Fiscal framework outturn report: 2018

2 Operation of the Fiscal Framework

Evolution of the Scottish Parliament’s fiscal powers

2.1 The Scotland Act 2012 and the Scotland Act 2016 devolved a number of significant new fiscal powers to Scotland.

2.2 Land and Buildings Transaction Tax ( LBTT) and Scottish Landfill Tax ( SLfT) were fully devolved from the financial year 2015-16 under the Scotland Act 2012. The Scottish Rate of Income Tax was devolved under the Scotland Act 2012, with the Scotland Act 2016 extending income tax powers significantly from 2017-18.

2.3 The Scottish Government’s capital and resource borrowing powers were granted in the Scotland Act 2012 and the limits were increased in the Scotland Act 2016. The detail of these powers is outlined in chapter five.

2.4 The Scotland Reserve replaced a previous power under the Scotland Act 2012 to operate a limited cash reserve and the Budget Exchange Mechanism operated by HM Treasury. The Reserve is capped in aggregate at £700 million. Annual drawdowns from the Reserve are limited to £250 million for resource and £100 million for capital.

2.5 The Fiscal Framework ^[2] sets the rules by which these new powers are implemented and managed. This year’s Fiscal Framework Outturn Report focuses on the three tax powers that have been fully implemented, as well as the use of borrowing powers and the Scotland Reserve. Data on forecasts and outturns for these taxes - both revenue and corresponding Block Grant Adjustments ( BGAs) - are presented in the chapter three of this report.

2.6 Further tax and social security powers in the Scotland Act 2016 are being implemented over the coming years.

2.7 Three Scotland Act 16 tax powers are yet to be implemented: assigned VAT, Air Passenger Duty and Aggregates Levy:

Assigned VAT - The Fiscal Framework agreed that VAT assignment will be implemented in 2019-20. There will be a one-year transitional period during which the assigned VAT will be forecast and calculated, but with no impact on the Scottish Government’s Budget.

Air Passenger Duty - Air Departure Tax ( ADT), replacing Air Passenger Duty ( APD), is fully devolved to Scotland. Its introduction has been deferred until a resolution is found for flights departing from the Highlands and Islands, with the UK Government continuing to apply APD in Scotland in the interim.

Aggregates Levy - There are ongoing legal issues in relation to the UK tax which are required to be resolved prior to the power being commenced.

2.8 Eleven benefits are transferring to the Scottish Parliament under the Scotland Act 2016. Funding for three benefits is transferred into the block grant with no Block Grant Adjustment and subsequent reconciliation required. These are Discretionary Housing Payments, ^[3] Best Start Grant and Funeral Expenses Assistance. All other benefits transferring to the Scottish Parliament will require a Block Grant Adjustment. Executive Competence for Carer’s Allowance transferred on 3 September 2018. The first Block Grant Adjustment for Carer’s Allowance will be processed at the UK Government’s forthcoming Autumn Budget. We will announce further details about timescales for future benefits in due course.

2.9 Data on powers that require a Block Grant Adjustment will be included in future reports once these powers have been implemented.

Why was a new Fiscal Framework needed?

2.10 When the devolved Scottish Government was first established in 1999, it inherited grant funding arrangements that were based on the long-standing Barnett formula. Under Barnett, each financial year’s Block Grant is equal to the previous year’s grant plus a population share of changes in comparable UK Government spending in devolved areas. ^[4]

2.11 The Smith Commission ^[5] - on whose conclusions the Fiscal Framework is based - envisaged a fundamental change in how the Scottish Government would be funded. ^[6] They foresaw a substantial proportion of the Government’s Budget coming directly from tax revenues raised in Scotland. The Commission made two key recommendations:

“The Block Grant from the UK Government to Scotland will continue to be determined via the operation of the Barnett Formula.” (p.25)

“The revised funding framework should result in the evolved Scottish Budget benefiting in full from policy decisions by the Scottish Government that increase revenues or reduce expenditure, and the devolved Scottish Budget bearing the full costs of policy decisions that reduce revenues or increase expenditure.” (p.25)

2.12 The objective of a new Fiscal Framework was to evolve the funding arrangement by transferring greater fiscal powers and policy responsibilities to Scotland while, to a significant extent, retaining the stability of Block Grant funding.

2.13 The Smith Commission laid down one key principle to guide the development of the new Framework – ‘no detriment’. In the context of fiscal devolution, ‘no detriment’ means:

“…initial devolution and assignment of tax receipts should be accompanied by a reduction in the Block Grant equivalent to the revenue foregone by the UK Government, and that future growth in the reduction to the Block Grant should be indexed appropriately.” (p.25)

How the Fiscal Framework works

2.14 Guided by Smith Commission principles, a new Fiscal Framework was agreed between the UK and Scottish Governments in February 2016. The Framework lays down three main components for calculating the Scottish Government’s Budget ^[7] .

Figure 2.1 - Guide to the new Scottish Budget process

2.15 Component One – Barnett-determined Block Grant
Barnett continues to determine the initial size of the Block Grant before adjustments are made to take account of tax and social security devolution.

2.16 Component Two – Adjustment to the Block Grant
The Block Grant is adjusted to reflect the impact of the transfer of greater fiscal powers to the Scottish Budget. In this report, only deductions from Block Grant, i.e. the revenues foregone by the UK Government in devolving revenues to Scotland, are relevant. In future years, Block Grant additions for social security benefits will also be applied.

2.17 Component Three – Devolved Revenues
These are the revenues now retained from devolved and assigned tax powers which contribute to Scotland’s funding.

2.18 In future, social security spending will be part of the Scottish Budget and the corresponding funding will be transferred to Scotland as additions to the Block Grant.

2.19 Other powers in the Fiscal Framework can also affect the Scottish Government’s overall Budget totals. The Government can choose to borrow for capital expenditure, or carry forward underspends from previous years in the Scotland Reserve.

How are the Block Grant Adjustments Calculated?

2.20 A ‘baseline value’ is required to establish the starting point for the Block Grant Adjustments. The baseline value reflects what was raised by the UK Government in Scotland in the year prior to the devolution of the tax. ^[8] For example, for Scotland Act 2016 Scottish Income Tax, 2016-17 was the year prior to devolution. For LBTT and SLfT, 2014-15 was the year prior to devolution.

2.21 To account for the revenue loss to the UK Government after the initial transfer of power, the baseline BGA is updated annually using an indexation mechanism reflecting the growth in the corresponding UK tax revenue.

2.22 The Governments agreed to apply two indexation mechanisms to track the growth in UK Government tax receipts – the Comparable Model ( CM) ^[9] and the Indexed Per Capita ( IPC) method. The Fiscal Framework states that, over the period to 2020/21, the indexation mechanism will be based on the Comparable Model ( CM), but then reconciled to the Indexed Per Capita ( IPC) method. In practice, it is therefore the IPC method which determines the Block Grant Adjustment, at least until 2021 when the Fiscal Framework will be reviewed.

2.23 Using IPC means that if corresponding UK Government tax revenues per head grow at the same rate as Scotland’s, the Scottish Budget will be no better or worse off than before devolution.

2.24 Using IPC therefore achieves the Smith Commission’s principle of no detriment - if Scotland’s economic performance and tax policy matches the rest of the UK, the Scottish Budget will be the same as under the previous arrangements.

2.25 Both the revenue being added to the Scottish Government’s Budget and the figures being deducted through the Block Grant Adjustment are based on forecasts at the time the Budget is set. As of 2018-19, the Scottish Government uses the Scottish Fiscal Commission’s ^[10] forecasts for revenues. For the Block Grant Adjustments, HMT use the forecasts of the Office for Budget Responsibility ( OBR). ^[11]

2.26 As revenue and Block Grant Adjustments are based on forecasts, these figures need to be ‘reconciled’ once tax outturn data is available. This is considered in detail in the next chapter. The box below illustrates how BGAs are calculated using 2017-18 LBTT as an example.

Example - BGA calculation for Land and Buildings Transaction Tax in 2017-18

For 2017-18, the deduction from the Scottish Government’s Block Grant was set in November 2016 based on the OBR forecast of growth in UK Government Stamp Duty Land Tax receipts at the UK Autumn Statement 2016. This was calculated in three steps:

Step One – Baseline Value – The Fiscal Framework agreed that the baseline value would be 2014-15 Stamp Duty Land Tax receipts in Scotland – in other words, what was being raised in Scotland the year before LBTT began operating in Scotland. The OBR’s forecast for 2014-15 tax receipts in Scotland at the Autumn Statement 2016 was £468 million. ^[12]

Step Two – Revenue Growth – This baseline adjustment is then indexed annually using growth in equivalent UK Government tax receipts. UK Government Stamp Duty Land Tax receipts grew by 4.2% between 2014-15 and 2015-16, 4.0% between 2015-16 and 2016-17, and were forecast to grow by 8.6% between 2016-17 and 2017-18.

Step Three – Relative Population Growth – Finally, the BGA also factors in the relative difference in population growth between Scotland and the rest of the UK. A figure of 99.7% was used for each of the years from 2015-16 to 2017-18.

Taking into account the baseline value, growth in UK Government Stamp Duty Land Tax receipts, and relative difference in population growth, the Block Grant Adjustment for LBTT was £486 million in 2015-16, £504 million in 2016-17, and £545 million in 2017-18, as is set out in the table below.

Table 2.1 – LBTT BGA Calculation*

	2014-15 (Year 0)	2015-16 (Year 1)	2016-17 (Year 2)	2017-18 (Year 3)
Step 1 - Initial baseline value
Scottish receipts (£m)	468
Step 2 - Indexation
rUK receipts (£m)	10,251	10,682	11,113	12,069
% growth in UKG receipts		4.2%	4.0%	8.6%
Step 3 – Adjustment for relative difference in population growth
rUK population (thousand)	59,249	59,737	60,229	60,725
Scottish population (thousand)	5,348	5,373	5,399	5,424
Relative Scottish/ rUK population growth		99.7%	99.7%	99.7%
BGA
2017-18 BGA (£m)		486	504	545

*Figures may not sum due to rounding.

Expressed otherwise, the calculation for each year is as follows:

2015-16 BGA
£468 million x 1.042 x 0.997 = £486 million

2016-17 BGA
£486 million x 1.040 x 0.997 = £504 million

2017-18 BGA
£504 million x 1.086 x 0.997 = £545 million

£545 million was therefore deducted from the Scottish Government’s 2017-18 Budget to reflect the UK Government’s revenue loss from devolving LBTT to Scotland.