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

4. Role of the UK Government

4.1. While the Scottish Parliament now has expanded powers, the UK Government retains a central role in determining both the size of the Scottish Budget and the overall economic climate. This is because key economic levers remain reserved to Westminster – monetary policy, macroeconomic policy and the majority of tax powers. Control over migration policy, which has a major impact on the economy, is also reserved.

4.2. Responsibility for tax policy and the economy are shared between the Scottish and UK Governments. This document outlines the Scottish Government's approach to sustainably managing Scotland's finances. Where decisions taken by the UK Government have an impact on Scotland's economy and public finances, we will continue to engage constructively with the UK Government to reduce any detriment to Scotland.

Current UK Government fiscal policy

4.3. Through the Fiscal Framework, the UK Government sets the overall funding envelope that is available to Scotland. While new powers allow the Scottish Parliament to use its taxation powers to increase or decrease the budget available, the starting point for the Scottish Budget is still determined by the size of the block grant.

4.4. This has been particularly challenging over the last decade with the UK Government's approach to austerity. This has meant that in real terms over the ten years to 2019-20 the Scottish Government's discretionary budget allocation will have been cut by over 9 per cent (£2.6 billion).

4.5. Managing difficult financial circumstances is the job of Government, which is why during the development of the 2018-19 Budget the decision was taken by the Scottish Government to introduce a five band income tax policy to generate additional revenues and reverse the real terms cut to the budget imposed by the UK Government.

4.6. The Scottish Government is committed to investing in our public services and our infrastructure and has continually urged the UK Government to change its course on austerity to provide the resources that our public services need.

4.7. A particular concern is how the UK Government's austerity policies disproportionately affect the most disadvantaged individuals. For example, the Resolution Foundation ^[7] estimates that the UK Government's policies will leave the poorest third of households an average of £745 a year worse off by 2022-23.

4.8. Social security changes that came into effect in April 2018 are being imposed on some of the most vulnerable sectors of society. The Resolution Foundation has estimated that 2018-19 is set to be the second biggest single year of social security cuts, with £2.5 billion of cuts expected.

4.9. The Scottish Government is fully committed to supporting and protecting these vulnerable populations and has made available £62 million in 2018-19 to local authorities to:

• fully mitigate the bedroom tax for more than 70,000 households;
• help mitigate other UK Government policies such as the Benefit Cap and Local Housing Allowance rates; and
• support those on low incomes.

4.10. Despite the UK fiscal deficit having now returned to pre-crisis levels, the UK Government is planning for further tax rises and spending cuts until the middle of the next decade. This objective is underpinned by the UK Government's fiscal rules to:

• reduce the structural deficit to below 2 per cent of GDP by 2020-21;
• have net debt as a percentage of GDP falling in 2020-21; and
• return the public finances to balance at the "earliest possible date in the next Parliament", currently assumed to be 2025-26.

4.11. To achieve these targets, the UK Government plans to continue with its programme of tax rises and spending cuts over the coming years. It is estimated that the UK Government's current plans aim to reduce the structural deficit by 6 per cent of GDP, or around £120 billion in today's terms.

4.12. The latest forecasts from the Office for Budget Responsibility show that the scale of the tax rises and spending cuts planned by the UK Government mean that it is on course to not just meet its first two fiscal targets in 2020-21 ^[8] but to go beyond them. The UK Government can therefore meet these fiscal objectives while reversing some of the spending cuts that are currently planned. As a broad illustration:

• this could provide approximately £60 billion of additional investment over the five year period to 2022-23, compared to current UK Budget plans, as set out at the Spring Statement. This in turn would make an additional £5 billion of investment available for Scotland over this period, compared to current UK Budget plans;
• alternatively, the UK Government could also adopt a more gradual deficit reduction which strikes a better balance between ensuring the sustainability of the UK public finances and investing in the public services which are vital to supporting households and long-term economic growth. As outlined in Annex C, such an approach could potentially provide an additional £7 billion in investment for Scottish public services relative to current plans.

4.13. The UK Government therefore has flexibility to meet its fiscal objectives without implementing in full the spending cuts that are currently planned for the coming years. Were the UK Government to use some of this fiscal headroom, this could result in billions of investment in our vital public services in Scotland.

4.14. While the central budget forecasts in this document have to be based on the UK Government fiscal rules and therefore upon a continuation of UK Government austerity, it is clear that austerity is a choice made by the UK Government rather than an economic necessity.

Immigration

4.15. In considering the financial outlook for this new document, it is important to reflect on the key fact that population growth has been the most significant driver of GDP growth in both Scotland and the UK in recent years.

4.16. The strategic importance of population growth to Scotland's economy has been recognised since 2007 in the National Performance Framework. The Purpose Target to match average European ( EU15) population growth over the period 2007 to 2017 has been met – statistics published in April 2018 confirm that Scotland's population grew slightly faster than the EU15 average over the last 10 years, closing the previous gap between Scotland and the EU15 in relation to population growth.

4.17. International migration has been the largest contributor to Scotland's population growth over the past 10 years, and to a greater extent than in any other part of the UK. The most recent population projections from National Records of Scotland indicate that all of Scotland's population growth over the next 25 years is expected to come from migration (from both overseas and the rest of the UK). Therefore migration is essential for Scotland and is particularly important given the prospect of more projected deaths than births in Scotland every year from now on.

4.18. The age profile of the population will also change. The proportion of the population of state pension age will increase by 25 per cent over the next 25 years. People aged 75 and over are projected to be the fastest growing age group in Scotland, increasing by 79 per cent over the same period.

4.19. At the same time as we expect to see these large increases in the proportion of the population of pensionable age, the working age population will grow only slightly, by around 1 per cent over the next 25 years.

4.20. All of this creates challenging future population demographics for Scotland.

4.21. The Scottish Fiscal Commission, in its first Economic and Fiscal Forecasts published in December 2017 ^[9] , observes that "the size of the population aged 16 to 64, which makes up most of the working age population, is very important for the economy and public finances. These individuals are more likely to be working and will be generating the highest tax receipts, for example, in income tax."

4.22. In variant population projections, where migration is reduced, the proportion of working age people in the population begins to decline. For example, in the scenario where projected migration from the EU is cut by half, the proportion of the population of working age falls by 0.8 per cent over the next 25 years.

4.23. Migration is crucial to help grow our working age population, but the impact of the UK's exit from the EU, the prospect of future restrictions on migration from the EU, and the 'hostile environment' policy of the UK Government all exacerbate the challenge and inhibit Scotland's population growth.

4.24. That has a direct impact on our economic prospects. The long-term impact on the economy of lower migration, as a result of the UK's exit from the EU, was set out in our recent paper "Scotland's population needs and migration policy: Discussion paper on evidence, policy and powers for the Scottish Parliament" ^[10] . The 'Brexit' effect of reduced migration could reduce Scotland's GDP by 4.5 per cent per year by 2040 – equivalent to a fall of almost £5 billion a year. That is a more significant reduction than the rest of the UK will face, where real GDP could be 3.7 per cent lower by 2040 as a result of an EU exit-driven reduction in migration. The proportionately larger impact on Scotland is equivalent to £1.2 billion per year by 2040.

4.25. If the UK Government achieves its arbitrary net migration target, to reduce net migration to the 'tens of thousands', the economic impact would be even more extreme. Using a low migration variant of the population projections, where net migration to the UK is assumed to be +85,000 per year in the long-term, real GDP in Scotland could be 9.3 per cent lower by 2040, or £10.2 billion of lost GDP.

4.26. This provides a compelling economic case for why Scotland needs a tailored approach to migration, particularly in the context of an evolving devolution settlement where the Scottish Parliament now has significant new powers in relation to taxation. The downside risks of immigration policies decided by the UK Government, and not supported by any party in the Scottish Parliament, have significant consequences for Scottish areas of devolved responsibility.

UK exit from the EU

4.27. The prospect of the UK leaving the European Union has created huge and significant uncertainties for the Scottish Government, the public sector, businesses and families.

4.28. While the outcome of the negotiations on the UK's departure from the EU is not yet known, both the Scottish Fiscal Commission and the Office for Budget Responsibility expect it to have a negative impact on the economy. This is due to the uncertainty created by the negotiations, and the anticipated outcome of the final settlement, which is expected to reduce growth in trade and limit immigration.

4.29. The actual impact on the Scottish Budget will depend on future UK Government spending decisions and the relative impact on Scottish and UK tax receipts. Changes in UK Government spending will directly affect the Scottish Budget through the Barnett formula.

4.30. The uncertainty over a UK exit from the EU – with no clearly agreed path in terms of our on-going access to key EU markets – is hampering economic growth and investment. The UK Government pursuit of a hard exit will undermine Scotland's economic prospects by creating significant impediments to trade in good and, in particular, services. Our paper "Scotland's Place in Europe: People, Jobs and Investment" showed that the pursuit of a hard exit will damage the Scottish economy and risk jobs and investment. A hard exit threatens to cost our economy £12.7 billion (£2,300 per person) a year by 2030, compared to remaining in the EU.

4.31. An EU exit which results in the UK being outside the European Single Market and Customs Union will have the most damaging consequences for Scotland. The EU is the largest single market for Scotland's international exports, with exports worth £12.7 billion in 2016 supporting directly and indirectly hundreds of thousands of jobs across Scotland.

4.32. Outside the Single Market we would also miss out on new measures in services and digital, for example, estimated to be worth an additional 2.4 per cent of EU GDP. The equivalent for Scottish GDP would be £3.6 billion, or £668 per person.

4.33. It is therefore clear that membership of the Single Market and Customs Union is the only way to allow the continued level of EU market integration that is so critical to the future of the economy.

4.34. Membership of the European Union also allows direct access to EU funding programmes, worth over £5 billion in the current 2014-20 EU budget round. Outside of the European Union, access to these funding streams is not guaranteed, creating significant uncertainty for those who are reliant on them.

Funding disputes

4.35. In recent years, the Scottish Government has also been pursuing a number of funding discussions with the UK Government in relation to issues such as the backdating of Police and Fire VAT; the funding deal that the UK Government reached with the Democratic Unionist Party (and the consequences of that for the rest of the UK); future levels of Network Rail funding; and funding to support the preparation for the UK Government's decision to leave the European Union – which taken together represent over £3 billion of potential funding.

4.36. Clearly all of these topics have a bearing on the overall level of funding available to the Scottish Government and a positive resolution to these would provide additional funding to support public services in Scotland.