Scotland’s Fiscal Outlook The Scottish Government’s Medium-Term Financial Strategy January 2021 Contents Foreword by the Cabinet Secretary for Finance ...................................................... 1 Executive Summary ........................................................................................................... 3 1. Introduction .................................................................................................................. 7 1.1 A turning point for Scotland ............................................................................. 7 1.1.1 The impact of COVID-19 ............................................................................. 7 1.1.2 Scotland cannot afford a return to austerity ....................................... 8 1.2 Delivering for the people of Scotland ......................................................... 11 1.2.1 Building back fairer and stronger from COVID-19 .......................... 11 2. Scotland’s economic outlook ................................................................................. 14 2.1 State of the economy ........................................................................................ 14 2.2 Economic risks and opportunities ................................................................ 15 2.2.1 Scotland’s relationship with Europe ..................................................... 17 2.2.2 Vaccines, restrictions and recovery from the pandemic ............... 18 2.3 Fiscal Implications of the economic outlook ............................................. 19 3. Scotland’s fiscal outlook ......................................................................................... 23 3.1 Central scenario .................................................................................................. 24 3.2 UK fiscal stance ................................................................................................... 26 3.2.1 Lower scenario analysis ........................................................................... 27 3.2.2 Upper scenario analysis............................................................................ 27 3.3 UK and Scottish relative fiscal performance ............................................ 27 3.3.1 Lower scenario analysis ........................................................................... 28 3.3.2 Upper scenario analysis............................................................................ 29 3.4 Summary of the scenarios............................................................................... 29 3.5 Key points on funding outlook and risks ................................................... 31 4. Broad spending outlook .......................................................................................... 32 4.1 Resource and capital spending context ...................................................... 32 4.1.1 Resource spending: the 2021-22 resource budget baseline ........ 32 4.1.2 Capital spending: the Capital Spending Review ................................ 33 4.2 Our medium-term strategic spending priorities ...................................... 34 4.2.1 New, good and green jobs........................................................................ 34 4.2.2 Promoting lifelong health and wellbeing ............................................ 36 4.2.3 Promoting equality and helping our young people fulfil their potential ....................................................................................................................... 37 4.2.4 A just transition to a green economy ................................................... 38 4.3 Medium-term resource expenditure outlook............................................ 40 4.4 Resource spending risks and pressures ...................................................... 43 4.4.1 Pay ................................................................................................................... 43 4.4.2 Public service pensions – a mandatory workforce cost ................ 45 4.4.3 Ageing is a significant driver of public service expenditure ....... 47 4.4.4 Demand-led volatility risk ....................................................................... 47 4.5 Approach to a Resource Spending Review ................................................ 48 5. Managing fiscal risks – current powers and options for change .............. 50 5.1 Current levers for managing volatility and risk ...................................... 54 5.1.1 Scotland Reserve policy............................................................................ 55 5.1.2 Resource borrowing policy ...................................................................... 55 5.1.3 Capital borrowing policy .......................................................................... 56 5.1.4 Existing powers are too limited ............................................................. 57 5.2 The need for a robust, comprehensive and timely review of the Fiscal Framework .......................................................................................................... 58 5.3 Devolved and reserved tax powers – responding to fiscal challenges 59 5.3.1 Threats and opportunities in relation to the tax base and performance ............................................................................................................... 60 5.3.2 Exploring further tax powers for Scotland ........................................ 63 5.3.3 VAT assignment and VAT devolution ................................................... 64 5.3.4 Full devolution of powers over Income Tax ...................................... 65 5.3.5 Other reserved tax powers ..................................................................... 66 6. Conclusion – an opportunity for renewal ......................................................... 67 List of Acronyms ............................................................................................................... 70 Glossary ................................................................................................................................ 73 List of figures, tables and boxes .................................................................................. 76 ANNEX A - Assessing forecast error risk to the Scottish Budget ..................... 78 ANNEX B - Risks to Scottish Income Tax receipts .................................................. 86 ANNEX C - Fiscal Framework data .............................................................................. 94 1 Foreword by the Cabinet Secretary for Finance In the midst of this global pandemic and economic crisis, the outlook for the economies and public finances of countries and Governments around the world has been upended. We all face the same intractable challenge: to balance the competing demands of increased public spending, reduced tax income and the pressing need to support citizens and businesses. The challenges we faced pre- pandemic are also still with us: the need to tackle climate change, the desire to invest in our public services and the efforts to build a wellbeing economy. While we share this challenge with our friends and neighbours, Scotland does not have access to the same tools and flexibilities that would help us to minimise the impact of the crisis and spread the cost of the response. Even before this crisis occurred, I had been clear that the current Fiscal Framework did not allow me adequately to manage the levels of fiscal risk in our Budget process. In the current context, these levels of risk and volatility have only been compounded. They illustrate, more than any of us could have predicted, the need for different parts of the UK to have access to fiscal levers in order to respond adequately to the needs of their local populations. Despite the challenges brought by 2020, compounded by the implications of EU Exit, I believe in the people of Scotland’s tenacity, commitment and ability to build a better society. I am certain that, together, we can meet these challenges. Now more than ever, we will need to be creative and enterprising, to lay out a vision of how we can emerge from this global crisis to rebuild, to innovate and to prosper. This crisis has shown us that we are resilient, united in our purpose and in our values. I have made no secret of my belief that only in an independent Scotland can we truly and fully fulfil this ambition. Although it is not a focus of this document, only independence would give us the full fiscal levers we require in order to set a different trajectory to that of the UK Government. Nonetheless, this document sets out how we will respond as a Government within our limited powers. It also outlines the further flexibilities and levers required in order to manage the risks and volatility with which the Scottish budget will need to contend in coming years. 2 By publishing this year’s Medium-Term Financial Strategy (MTFS) alongside the Budget, I want to provide a clear direction at a time of significant uncertainty and set some context around the difficult decisions that need to be made as part of this Budget. After the Holyrood election, it will be for the incoming Government to work with the next Parliament to agree how best the MTFS can continue to support budget scrutiny, accountability and transparency, by setting out the evolving context for annual budgets. The First Minister, by being open about the challenges brought by the Covid-19 pandemic, has set a clear tone for a maturing relationship between