DFP/S4/15/6/A DEVOLUTION (FURTHER POWERS) COMMITTEE AGENDA 6th Meeting, 2015 (Session 4) Thursday 26 February 2015 The Committee will meet at 9.00 am in the Mary Fairfax Somerville Room (CR2). 1. Decision on taking business in private: The Committee will decide whether to take items 6 and 7 in private and all future Committee reports in private. 2. Subordinate Legislation: The Committee will take evidence on the Scotland Act 1998 (Modification of Schedules 4 and 5 and Transfer of Functions to the Scottish Ministers etc.) Order 2015 from— John Swinney, Cabinet Secretary for Finance, Constitution and Economy; Stephen Sadler, Team Leader, Elections and Constitution Division, and Neel Mojee, Policy Adviser, Elections and Constitution Division, Scottish Government. 3. Subordinate Legislation: John Swinney, Cabinet Secretary for Finance, Constitution and Economy to move—S4M-12439—That the Devolution (Further Powers) Committee recommends that the Scotland Act 1998 (Modification of Schedules 4 and 5 and Transfer of Functions to the Scottish Ministers etc.) Order 2015 [draft] be approved. 4. Evidence on Borrowing Powers The Committee will take evidence from— Professor David Bell, Professor of Economics, University of Stirling; Don Peebles, Head of CIPFA Scotland; Philip Milburn, Investment Manager, Kames Capital and the Investment Association. 5. Review of evidence (in private): The Committee will review the evidence taken on borrowing powers at today's meeting. DFP/S4/15/6/A 6. Draft report on the sections 30 and 63 Order on votes for 16-17 year olds (in private): The Committee will consider a draft report. 7. Draft report on the electoral management of the Scottish Independence Referendum (in private): The Committee will consider a draft report. Stephen Imrie Clerk to the Devolution (Further Powers) Committee Room T3.40 The Scottish Parliament Edinburgh Tel: 85206 Email: [email protected] DFP/S4/15/6/A The papers for this meeting are as follows— Agenda Item 2 PRIVATE PAPER DFP/S4/15/6/1 (P) Agenda Item 4 David Bell Written Evidence DFP/S4/15/6/2 CIPFA Written Evidence DFP/S4/15/6/3 Investment Association Written Evidence DFP/S4/15/6/4 PRIVATE PAPER DFP/S4/15/6/5 (P) Agenda Item 6 PRIVATE PAPER DFP/S4/15/6/6 (P) Agenda Item 7 PRIVATE PAPER DFP/S4/15/6/7 (P) Scotland’s Fiscal Framework under the Smith Commission Proposals Professor David Bell Division of Economics Stirling Management School University of Stirling February 2015 Introduction This paper discusses the approach taken to Scotland’s fiscal framework as laid out in the Smith Commission report and then subsequently interpreted in “Scotland in the UK: an Enduring Settlement ”. It considers the fiscal framework in general but focuses particularly on borrowing powers. There are two key elements to a fiscal framework: the rules by which fiscal policy is governed the institutions which oversee these rules The role of the fiscal framework is to maintain a sustainable fiscal policy. A breakdown of fiscal sustainability can have serious economic and social consequences. The current events in Greece are a salutary lesson of the need to maintain fiscal sustainability. I have relatively little to say on the institutional framework, other than to argue that, rather than following the UK approach – i.e. the establishment of a “Scottish OBR” ‐ it might be more suitable to take lessons from other countries, such as the USA, and embed the institution whose role is to support the fiscal framework within the Scottish Parliament. This would strengthen the role of the Parliament and also provide assurance of its independence from governmental influence. Borrowing powers Borrowing powers are an essential component of any fiscal framework. The relevant paragraphs from the Smith Commission report and the UK government response are set out in Appendices 1 and 2. There are two types of borrowing: 1. borrowing to deal with volatility in current revenues 2. borrowing for investment in capital projects Borrowing has to be sustainable. Politicians have an electoral incentive to increase borrowing since increased spending may improve their chances of re‐election. Further, they may not incur the costs of such borrowing which may fall on future generations. Hence, borrowing to cover current (resource) spending should only be for short‐term purposes to deal with unexpected variation in tax receipts. Borrowing for investment purposes will create assets which benefit future generations. Obviously future generations have no power to influence these decisions. The assessment they will make of the costs and benefits of investment by their predecessors cannot be known with certainty. Thus, for example, the building of the new Forth road bridge may be viewed in the future as a wise investment in Scotland’s road infrastructure or as an unnecessary cost if there is a steep decline in road traffic. These two types of borrowing were dealt with by the Scotland Act 2012, which provides that the Scottish Government can borrow from the National Loans Fund, commercial lenders or through issuing bonds to fund capital expenditure. Specifically, it can borrow up to 10% of its capital budget each year subject to a £2.2 billion cap. For example, this would enable it to borrow £300 million in 2015‐16. We deal with revenue and capital borrowing in turn. Borrowing for Revenue Volatility To cover volatility in tax revenues, the Scottish government can operate a cash reserve. Clearly it can make savings through underspending its current DEL allocation and it can borrow up to £200 million per year up to a £500 million borrowing limit. The notion of a cash reserve is somewhat analogous to the End Year Flexibility (EYF) process which used to be operated by the Scottish Government. Treasury rules have always prevented departments from overspending their allocated DEL budgets. It was therefore common for departments to underspend. This created unspent cash reserves which were known as EYF. These could be substantial. In 2000‐01, Scotland’s EYF was £718 million. Departments were permitted to retain a proportion of these which reduced the pressure for unnecessary end of year spending and accommodated slippage in spending on capital projects. In effect, EYF played the role of a cash buffer to deal with short run volatility in departmental spending. Once the Scotland Act 2012 comes into force, there will be an additional source of volatility, namely unexpected variation in tax revenues. This volatility will grow as Scotland becomes more dependent on its own revenues. So the implementation of the Smith proposals would increase substantially the potential volatility in Scotland’s revenues. Hence the provisions to deal with that volatility will also have to increase. This might suggest that the £200 million limit is relatively modest, since it was designed for a different revenue structure. The additional source of volatility will centre around the independent forecasts of Scotland’s tax revenues. The Finance Secretary will be obliged to use these forecasts as the basis for the Scottish Budget. If the forecasts are incorrect, the budget could be in surplus or deficit at the year‐end. The Finance Secretary would then have to adjust the budget for the following year to take into account the overspend or underspend from the previous year. Clearly borrowing will only be required in the case of an overspend. Consider the experience of the UK economy before the beginning of the Great Recession. This illustrates the dangers associated with errant forecasts. Figure 1 shows the forecasts of income tax revenue made by the UK government at the time of the 2007‐08, 2008‐09 and 2009‐10 budgets along with the outturn values. My focus is on income tax because that will be the major source of income to the Scottish Government if the Smith Commission proposals are implemented. It indicates that there was a considerable error in forecasting income tax revenues. The 2008‐09 budget forecast income tax revenues of £160.1 billion: the outcome was £153.4 billion, an over‐estimate of 4.4%. In terms of Scottish income tax revenue this would translate to an error of about £490 million. The fall in income tax revenues in 2008‐09 was among the most extreme shocks that the UK economy has faced in the post‐war era. Perhaps lessons have subsequently been learned and such a large forecast error will not recur. Nevertheless, the recent dramatic decline in the oil price was not forecast in last year’s budget. It could potentially have a significant effect on Scotland’s income tax revenues in 2015‐16 and if the shock were large enough it is possible that the £200 million annual buffer might prove too small if Scotland were in receipt of the entirety of income tax revenues. Figure 1: UK Government Forecast Errors for Income Tax Receipts 165 160 155 (£bn) 150 Budget 2007 145 Receipts Budget 2008 Tax 140 Budget 2009 135 Actual Income 130 UK 125 120 2005‐06 2006‐07 2007‐08 2008‐09 2009‐10 Source: HM Treasury ‐ various UK budgets The issues associated with volatility are discussed in “Scotland in the United Kingdom: An Enduring Settlement”. However, the mechanisms by which the size and design of the borrowing facility is not specified. Instead, they will have to be agreed “on the basis of the specific risks1” that Scotland will face, given the funding arrangements and in particular its sources of revenue. This discussion has illustrated two of these risks ‐ errors in forecasting spending and errors in forecasting revenues ‐ that will form a key part of any such agreement. 1 Scotland in the United Kingdom: An Enduring Settlement, Para 2.4.23 Borrowing for Capital Spending The question of borrowing for capital spending is extremely complex.