital DEL budget (approximately £230 million in 2014-15), and up to £500 million to manage any budget shortfalls including those as a result of volatility in tax receipts. The Act allows the Scottish Government to borrow by way of a loan from either the National Loans Fund (that is, from the UK Government) or from commercial banks.

3.6 An RMG poll for the Institute of Welsh Affairs demonstrated that 59% of respondents believe that the proposed borrowing powers of the Wales Act would benefit the Welsh economy, compared to 25% who felt they would not, and 17% of respondents who felt that these proposals would not make difference. This demonstrates a clear desire in Wales for borrowing powers.

3.7 The Welsh Liberal Democrats welcome borrowing powers as a way to provide the Welsh Government with more scope to stimulate the economy with investment in significant capital expenditure projects.

3.8 We would recommend that the Economic Affairs Committee work with the UK Government to ensure that Wales is provided with the borrowing powers that we need to ensure a stronger economy and a fairer society.

Welsh Liberal Democrats – Written evidence (DPF0009)

Tax Powers

What is the rationale behind the choice of taxes devolved by the Wales Act 2014?

4.1 The Wales Act 2014 provided for the devolution of landfill disposals tax, land transaction tax and partial devolution of income tax. It also provided for business rates to be fully devolved to the Welsh Government. The decision to include these taxes in the Wales Act 2014 was made in response to the November 2012 recommendations of the Commission on Devolution in Wales, chaired by Paul Silk. It was felt that devolving these taxes would increase financial accountability and better empower the National Assembly for Wales to deliver policy objectives in devolved areas.

4.2 The Welsh Liberal Democrats believe that the principles of effectiveness, accountability and ease of operation are crucial.

4.3 Effectiveness: The devolution of various taxes must enable the Welsh government to achieve specific policy aims. This means the government should have control over taxes and charges for subjects which are already devolved to ensure that the government has the most control over areas that are already devolved.

4.4 Accountability: No devolved parliament should be wholly reliant for its revenue on another Parliament nor it should it be responsible for its spending without also being accountable for how at least some of it is raised. Without this accountability, there is too little incentive for achieving economic growth because successful economic development does not then lead to higher revenues for the devolved administration. It should also be clear which taxes are levied by which government.

4.5 Ease of operation: We believe that any system of taxation should be simple to operate, efficient to collect and enforce and provide the least instability for the Welsh government’s fiscal planning.

With the above measures in place, will Scotland, Wales and Northern Ireland have the correct tax raising powers? Should other taxes be devolved (for example corporation tax to Scotland and Wales)?

5.1 The majority of the Silk 1 recommendations were implemented by the Wales Act 2014. This law is one of the biggest steps in our devolution journey, giving Wales its first tax- varying powers, and makes the Welsh Government responsible for raising some of the money it spends. It devolved control over stamp duty land tax (SDLT), landfill tax, business rates and 10p in the existing rates for income tax. Silk recommend that Air Passenger Duty should be devolved for direct long haul flights initially and devolving all rates for APD to Wales should be part of the UK Government’s future work on aviation taxation.

5.2 We call for the full implementation of the remaining Silk Part 1 proposals on financial powers for Wales including long-haul Air Passenger Duty.

5.3 The Silk Commission specifically recommended that alcohol and excise duty; Vehicle Excise Duty; Capital Gains Tax; Insurance Premium Tax; stamp duty on shares;

Welsh Liberal Democrats – Written evidence (DPF0009)

Inheritance Tax; betting and gaming duties; and the Climate Change Levy should not be devolved to Wales. However, we believe that the debate has moved on in light of new powers being offered to Scotland, and we would encourage work be commissioned to see if these taxes could be devolved to Wales and the other constituent parts of the UK, without an overly increased risk of avoidance. We would also explore enabling the Welsh Government to issue its own bonds.

5.4 The report of the Home Rule and Community Rule Commission of the Scottish Liberal Democrats, also known as the Campbell Commission, provides a basis for a possible federal future and some of its recommendations could be applied to Wales, such as assigning corporation tax to the Welsh Assembly to give it a stake in the fruits of improved economic performance ; allocating powers over Capital Gains Tax to Wales; allocating control of Inheritance Tax to Wales; the Welsh Government acting as the agent for the UK Government in Wales on much of the work of Job Centre Plus and the Work Programme; and more. Welsh Liberal Democrats would explore these as potential new powers for Wales in a constitutional convention.

5.5 We believe that the Economic Affairs committee should consider such taxes in their ongoing work regarding further devolution of tax-raising powers to Wales.

21 August 2015