Scotland's Fiscal Outlook: the Scottish Government's five-year financial strategy

2. The Scottish Budget and Fiscal Framework

How the Scottish Budget financial settlement has evolved

2.1. When a devolved government was first introduced in Scotland in 1999, it inherited funding arrangements driven by the long-standing Barnett formula. Under the Barnett formula, the Scottish Government's block grant each financial year is equal to the block grant baseline plus a population share of changes in UK Government spending on areas that are devolved to the Scottish Parliament. This mechanism continues to apply today to changes in UK Government spending on areas that are devolved to the Scottish Parliament. The detail of how the Barnett formula works is set out in the UK Government's Statement of Funding Policy ^[1] .

2.2. The Scottish Government's budget is now determined through a combination of block grant funding from HM Treasury, adjusted to reflect forecasts of receipts generated through taxes devolved to Scotland (through the Scotland Acts 2012 and 2016) and the planned use of available devolved borrowing powers. The Scottish Government will retain all devolved and assigned Scottish tax revenues.

2.3. This means that the block grant is reduced to take account of the tax revenues raised in Scotland and no longer raised in the rest of the UK. This is done through a Block Grant Adjustment ( BGA) mechanism which is set out in the Fiscal Framework.

2.4. It should be remembered that macroeconomic and monetary policy, and the overall public expenditure control framework, are reserved matters. This means that the UK Government's decisions on the envelope for public expenditure and its allocation between UK Departments are still a major determining factor in the overall funding available for Scottish devolved public spending.

2.5. Once overall public expenditure budgets have been determined in accordance with the Statement of Funding Policy and the Fiscal Framework, the Scottish Government has freedom to make its own tax decisions and spending decisions on devolved programmes, within the overall budgetary control totals set by HM Treasury and in compliance with the Consolidated Budgeting Guidance issued by HM Treasury.

2.6. The Scotland Acts 2012 ^[2] and 2016 ^[3] and the associated Fiscal Framework ^[4] change the sources of funding that support Scottish Government expenditure. Currently the revenue raising powers include:

• Income Tax – HM Revenue and Customs ( HMRC) is responsible for the collection and management of income tax in Scotland and the rest of the UK. The Scotland Act 2016 gave the Scottish Parliament the power to set all income tax rates and bands (but not the power to determine any reliefs or exemptions, including the Personal Allowance) that apply to Scottish taxpayers' non-savings and non-dividend ( NSND) income. On 20 February 2018 the Scottish Parliament set new income tax rates and bands for the new tax year 2018-19. ^[5]
• Land and Buildings Transaction Tax – This replaced the UK Stamp Duty Land Tax in Scotland from 1 April 2015. The new Land and Buildings Transaction Tax ( LBTT) is applied to residential and commercial land and buildings transactions in Scotland (including commercial purchases and commercial leases) where a chargeable interest is acquired. Revenue Scotland administers the collection of this tax.
• Scottish Landfill Tax – The Scottish Landfill Tax ( SLfT) replaced the UK Landfill Tax in Scotland from 1 April 2015. Revenue Scotland administers the collection of this tax with support from the Scottish Environment Protection Agency.

2.7. Further tax raising powers still to be adopted by the Scottish Government include:

• Air Departure Tax – Following the Scotland Act 2016, the Scottish Parliament passed the Air Departure Tax (Scotland) Act 2017 which provides for Air Departure Tax ( ADT). This will replace UK Air Passenger Duty ( APD) in Scotland once the new tax is introduced. The Programme for Government 2017-18 reaffirmed the Scottish Government's commitment to reducing the overall burden of ADT by 50 per cent, and to abolishing the tax altogether when resources allow.

The introduction of this new devolved tax has been deferred until the issues related to State aid and the Highlands and Islands exemption have been sufficiently resolved to avoid compromising the devolved powers. The Scottish Government and UK Government are working closely to find a solution.

• Aggregates Levy – This is a tax on the commercial exploitation of rock, sand and gravel. The Scotland Act 2016 gave the Scottish Parliament the power to legislate for a tax to replace the Aggregates Levy in Scotland. The UK tax has on-going domestic and EU legal issues around State aid which need to be resolved before the power can be commenced. The ability to set Aggregates Levy policy will provide opportunities to better integrate environment, planning and other policies within Scotland.
• Value Added Tax ( VAT) – In Scotland, VAT is estimated to raise around £10 billion a year for the UK Government. The Scotland Act 2016 allows for receipts from the first 10p of the standard rate of VAT and the first 2.5p of the reduced rate of VAT in Scotland to be assigned to the Scottish Government. All VAT policy, including the power to set VAT rates, will remain reserved to the UK Government.

Scottish assigned VAT is expected to be the second largest tax revenue, after income tax, for the Scottish Government. A transitional year for VAT assignment powers is expected to operate in 2019-20, and the Scottish Government's budget will face the fiscal impact of these measures from 2020-21.

2.8. The financial settlement continues to evolve to take account of changes being introduced. For example the social security forecasts which are set out in the Supplementary Financial Memorandum to the Social Security (Scotland) Bill show that by 2022-23, the Scottish Government will potentially receive a funding transfer of more than £3.5 billion from the UK Government to fund the delivery of the new social security benefits. Funding for existing benefits will be transferred through the Fiscal Framework. This level of funding assumes no changes to eligibility criteria and uprating policy by the UK Government. Future increases in social security demand and new policy choices will require to be funded from the Scottish Budget in the future.

How is the Scottish Government resource budget now calculated?

2.9. The Fiscal Framework sets the rules by which these new tax powers are implemented and managed. The key element of this is how the block grant is adjusted to account for the fact that the Scottish Budget is now funded to a greater extent through Scottish tax revenues.

2.10. An initial baseline adjustment is made for each tax. This is to compensate the UK Government for the tax revenue which is now being retained by the Scottish Government. This deduction is equal to the UK Government's receipts from the relevant tax generated in Scotland in the year immediately prior to devolution.

2.11. In subsequent years, the Block Grant Adjustments ( BGAs) for each tax are updated to take account of changing UK Government tax revenue over time. The block grant is therefore adjusted in line with the change in corresponding UK Government tax revenues per head.

2.12. This means that if devolved Scottish tax revenues per head grow at the same rate as in the rest of the UK, the Scottish Budget will be no better or worse off than before devolution. This is because the amount being taken out through the Block Grant Adjustment is the same as the amount coming in through devolved tax revenues.

2.13. If per capita tax revenues grow faster in Scotland than the rest of the UK then the Scottish Budget is better off than would have been the case under pre-devolution funding arrangements, and vice versa. The reasons for this could reflect differences in economic performance in Scotland and the UK as well as different choices about tax policy.

2.14. The Scottish Budget is, therefore, now calculated as follows:

Barnett determined block grant	-	Adjustment to reflect rUK revenues foregone (BGA)	+	Revenues raised from devolved tax in Scotland	=	Scottish Budget

2.15. It is worth noting that Block Grant Adjustments are initially based on forecasts. Once outturn data is available, any difference between the forecast Block Grant Adjustment and the outturn Block Grant Adjustments will be applied to the Scottish Government block grant following the publication of outturn data. The exception is VAT, which relies on estimates of Scottish specific data, from survey data, as Scottish VAT cannot be identified separately without an unreasonable administrative burden on businesses.

2.16. It is recognised that these changes are new and need time to determine how they will work and best be implemented. It is therefore planned that an independent review of the current Fiscal Framework will be undertaken and that this review should be informed by an independent report with recommendations presented to both Governments by the end of 2021.

Key components of the Scottish Budget

2.17. The funding available to support the Scottish Budget consists of a number of elements: resource funding, capital funding, Financial Transactions from the UK Government through the residual block grant, and other sources of income including devolved taxes and non-domestic rates. Chart 2.1 illustrates the way in which the overall Scottish Budget (resource, capital and Financial Transactions) was allocated across Portfolios in 2018-19 – with the percentage share and budget amounts for the larger Portfolios.

Chart 2.1 – TOTAL PORTFOLIO BUDGETS FOR 2018-19

Resource budget

2.18. The resource budget funds spending on operating costs for public services. The resource budget has two elements: cash and non-cash. The cash element covers day-to-day spending, including staff pay, heating and lighting for schools, hospitals and other public buildings, support for front line public services and social security payments. This element of the budget is funded by a combination of the newly devolved taxes and the block grant.

2.19. The non-cash element of the resource budget is used to meet depreciation and particular accounting charges and is ring-fenced so it cannot be used for any other purpose. The budget projections in this document do not include any analysis of non-cash.

2.20. A small number of programmes, while they fall within the devolved responsibilities of the Scottish Government, are funded annually by the UK Government on the basis of demand (known as UK funded Annually Managed Expenditure ( AME)). These budgets are ring-fenced for specific purposes – principally NHS and Teachers' pension payments and student loans. While the amounts for these areas are significant – NHS and Teachers pension costs alone are in excess of £2.5 billion per year – the UK funding mechanism means that these areas have no impact on the wider budget management of the Scottish Government. These areas are funded on the basis of the estimates of what we need and HM Treasury fiscal rules prohibit the use of funding provided for these areas to support other expenditure. Consequently, although these amounts are included in the total budget managed by the Scottish Government, they are not considered further in this publication.

2.21. Public sector pensions are clearly a significant future call on the public finances and an area of significant financial risks given the demographic changes expected in the medium and longer term. However, the mixture of reserved and devolved funding arrangements for the vast majority of central government pension liabilities in Scotland shares the risk between the Scottish and UK Governments. We are keeping pension liabilities in devolved areas under careful review.

Capital budget

2.22. Capital spending is money that is spent on maintenance of and investment in new assets that support and will create growth in the future. The Scottish Government capital budget plays an important role in funding major infrastructure projects in Scotland. When contracts are agreed for these, they become legal commitments which run over a number of financial years and impact on future budgets. The capital budget is funded from a combination of the block grant received from the UK Government, capital receipts (for example sale of land and buildings) and any capital borrowing undertaken by the Scottish Government.

2.23. The Scottish Government's Infrastructure Investment Programme includes both economic and social infrastructure and is defined as:

"The physical and technical facilities, and fundamental systems necessary for the economy to function and to enable, sustain or enhance societal living conditions. These include the networks, connections and storage relating to enabling infrastructure of transport, energy, water, telecoms and internet, to permit the ready movement of people, goods and services. They include the built environment of housing; public infrastructure such as education, health, justice and cultural facilities; safety enhancement such as waste management or flood prevention; and public services such as emergency services and resilience."

2.24. The capital budget also funds expenditure on maintenance which enhances the economic life of existing assets and can also be used for financial assets such as investments and loans. Capital grants can also be used to enable other organisations, such as local authorities and registered social landlords, to fund their own capital programmes.

Financial Transactions

2.25. Financial Transactions ( FTs) are a subset of capital funding from HM Treasury which were introduced in financial year 2012-13 and which can only be used to make loans to, or equity investments in, entities or individuals outside the public sector. FTs need to be repaid to the Scottish Government for onward repayment to HM Treasury. Agreement has been reached with HM Treasury that only 80 per cent of the total needs to be repaid, with the remainder available for recycling into other FT funded schemes. The most recent repayment schedule for FTs is illustrated in Annex A.

2.26. No interest is payable to HM Treasury by the Scottish Government for the repayment of FTs. Interest rates charged on FT schemes can vary and be at commercial or below market rates, depending on the purpose of the loan and compliance with State aid rules. The repayment period should be appropriate to the nature of the loan/investment and could be shorter or longer in duration.

Other sources of funding

Non-domestic rates

2.27. Non-domestic rates ( NDR), also known as business rates, are a tax on non-domestic properties to help pay for local council services. They are charged on most non-domestic and commercial properties, including shops, offices, pubs and hotels.

2.28. This tax is collected and retained by local authorities, on behalf of the Scottish Government. The Scottish Government guarantees each local authority's needs-based formula share of the annual central government funding. This formula share is derived from a combination of the retained NDR income together with a general revenue grant paid by the Scottish Government.

2.29. The operation of the Non-Domestic Rate Account is set out in Schedule 12 of the Local Government Finance Act of 1992. The legislation requires that Ministers set a distributable amount of NDR income for any year in the annual Local Government Finance Order, which is issued in advance of the start of the financial year to which it relates.

2.30. The distributable amount is set with reference to the forecast NDR income to be collected for the year and the accumulated balance on the NDR account. From 2018-19 the Scottish Fiscal Commission ( SFC) is responsible for preparing the forecast for NDR income to be collected. The forecast of the likely NDR income for the year is developed based on a number of factors (including the impact of a revaluation, an assessment of likely successful appeals losses, the level at which the poundage is set and the package of reliefs that Ministers wish to put in place). The distributable amount is based on that forecast, the accumulated balance in the NDR account and the overall financial outlook for the Scottish Budget.

2.31. The estimate of NDR income is unlikely to equal the amount actually collected for that year by local authorities, as a range of factors will influence the final receipts ( e.g. economic growth may be higher/lower than forecast or successful appeals may be more/ less than forecast). A statement of the NDR account is published annually in accordance with legislative requirements.

2.32. The Scottish Government is committed to keeping the NDR Account in balance over time. The impact of variations in forecast, against actual receipts, when compared with the distributable amount, can be expected to give rise to individual surpluses or deficits at times.

2.33. Details of the amounts of NDR income estimated to be collected and distributed, together with the calculation of the amount to be distributed, are published in the annual Scottish Budget.

Fees and charges

2.34. Charging for public services is a feature of the public sector landscape across the world, and is particularly important in the delivery of services provided by local authorities and public bodies.

2.35. Where it is well targeted and designed, charging can be an integral part of a progressive approach to the delivery of public services, reducing the burdens on taxpayers and encouraging the type of behaviours that we would want to see as a progressive society, particularly in relation to environmental behaviours. For example, the Scottish Government is setting up an expert panel to advise on the use of fees and charges to manage materials which are difficult to collect and recycle and which cause significant environmental impacts.

2.36. The Scottish Government, in consultation with local government partners and public bodies will continue to consider the role of fees and charges in a progressive approach to delivery of public services.

The Scottish Budget process

2.37. There are a number of important steps in the budget setting process. The resources managed by the Scottish Government must be authorised by a Budget Act agreed by the Scottish Parliament. The Scottish Fiscal Commission also has a crucial role to play here in accurately forecasting future income in Scotland from devolved taxes and expenditure on devolved social security.

2.38. The principles and procedures for the annual budgeting process, the format of the budget documents and procedures for in-year reallocation of budgetary provision are the subject of a Written Agreement between the Scottish Government and the Scottish Parliament Finance and Constitution Committee – which was agreed by the Scottish Parliament on 8 May 2018.

2.39. Under the full Scotland Act 2016 powers, the Scottish Parliament will ultimately be responsible for agreeing around £21 billion in devolved and assigned tax revenue and over £3.5 billion in devolved social security spending. To enable the Scottish Government to manage the additional risks and volatility associated with the devolution of these powers, the Fiscal Framework set out a limited set of fiscal tools available to it. These are explained further in Chapter 3.

2.40. In recent years the Scottish Government has delivered a series of annual budgets, an approach which will continue for the 2019-20 budget process, the last year of the current UK Spending Review period. There is an expectation that the next UK Spending Review (in 2019) will offer sufficient multi-year budget information to provide the Scottish Government with the opportunity to develop a multi-year approach to the development of its budgets.

Other factors which affect the Scottish Budget

2.41. In addition to spending decisions by the UK Government at the UK Autumn Budget that will impact on the Scottish Budget via Barnett consequentials, there are other factors which will have consequences for the Scottish Government's budget. These include:

• Reconciliations of forecasts to outturn – Block Grant Adjustments are initially based on forecasts by the UK Government Office for Budget Responsibility of corresponding UK tax receipts and expenditure in the rest of the UK. Once outturn data is available, any difference from the forecast figure will be applied to the Scottish block grant in the subsequent Scottish Budget. For the fully devolved taxes, outturn data is available around six months after the financial year and for income tax, outturn data is available around 15 months after the financial year.

For income tax, there is a further reconciliation applied to the block grant to account for any difference between the Scottish Fiscal Commission income tax forecast used at the budget for the relevant financial year and final HMRC outturn for Scottish income tax. In effect, it is therefore the net difference between this reconciliation and the income tax BGA reconciliation outlined above that will have an impact on the Scottish Budget.

• Land and Buildings Transaction Tax and Scottish Landfill Tax – The Scottish Government receives these receipts during the financial year from Revenue Scotland as they are collected. There is therefore no need for a reconciliation. However, any variance from forecast amounts is managed within the year as part of the overall budget management strategy.
• Tax policy changes by the UK Government at the Autumn Budget – Policy changes made by the UK Government to taxes that are devolved to Scotland will feed through to the Scottish Budget via adjustments to the block grant.

The role of the Scottish Fiscal Commission

2.42. The Scottish Fiscal Commission was established on a statutory basis from 1 April 2017 under the Scottish Fiscal Commission Act 2016. The Commission is structurally and operationally independent of the Scottish Government. Commissioners are accountable to and give evidence to the Scottish Parliament as required.

2.43. The Commission produces, twice yearly, independent forecasts of:

• Revenue from fully devolved taxes;
• Non-savings, non-dividend income tax receipts;
• Onshore Gross Domestic Product ( GDP) in Scotland; and
• Expenditure on devolved social security benefits.

2.44. The Commission is also responsible for setting out its assessment of the reasonableness of the Scottish Government's projections of borrowing requirements.

2.45. Under the Fiscal Framework arrangements, the independent forecasts by the Commission have a crucial role in helping the Scottish Government plan its expenditure. For example, these forecasts are vitally important in developing the annual budget and this new Medium Term Financial Strategy by forecasting what the future likely income will be for the Scottish Government over the next five years as well as expenditure on social security.