Fiscal Framework Review: Independent Report

2. Block grant adjustments and the Smith Commission

This section of our report provides key background information. It first explains the block grant, the devolution of tax and social security powers, and the resulting need for block grant adjustments. It then sets out the principles agreed by the Smith Commission in 2014 to inform the design of the block grant adjustments. Subsequent sections assess the existing approaches to calculating block grant adjustments and potential alternative approaches against these principles.

2.1 The block grant, fiscal devolution and block grant adjustments

Historically the vast majority of the Scottish Government's funding took the form of a block grant from the UK government. This was paid for using UK-wide taxation, and paid for nearly all spending on devolved public services, such as health, education, justice and transport.

Each year, the change in the block grant was determined using the Barnett Formula. Under this formula, the change in the Scottish block grant is equal to Scotland's population share of the change in funding allocated by the HM Treasury to comparable spending programmes, such as health, education, justice and transport in England (or England and Wales). For example, if spending allocated to health in England increases by £1,000m, the Scottish Government would receive an additional £97m since Scotland's population is 9.7% of that in England.

The Scotland Act 2016 gave the Scottish Government new tax and social security powers. These enabled it to keep most of the proceeds of income tax raised from Scottish taxpayers, and gave it the responsibility to design and pay for most disability-related benefits, to provide two key examples. The aim of devolving these new powers was to 'better deliver prosperity, a healthy economy, jobs and social justice', and to 'strengthen the financial responsibility of the Scottish Parliament'.^[1]

Table 2.1. sets out the full set of taxes and social security benefits which were devolved to Scotland under the Scotland Act. The table shows tax revenues and spending levels for each tax and benefit devolved, in 2020/21, the most recent year for which outturn data is available for all taxes and social security benefits. For the three taxes that are intended to be devolved but which have not been implemented, the figures in the Table represent the latest estimates of revenues raised in Scotland.

Sources: For the three taxes devolved to-date, figures are outturn for 2020/21. For the three taxes that are expected to be devolved, figures are latest estimates of the Scottish share for 2020/21. For the social security benefits devolved to-date, figures are outturn from 2020/21. For other benefits, figures are latest estimates.

Notes: Ten percentage points of each band of income tax on non-savings, non-dividends income was devolved in 2016/17, with all revenue from NSND income devolved in 2017/18. The dates reported for social security benefits are when responsibility for funding the benefits was transferred. In the case of child and adult disability payments, the new Scottish benefits did not begin to be rolled out until 2021/22 and 2022/23, respectively. Sure Start Maternity Grant has been replaced by Best Start grants, which also provide additional payments as children get older. Note that the choice of year as 2020/21 results in revenues for some taxes being somewhat smaller than would typically be expected. This is particularly the case for Air Passenger Duty, revenues for which might have been around ten times higher in the absence of the pandemic.

The devolution of these additional revenue streams and spending responsibilities necessitated adjustments to the Scottish Government's block grant funding. In particular, the devolution of a revenue stream, such as income tax, requires a reduction to the block grant to reflect the transfer of a revenue stream from the UK government to the Scottish Government: Scotland has gained additional tax revenue, while the UK government has lost the same amount. The devolution of an additional area of spending, such as disability-related benefits, requires an addition to the block grant to reflect the transfer of responsibility for that spending from the UK government to the Scottish Government.

These block grant adjustments (BGAs) are required every year following the devolution of new revenue streams and/or spending responsibilities. At the initial point of devolution, it is possible (and indeed, potentially desirable) to set the BGAs equal to the amount of revenue or spending that is being transferred from the UK to the Scottish Government. However, it is not desirable for the BGAs to be set equal to the revenues actually raised, or spending actually incurred, in Scotland in subsequent years. That is because faster or slower growth in revenue (or spending) in Scotland would be offset by faster or slower growth in the BGAs, meaning no net change in the Scottish Government's funding. That would mean devolution would not satisfy its key aim: the financial accountability of the Scottish Parliament would not be increased, as just like prior to devolution, the funding available to it would not be affected by the increases in tax revenue and falls in social security spending associated with better economic performance or changes in policy. Indeed, the Scottish Government would have an incentive to cut tax rates (and increase social security benefit rates), knowing that the resulting revenue loss (and spending increase) would be offset by a lower (and a higher) BGA.

This means that after the initial BGA is calculated, an indexation method to update that initial adjustment over time is required.

2.2 The Smith Commission's principles

The Smith Commission, which agreed the devolution of powers subsequently legislated for in the Scotland Act 2016, also set out a set of principles to guide both the calculation of the initial BGAs, and the design of the subsequent indexation method. The key principles agreed were that:

• There should be no detriment to the Scottish or UK governments' budget simply as a result of the initial transfer of tax and/or spending powers ('no detriment from the initial decision to devolve'). In defining this principle, the Commission also stated that the BGAs should be 'indexed appropriately'.
• The devolved Scottish budget should benefit in full from policy decisions by the Scottish Government that increase revenues or reduce expenditure, and the devolved Scottish budget should bear the full costs of policy decisions that reduce revenues or increase expenditure ('economic responsibility').
• Changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK; changes to devolved taxes in Scotland should only affect public spending in Scotland (this has often been referred to as 'taxpayer fairness', although that terminology was not explicitly used by the Smith Commission).
• The UK government should continue to manage the fiscal risks and shocks that affect the whole of the UK for the newly devolved revenue streams and spending responsibilities ('UK economic shocks').

In addition, the Smith Commission agreed that the Barnett Formula should continue to determine the underlying block grant (before the BGAs). The block grant remains the single largest component of Scottish Government funding, equivalent to around 1.5 times as much as devolved income tax revenues, the second largest component.

The principle of 'no detriment from the decision to devolve' implies that the initial BGAs should be set equal to the revenues or spending being devolved, as has already been discussed. As we discuss further below, it may also have implications for how the BGAs are indexed if one interprets this principle as having dynamic implications in the years following devolution. The other principles suggest approaches to indexing the BGAs based on the change in 'comparable' UK government revenues or spending in the rest of the UK (rUK). In particular, indexing BGAs by reference to the change in 'comparable' revenues or spending in rUK:

1. Helps ensure that the UK government bears the risks of UK-wide fiscal shocks. For example, if a recession reduces revenues across all of the UK, including Scotland, the BGA will fall because 'comparable' revenues have declined. Lower Scottish tax revenues are offset by a smaller deduction from the block grant leaving the UK government bearing the cost of recessions that affect Scotland and the rest of the UK equally.

2. Helps ensure that the Scottish Government benefits from or bears the costs of its own policy decisions. For example, if the Scottish Government increases income tax rates in Scotland and this increases its tax revenues, Scottish revenues would exceed the BGA (which is determined by what happens to revenues in the rest of the UK rather than what happens in Scotland) and the Scottish budget would be 'better off' to the extent of the difference.

3. Helps ensure that Scotland does not benefit from increases in UK government spending that is funded by an increase in tax revenues in the rest of the UK for a tax that has been devolved in Scotland.

This third point is perhaps less intuitive than the first two. If the UK government increases tax rates for a tax that has been devolved in Scotland, then that tax increase would not apply in Scotland. The associated BGA would increase, reflecting the increase in rUK revenues. At first glance, this might not appear reasonable insofar as the treatment of the Scottish budget goes. However, it must be remembered that the UK government's additional revenues would be spent.

If they were spent on 'comparable' public services in England, this would generate a consequential increase in the Scottish Government's block grant, via the Barnett formula. The higher BGA would act to approximately offset this increase in the underlying block grant. Without an increase in the BGA, the Scottish Government would see an increase in its block grant funded by a tax increase in rUK that did not apply in Scotland. Indexing the BGA to a measure of comparable UK government revenues is therefore important when we recognise that the revenue effect of tax changes by the UK government can 'flow' to Scotland via the Barnett Formula, even when the tax changes apply to a tax that is 'devolved' in Scotland.

If the UK government spent the additional revenues on 'reserved' matters (like defence, state pensions, universal credit or debt interest) that benefit the whole of the UK, the increase in the BGA would ensure that taxpayers in Scotland make a broadly similar contribution to that expenditure as taxpayers in rUK, despite the tax increase not applying directly in Scotland.

The same logic applies in the case of tax cuts and reductions in spending by the UK government: indexing the BGA to revenues in rUK offsets the reduction in funding via the Barnett formula or amount spent on reserved matters, helping ensure residents of Scotland do not see a reduction in government spending despite continuing to pay the same the same level of taxes.

The preceding discussion highlights the merits, indeed the critical importance of, indexing the BGAs to some measure of the change in comparable revenues and social security spending in rUK. Note that more precisely, the BGA should be indexed according to some measure of the change in comparable revenues and spending in those parts of the UK where UK government tax and benefits policy directly applies. This is England and Northern Ireland for the devolved taxes (because of tax devolution to Wales) and England and Wales for social security (given benefits are officially devolved to Northern Ireland). This is shown in the rightmost column of Table 2.1, but hereafter, rather than regularly switching between "England and Northern Ireland", and "England and Wales" we use the term "rUK" as a general term to refer to the relevant territorial area.

However, there is more than one way of measuring the change in comparable revenues and social security spending in rUK. Figures can be calculated on a cash or percentage basis. They can also adjust for various factors such as differential population and demographic change and differences in the structures of taxbases that may affect expected growth in tax revenues. Most of the rest of this report considers whether different specific ways of calculating the change in comparable revenues and spending in rUK are more consistent with the Smith Commission's principles than others – as well as the risks and incentives they expose the different governments to and their potential financial implications. This is the subject of the next chapter of this report.

Another key feature of the way the BGAs are calculated that has implications for the budgetary risks faced by the Scottish Government is that they are initially determined by Office for Budget Responsibility forecasts of rUK revenues and social security spending, and subsequently reconciled to outturns once data becomes available. Similarly, the tax revenues and social security spending that accrues to the Scottish budget are also initially based on Scottish Fiscal Commission forecasts, and again reconciled to outturns later. This process of forecasting and reconciliation can mean the Scottish Government has to 'pay back' funding to the UK government (if, for example, outturn tax BGAs are higher than forecast, and/or outturns tax revenues are lower than forecasts), or may receive extra funding from the UK government (if, for example, outturn tax BGAs are lower than forecast, and/or outturn tax revenues are higher than forecast). A number of respondents to our call for evidence highlighted the uncertainty and risk associated with this process. In our view it's an inherent and unavoidable feature of BGA indexation linked to rUK revenues and spending. Other elements of the Fiscal Framework – such as powers to borrow and hold and draw down reserves – are the best mechanisms to address these uncertainties and risks.