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

7. Policy Priorities

The distinct Scottish Government policy approach

7.1. A decade ago, in 2007, the introduction of the Scottish Government National Performance Framework ( NPF) ^[13] and the outcomes-based approach to Government was ground breaking and presented the foundation for a transformative shift in how future policy would be developed and delivered by the Scottish Government.

7.2. Our "Scottish Approach" is focused on outcomes – on driving improvement; on building on the strengths and assets of individuals and communities; and on services which are shaped and co-produced by both service providers and the people and communities who receive and engage with those services.

7.3. The principles of this performance framework have stood the test of time and they are as relevant now as they were ten years ago. Since its introduction the NPF was refreshed in 2011 and 2016. With the introduction of the Community Empowerment (Scotland) Act 2015 (which came into force 15 April 2016), the outcomes-based approach has been given a statutory footing and the Scottish Government has taken this opportunity to undertake a wholesale review of the framework to ensure that it is as strong and relevant as it can be.

7.4. The scope of this review includes building wider consensus around the framework; improving alignment with the UN Sustainable Development Goals and other frameworks, such as Scotland's National Action Plan for Human Rights and Scotland's Economic Strategy; and simplifying the language and look of the framework to make it more accessible. Subject to Parliamentary consideration, the new National Performance Framework will be formally launched in summer 2018.

7.5. Building on the outcomes approach, Scotland's Economic Strategy sets out an overarching framework for how we aim to achieve a more productive, cohesive and fairer Scotland. It is the strategic plan for existing and future Scottish Government policy and represents the blue print for building a stronger and more diverse future Scottish economy.

Managing challenges and uncertainty

7.6. Despite the economic turbulence created by the UK Government through the uncertainty around the UK's exit from the EU and its continued approach to austerity, the Scottish Government's clear vision of building the economy, protecting public services and developing a fairer and more inclusive society continues to lead Scotland through these uncertain times.

7.7. In common with other developed countries, Scotland has an ageing population, reflecting welcome medical and economic advances, and Scotland will benefit hugely from the skills and life experiences of its older citizens. However, changes in the Scottish population will create pressure on public sector budgets in the future.

7.8. This is reflected in the latest Programme for Government, where the First Minister highlights that, "as our population ages, we must meet the needs of our older citizens while ensuring fairness across the generations".

7.9. An ageing population is not new. It has been with us for the last 15 years but is set to accelerate from 2021 onwards and is happening at a faster rate than in the rest of the UK. There are two dimensions to this:

• first, we will see a big increase in the number of people aged 75 plus, as baby boomers age. Over the next 20 years, more than 70 per cent of all population growth will be in the 75 plus age group. The Fraser of Allander Institute's assessment of long‑term fiscal challenges noted that as our population ages and as the prevalence of chronic health conditions increases, Scotland's public finances are likely to come under significant pressure over the medium to long term from rising health costs; and
• second, our working population is ageing too, with fewer younger workers and more workers in the 50 plus age bracket. Over recent years the number of people aged 50 plus who are still working has increased in Scotland, but remains lower than in some countries in Europe. With less certainty over migration levels after the UK's exit from the EU, it will be even more important that people aged 50 plus remain in work to retirement age. As well as maintaining the size of our working population and associated income tax revenues, it is important that Scotland draws on the skills and experience of older workers and provides the opportunity for work as an important part of a fulfilling life.

7.10. A further challenge is to ensure that Scotland can maximise the benefits of its currently diverse population. A more inclusive economy where all members of Scottish society, irrespective of gender, race, disability, age or socio-economic background, are able to access appropriate, quality jobs, generate business opportunities or undertake skills progression would optimise economic and social impact.

7.11. While there is some uncertainty about how elements of demographic change will play out, the fundamentals are set, and are well understood. The challenge of an ageing population will continue at least for the next 25 years and over the longer term all future Scottish Governments will need to respond to the pressures this creates.

7.12. In contrast, the impact of technological change is less clear, yet is likely to be significant in scale. Commentators have described artificial intelligence, automation and other technological changes as one of the 'biggest economic issues of our age' and forecasts suggest that one in five jobs in Britain's cities could be displaced by 2030.

7.13. 80 per cent of the workforce in 2030 is already in the workforce now. One of the biggest strategic challenges associated with technological change is its impact on jobs – some jobs are at risk of being overtaken by automation entirely, many others will change significantly. Overlaying Scotland's demographics – in particular our ageing workforce – amplifies this challenge.

7.14. Again this will play out well beyond the five year time horizon of the Medium Term Financial Strategy, but its potential impact on economic performance, employment levels and tax revenue, constitutes a key consideration for current and future Governments and drives our investment in the economy.

Paying for public services and our policy goals

7.15. The First Minister set out a clear vision for Scotland through the 2017 Programme for Government, focused on building an inclusive, fair, prosperous and empowered Scotland. The Scottish Government will continue to implement that vision in 2018-19 and beyond and this year's budget provided the resources necessary to support that work in 2018-19.

7.16. The Programme for Government sets out the key elements of the social contract between the Scottish Government and the people of Scotland including health care, a strong and fair justice system, excellent public sector education (including free tuition fees) and support for the vulnerable – an approach which begins to lay foundations to address the demographic challenges outlined above.

7.17. Despite the challenging economic and financial context, the Scottish Government has sought to protect public services, but recognised that a fresh debate was required to talk about how we continue to maintain appropriate investment in our public services, while recognising the pressure that household incomes are under.

7.18. Ahead of the 2018-19 Budget the Scottish Government published an income tax discussion paper. Following that, we have introduced a revised, fairer income tax system for Scotland which uses the powers available to us as a lever to counter on-going UK Government austerity and support sustainability in our public services.

7.19. The Scottish Government's approach to taxation is founded on the four key Adam Smith principles of certainty, convenience, efficiency and proportionality to the ability to pay:

• certainty – this is important for households and businesses alike to ensure that financial decisions can be taken from an informed position on the path of future tax policy. That is why, for example, the Scottish Government provided certainty to landfill operators by committing that Scottish Landfill Tax will be no lower than prevailing UK rates;
• convenience – the vast majority of income taxpayers pay their income tax through Pay As You Earn ( PAYE), with little or no administrative impact on taxpayers. Decisions made in setting Scottish income tax rates and bands were made with this in mind. That is why the Scottish Government also legislated for a digital first approach to the fully devolved taxes, delivering convenience and efficiency through the use of a modern electronic payment system, while still allowing for paper returns where required;
• efficiency – this is central to the Scottish Government's approach on the fully devolved taxes. That is why the Scottish Government enabled the Land and Buildings Transaction Tax to be collected by Registers of Scotland, on behalf of Revenue Scotland, drawing on their existing knowledge and expertise of property taxes and the familiarity of taxpayers and agents with the processes involved; and
• proportionality – proportionality to the ability to pay is vital. Everyone benefits from public services and all those who can contribute are expected to do so, and those with the broadest shoulders should make the greatest contribution. Scotland led the way in the UK by establishing a progressive approach to the setting of rates and bands for Land and Buildings Transaction Tax, with the amount paid more closely related to the value of the property or transaction and therefore to the ability of individuals to pay.

7.20. As well as these principles, the Scottish Government's approach to tax is based on collaborative tax policy development, characterised by regular and engaged consultation with taxpayers, industry representatives and professional bodies and a firm approach to tax avoidance.

7.21. We want to encourage a culture of responsible taxpaying where people and companies pay their tax as Parliament intended.

7.22. The 2018-19 Budget provided a more progressive approach to taxation in Scotland, that offers both significant protection to the lowest earning tax payers and asks those best able to afford it to contribute more towards sustaining public services.

7.23. This approach introduced new income tax Starter and Intermediate rates which, alongside the increase in the Personal Allowance, see no one earning less than £33,000 per year paying more than they did in 2017-18 – meaning that more than half of all taxpayers will pay less than if they lived elsewhere in the UK.

7.24. Those changes are combined with a 1 per cent increase in the Higher Rate Threshold and asking Higher and Top rate taxpayers to pay 1 per cent more. In combination, these policies were sufficient to reverse the real terms cuts to Scottish Budgets in 2018-19, imposed by the UK Government, and are projected to contribute over £400 million a year in net additional revenues by 2022-23.

7.25. The public response to the taxation changes confirms a wider public acceptance of this balanced approach to funding public services. In developing that approach we set out four policy tests that we believe any income tax policy change must meet if it is to successfully support our economy and the delivery of, and investment in, our public services. The four tests are:

• revenue – income tax policy should maintain and promote the level of public services which people in Scotland expect;
• protecting lower earners – the lowest earning taxpayers should not see their taxes increase;
• progressivity – any tax changes should make the tax system more progressive and reduce inequality; and
• economic growth – the changes we make, along with our decisions on spending, should support our economy.

7.26. The Scottish Government's chosen income tax policy met those tests in the following ways:

• revenue – the policy is expected to raise over £210 million in 2018-19 in net additional revenues for public services in Scotland. Rate-setting decisions have been taken to ensure a balance where any behavioural impacts are forecast to be minimised;
• protecting lower earners – overall, when combined with the planned increase in the Personal Allowance, for an unchanged income, 70 per cent of Scottish taxpayers (those earning up to £33,000) will not pay any more tax in 2018-19 than they did in 2017‑18;
• progressivity – the policy improves the progressivity of the tax system by increasing the number of bands, lowering the rate on income up to £13,850, and asking the highest earning 30 per cent of taxpayers to contribute more for an unchanged income than they did last year. Under our proposal the Gini co-efficient ^[14] in Scotland is estimated to fall; and
• economic growth – the proposal will increase income tax revenues by around 1.4 per cent and the Budget sets out a range of expenditure decisions that will support inclusive growth. As outlined in the income tax discussion paper, any economic impacts from a tax rise on this scale are likely to be relatively small. Moreover, because lower earners (who spend a higher proportion of their income) are protected, the risk of an immediate impact on consumer spending will be reduced. Increasing the Top Rate by 1p, rather than the 5p proposed under some of the alternative approaches assessed in the discussion paper, also reduces the risk that high earners would change their behaviour in ways that impact on the economy.

7.27. The additional revenues generated from our income tax policy are part of what allows us to sustain our social contract with the people of Scotland and deliver on the key policy commitments set out below, which we will deliver over the medium term.

Public Service Reform – maximising the use of our resources

7.28. In addition to building the tax base in Scotland and maximising available funding, the Scottish Government is committed to reforming how public services use resources to address demographic and resource pressures to improve outcomes, especially for those whose wellbeing and life chances are poorest.

7.29. This commitment is rooted in the Christie Commission's four key principles of prevention, performance, partnership and people. This recognises that public services can improve outcomes and work more efficiently when they work together to shape joined-up services around the distinctive needs of communities, including building preventative approaches to strengthen positive outcomes and tackle persistent inequalities.

7.30. This commitment to reform underpins many of our key spending commitments, including supporting the transformation in health and social care; investment in preventative activity to give all our young people the best start in life; closing the attainment gap; and extending healthy life expectancy.

7.31. This approach requires our public services to shape their work around the needs of people – working together and with the third sector, private sector and communities to pursue accelerated progress on reform activity at local and regional levels through:

• strong, shared leadership to provide vision and drive;
• digital transformation;
• freeing up frontline staff to draw on their skills, insight and understanding of people's needs to reform local services;
• involving and empowering communities to take action to improve their wellbeing; and
• embracing the power of data and digital technologies to improve outcomes.

7.32. Examples of this work and how we are creating the conditions for reform include:

• education reform – with local government we have established six new Regional Improvement Collaborative areas. These bring together local and national expertise to support our schools to respond to local needs, work collaboratively and drive improvement, including in closing the attainment gap;
• children's services – we are supporting local public services to redesign children's services in ways that enable prevention and early intervention and reduce the need for high-intensity, high-cost services; and
• public health – our joint work with COSLA to take forward public health reform recognises that we must empower communities to make decisions to create the conditions for health in their areas. This work will take advantage of the Local Governance Review, which is creating space for new ideas to empower local communities and support inclusive growth at local and regional levels.

Outline of key policy priorities

7.33. The Scottish Government's core purpose, to focus on creating a more successful country with opportunities for all of Scotland to flourish through increased wellbeing, and sustainable and inclusive economic growth, drives the delivery of our policies and public services.

7.34. This is built on the principle of equality for all, from birth through early years and education, to employment and retirement, with access to essential public services, at the right time, which are free at the point of delivery. We target our resources to support the delivery of this 'social contract'.

7.35. We have a clear vision of the main commitments that will achieve this, which have been set out in the Programme for Government each year, with delivery over the current Parliamentary term and beyond.

7.36. The budget for these commitments in 2018-19 has been agreed by the Scottish Parliament and decisions on the level of future investment required in these policy areas will be taken as part of future budget setting processes. In detailing these commitments and explaining the challenges ahead, it is important to understand that this document is not seeking to set or determine future budgets for individual commitments or portfolios.

7.37. It is also important to note that this document does not cover all of the spending commitments that the Scottish Government will meet over the next four years, but instead highlights a range of key commitments with an indication of the potential investment that will be required to deliver them.

Resource budget

7.38. The key resource budget commitments that support the Scottish Government's social contract and require significant investment are:

• Health;
• Police;
• Early Learning and Childcare;
• Attainment;
• Higher Education; and
• Social Security.

Health

7.39. The NHS, which celebrates its 70th anniversary in 2018, is our most treasured public service. The Scottish Government is committed both to reform of and investment in the health service, including a pledge to increase resource spending on the NHS by £2 billion over the course of this Parliament.

7.40. The Scottish Government will also be publishing a Medium Term Health and Social Care Financial Framework in June 2018. The Health Framework has been developed in consultation with NHS Boards, COSLA, local government and Integration Authorities. That document considers the whole health and social care landscape (recognising that it is a framework and that further detail on financial plans and how transformation will be achieved will require to be set out elsewhere). That Framework has been structured into five main sections that:

• set out an overview of current expenditure – considering historical expenditure trends and examine how these resources have been used to deliver additional activity and an associated estimate of productivity;
• provide an estimate of the resources required to meet Scotland's health and social care needs in the future - Scotland like all other countries in the world is facing increases in demand for care due to demographic growth and increased expectations from people using services;
• map out policy initiatives and how these will influence the future shape of expenditure;
• set out the transformation activities that will be required to ensure the health and social care system is financially sustainable in the long term; and
• consider transformation funding - how reform and system change will be financed.

7.41. In the early years of the Parliament the health budget has received significant additions on an annual basis, including additional resource investment of over £400 million in the health service in 2018-19. This continued investment will ensure that prevention and early intervention improve healthy life expectancy while we transform the way we deliver health and social care to adapt to Scotland's changing health and care needs. As part of the overall financial settlement for Health, reflecting our commitment to the social contract, the Scottish Government will continue to support the provision of free prescriptions, free personal care for the elderly and free eye examinations.

7.42. That investment needs to continue over the remainder of this Parliament and decisions on the precise allocations for each year will be taken as part of the annual budget setting process.

7.43. In order to illustrate the impact of the £2 billion commitment (and to meet the commitment to pass on all health resource consequentials), Table 7.1 models an increase in the health budget of around £400 million in 2019-20, a further £300 million in 2020-21 and around an additional £600 million in 2021-22. The precise profile of funding will be considered as part of the annual budget process in the usual way.

7.44. The commitment for increased health funding runs to 2021-22 and no commitments on funding levels for the period beyond 2021-22 currently exist. For the purposes of this Medium Term Financial Strategy we have modelled an inflationary uplift in the health budget for 2022-23.

Table 7.1 – Potential health funding uplift profile

£bn	2018-19	2019-20	2020-21	2021-22	2022-23
Potential Health Funding Uplift	-	+0.38	+0.29	+0.59	+0.24
Potential Health Budget Total	12.87	13.25	13.54	14.13	14.37

Police

7.45. The Scottish Government is dedicated to protecting local communities through effective policing and, with recorded crime at a 42 year low, Scotland is as safe as it has been for over a generation.

7.46. Building on the success of police reform, we will continue to support the Scottish Police Authority ( SPA) and Police Scotland to deliver the priorities in the Policing 2026 Strategy which was laid before Parliament in June 2017. The Strategy sets out how Police Scotland will strengthen its service to communities and respond to changing demands.

7.47. In order to support that work the Scottish Government will continue to protect the resource budget of the SPA in real terms for the entirety of the Parliament – delivering an additional £100 million of investment by 2021. This equates to approximately £20 million extra in each financial year.

7.48. In addition, from April 2018 we have ensured that policing will fully benefit from being able to reclaim the VAT previously paid to the UK Government. This commitment means that the effective spending power on policing will increase by around £25 million compared with previous years. This does not require additional budget to be allocated to Police Scotland, it simply allows them to use their existing budget provision for other purposes as they no longer need to meet the VAT liability.

Early Learning and Childcare

7.49. Our focus on the early years will embed an approach rooted in prevention and early intervention, and will support those children and families who will benefit most. That is why, as part of providing the best start for every child, we are committed to a transformative expansion of Early Learning and Childcare ( ELC) provision.

7.50. We have already increased publicly funded, high quality Early Learning and Childcare by almost 50 per cent to 600 hours per year since 2007 and extended entitlement to around a quarter of two year olds, and the 2018-19 budget continues to fund that in full through local authorities. We are now working closely with local authorities to deliver our ambitious goal of increasing funded ELC entitlement to 1,140 hours per year – the same number of hours a child spends in primary school.

7.51. This will require substantial additional investment in both extra staff and premises – the 2018-19 budget delivers over £240 million of investment (resource and capital) for ELC expansion.

7.52. In line with the commitment in the 2017 Programme for Government to provide multi-year funding allocations for the ELC expansion programme, agreement has now been reached with COSLA on both the overall quantum of funding to support the expansion and the profile of that funding between now and 2021-22.

7.53. This will require further (recurring) uplifts in resource funding to local authorities of £210 million in 2019-20, £201 million in 2020-21 and £59 million in 2021-22. The multi-year funding deal agreed with local authorities currently extends until 2021-22. For the purposes of this modelling we have simply rolled forward the 2021-22 figures into 2022-23 (decisions on funding beyond 2021-22 will be agreed in future budget processes).

7.54. Table 7.2 sets out the resource funding package that has been agreed with local authorities to support the ELC expansion.

Table 7.2 – ELC expansion resource funding agreed with local authorities

£m	2018-19	2019-20	2020-21	2021-22	2022-23
Resource funding	96	307	508	567	567
Annual additional funding	-	+210	+201	+59	-

7.55. In addition to the local authority funding outlined above there are also other small elements of ELC funding within the Scottish Government Education and Skills Portfolio budget.

Attainment

7.56. All children and young people, whatever their background or circumstances, deserve the same chance to reach their full potential. That is why improving outcomes for children, young people and their families is at the heart of the Scottish Government's agenda and spending plans.

7.57. Our top priorities are to raise attainment and close the attainment gap; promote health and wellbeing; and improve skills and employability. Ensuring the best start in life for every child, irrespective of their gender, ethnicity, disability or socio-economic background, contributes to each of these four high-level priorities. Everyone will benefit in future if we invest in our young people now.

7.58. In order to support this work, the Scottish Government has committed to allocate £750 million through the Attainment Scotland Fund, over the term of the Parliament, to tackle the attainment gap.

7.59. We are already two years into this commitment, with Pupil Equity Funding already beginning to transform schools by enabling head teachers to secure the additional staffing or resources they need to support pupils affected by poverty and boost attainment levels. As minority ethnic children and children living in a household with a disabled parent or child are more likely to be in poverty, this fund also tackles wider inequalities. In 2018-19, we have allocated £180 million towards raising attainment and closing the attainment gap.

7.60. In order to fulfil this commitment, we will need to allocate around £180 million in each of the remaining years of the Parliament in order to meet the £750 million overall commitment. The precise profile of this funding has not yet been finalised, but for the purposes of the Medium Term Financial Strategy, we have assumed that this will be approximately £180 million in 2019-20 and 2020-21.

Higher Education

7.61. Scotland has an internationally successful Higher Education sector, including some of the world's oldest and most prestigious universities as well as world leading modern and specialist institutions.

7.62. The Scottish Government has made clear that we want every child, no matter their background, to have an equal chance of entering and succeeding in Higher Education – a commitment that was made in the 2014 Programme for Government. By 2030, the Scottish Government wants 20 per cent of students entering university to be from Scotland's 20 per cent most deprived backgrounds and we want a better gender balance across subjects studied.

7.63. We believe education should be based on the ability to learn, not to pay, and we are providing record levels of support for students in higher and further education as part of our commitment to the social contract. We are protecting free tuition and are also committed to providing an annual minimum income for the least well-off full-time students in higher education. We are also working closely with universities and colleges to reach a better gender balance across courses with more girls entering Science, Technology, Engineering and Mathematics ( STEM) and more boys entering social science, teaching and care courses.

7.64. We continue to prioritise funding for this and have invested over £1 billion in Higher Education in the budget settlement for the Education and Skills portfolio in 2018-19. We will fund over 125,000 free places in 2018-19. For the purposes of this document, we have assumed that a similar level of funding will be required in each of the following financial years out to 2022-23 to continue to support the delivery of this policy. Decisions on the actual amounts of funding in each year will be taken in the annual budget process. Funding is delivered through the Scottish Funding Council.

Social Security

7.65. The Social Security (Scotland) Bill was approved by the Scottish Parliament on 25 April 2018. The Bill sets up a framework for a new, Scottish social security system, drawing on the responses received to our wide public consultation and engagement programme. It transposes 11 devolved social security benefits onto a Scottish legislative platform, allowing the Scottish Government to shape a distinctly Scottish social security system based on dignity and respect. At all stages we have committed to include the views of people with lived experience of applying for and receiving devolved benefits.

7.66. The range of benefits that are being transferred from the UK Government to the Scottish Government are:

• Personal Independence Payments;
• Carer's Allowance;
• Attendance Allowance;
• Disability Living Allowance;
• Winter Fuel Payments;
• Cold Weather Payments;
• Severe Disablement Allowance;
• Industrial Injuries Disability Benefits;
• Funeral Expenses Payments (to be replaced by Funeral Expense Assistance);
• Sure Start Maternity Grant (to be replaced by Best Start Grant); and
• Discretionary Housing Payments.

7.67. The annual block grant to the Scottish Government will be adjusted to reflect the transfer of responsibility for social security from 2018-19, with additional adjustments made in future years as these social security benefits transfer to Scotland. This transfer process will be undertaken in a phased way with the majority of the social security expenditure (and associated funding) expected to come online from 2021-22 and the years that follow. Initial baseline additions to the block grant will be calculated based on UK Government spending on the area in Scotland in the year prior to devolution (as forecast by the Office for Budget Responsibility) – additions or deductions to the baseline will then be processed based on UK Government spending.

7.68. The Scottish Fiscal Commission will be responsible for the production of independent forecasts to inform the Scottish Government's annual budget.

7.69. The Scottish Government has made a number of clear commitments around the way in which it will manage the social security system in Scotland. This includes announcing that the delivery of the first of the newly devolved benefits – an increased Carer's Allowance – will take place from summer 2018 (and be backdated to April 2018) preparing for the effective delivery of the new Best Start Grant and the new Funeral Expense Assistance by summer 2019, and the introduction of a Young Carer Grant by autumn 2019.

7.70. The anticipated costs associated with these new and enhanced benefits will be met from the Scottish Budget and the anticipated additional costs for the four benefits referred to here are set out in Table 7.3.

Table 7.3 – Anticipated additional costs of devolved benefits

£m	2018-19	2019-20	2020-21	2021-22	2022-23
Carers Allowance Supplement	35.0	37.0	40.0	42.0	44.0
Best Start Grant	-	15.3	15.4	15.4	15.6
Funeral Expense Assistance	-	3.4	3.5	3.5	3.5
Young Carer Grant	-	0.5	0.5	0.5	0.5
TOTAL	35.0	56.2	59.4	61.4	63.6

7.71. The estimated implementation costs for the new social security system (as set out in the Financial Memorandum to the Social Security (Scotland) Bill) are £308 million over the period to 2020-21. These costs continue to be refined and updated as the iterative transfer of the powers progresses and as a result an agreed profile of spend has not been fixed at this time – but the Minister for Social Security confirmed at the Stage 3 debate on the Bill in April 2018 that she does not expect that figure to increase.

7.72. The Fiscal Framework provides a baseline £66 million for social security administration costs and a one-off amount of £200 million for implementation for all the newly-devolved powers (these amounts are factored into the funding projections contained in Chapter 6 of this document). These amounts represent the financial settlement delivered by the Fiscal Framework, but do not represent the full costs of implementation or administration of the new social security powers. Any additional sums required would need to be funded from the existing Scottish Budget envelope. Any required funds will be allocated as part of the normal Scottish Budget process.

7.73. In addition to the benefits highlighted above, as part of our commitment to tackling child poverty, the Scottish Government has pledged to introduce an Income Supplement for low income families. Further work is being undertaken to develop the policy of the income supplement and assess what the most cost-effective delivery route would be. Decisions on a delivery model will be based on analysis which demonstrates the most effective use of resources in lifting the maximum number of children out of poverty. Funding for the income supplement will be considered through the normal budget process at the appropriate time and no costs have been included as part of the Medium Term Financial Strategy.

7.74. The Scottish Government also remains committed to continue to fully mitigate the deductions to housing support for working age households in the social rented sector who are deemed to be under-occupying their home by the Department for Work and Pensions ( DWP), commonly known as the bedroom tax. This is currently achieved through Discretionary Housing Payments. We are committed to using our new powers to abolish the bedroom tax at source through Universal Credit ( UC) as soon as practicable and officials had been working with DWP towards achieving this by spring 2019. DWP have recently advised that the changes to the UC system to allow the bedroom tax to be abolished in Scotland would be delayed until May 2020 at the earliest. We expect to spend over £125 million in 2018-19 on social security reform mitigation measures including fully mitigating the bedroom tax to help protect those on low incomes and continuing to mitigate the bedroom tax in full is expected to cost around £55 million each year of the Medium Term Financial Strategy period.

What this means for spending elsewhere

7.75. In addition to these key areas of investment, there are of course a range of wider commitments across all Scottish Government portfolios that will need to be managed from within our available budget. This will include commitments on homelessness, child poverty, concessionary travel, free personal care, supporting the Scottish economy, establishment of the Scottish National Investment Bank, delivering on our climate change ambitions and continuing to deliver the range of public services that we have responsibility for. All of these will require a share of the overall resource budget funding that is available.

Local government funding

7.76. As partners in the delivery of public services, the Scottish Government invests a significant proportion of its budget in supporting local government to provide the essential and high quality services the people of Scotland expect and deserve.

7.77. This funding is split into revenue and capital funding and in 2018-19 the Scottish Government will provide local government with £9,814 million ^[15] of resource funding and £876 million capital funding. This represents a real terms increase in the level of resource and capital funding available to local government in 2018-19.

7.78. Revenue funding from the Scottish Government to local authorities is made up of three different components:

• general revenue grant – this makes up the majority of the funding support from the Scottish Government for local authority for revenue expenditure;
• non-domestic rates income ( NDR) – 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 which consists of a combination of the retained NDR income together with the General Revenue Grant paid by the Scottish Government; and
• specific revenue grants – these are provided by the Scottish Government and are tied to spending to support the delivery of specific policy objectives.

Public sector pay

7.79. The Scottish Government recognises the importance of supporting workers across the public sector and in 2017 agreed to remove the 1 per cent public sector pay cap from 2018. The cap had been in force since 2013 as a result of austerity measures. To help the public sector further, the Scottish Government allowed public bodies to bring forward their pay award date, meaning early access to pay awards for many public sector workers.

7.80. The Scottish Government is acutely aware of the impact that inflation and social security cuts have on working households and the removal of this 1 per cent pay increase cap will bring a much needed boost to family finances. Given the prevalence of women employed in the public sector, it should also particularly boost women's income. At the same time the need remains to balance this with what public sector employers can reasonably afford in the context of a Scottish Budget squeezed by a continued UK Government austerity policy.

7.81. Decisions on future pay policy will be taken as part of the annual Scottish Budget process, with the next budget expected in December 2018. To illustrate the potential costs of a progressive approach to pay for public sector workers, we have modelled three theoretical public sector pay award scenarios (see Table 7.4).

7.82. A central scenario assumes a continuation of the 2018-19 pay policy (based on 3 per cent up to £36,500, 2 per cent up to £80,000 and £1,600 above £80,000) in each of the years covered by the modelling. An upper scenario of 4 per cent and a lower scenario of 2 per cent are also modelled. Table 7.4 indicates what the aggregate cost could be for each year for each scenario. The costings of the policy are based on the Scottish Government, the 43 public bodies covered by the pay policy, the NHS, teachers, police, fire and further education (they do not include other local government pay costs).

Table 7.4 – Modelled public sector pay scenarios

Forecast Paybill based on Scenarios	Cost (inc on-costs) – £m
	2019-20	2020-21	2021-22	2022-23
2% per year	248	253	258	264
3%/2% per year	313	321	330	338
4% per year	497	517	537	559

7.83. The importance of carefully controlling pay increases in the public sector remains. The Scottish Government recognises that maintaining employment and fair rates of pay in the public sector is crucial in ensuring Scotland's economy remains strong and that investment in Scotland's public services remains a priority.

7.84. That is why the Scottish Government has continued its commitment to the real Living Wage and why it has maintained its position on no compulsory redundancy. It is also the Scottish Government's view that it is for employers to take their own decisions about pay progression based on business need, maintaining headcount and affordability.

7.85. The Scottish Government acknowledges the contribution of public sector workers in achieving our ambition and delivering on our priorities. That is why the 2018-19 pay policy sets an important direction of travel, subject to available resources, and will continue in future years to strike the balance between affordability and offering a fair deal for staff.

EU funding

7.86. European funding in Scotland is very important to a wide range of sectors and its loss following the UK's exit from the EU could create pressures on Scotland's public finances. The current EU funding round (2014 – 2020) is expected to benefit Scotland by over £5 billion, with the funding programmes supporting jobs, delivering infrastructure, sustaining rural communities, providing valuable support for the farming and fishing industries and delivering research funding for universities.

7.87. Details of successor arrangements to replace these EU funding programmes have yet to be proposed by the UK Government and this continues to create significant uncertainty for those who rely heavily on this investment. In addition to the direct funding that Scotland's people, public services and businesses receive from the EU, there will be wider cost implications of the UK's exit from the EU. These cannot be fully quantified at present as they are dependent on the outcome of negotiations with the EU and on policy decisions yet to be taken, and this creates an uncertain future for Scotland.

7.88. This document does not therefore speculate on the future financial arrangements for post-exit EU funding as these have yet to be set out by and agreed with the UK Government. However, we have been absolutely clear that Scotland must not be any worse off in respect of the funding allocations that replace those currently provided from the EU.

7.89. Despite the UK's exit from the EU not being Scotland's choice, the Scottish Government is working hard to press the UK Government to fully consider its implications for Scotland's public finances, in order to mitigate the worst effects in Scotland and to ensure that Scotland's finances are not detrimentally impacted.

Future shape of the resource budget

7.90. As is the case in any organisation, the setting of budgets to meet the organisation's commitments and obligations requires careful choices, decisions and prioritisation. As part of that process, we will be exploring a wide range of options, looking to deliver efficiency savings across portfolios, carefully prioritising expenditure to ensure that it has maximum impact on delivering key outcomes and priorities, including options to reduce demand through earlier intervention, looking at options for generating additional revenues and considering options for further public service reform to allow us to protect the delivery of public services at a time of financial constraint.

7.91. Looking at the central scenario for the resource budget, and taking account of the key policy commitments outlined above, this shows that in future years the proportion of the overall resource budget that is utilised by these commitments grows from 56 per cent in 2019-20 to 64 per cent in 2022-23, with overall health spending making up between 68-82 per cent of that share across the five year period. All other funding commitments will need to be met from the remainder of the budget. This position is summarised in Chart 7.1 below.

Chart 7.1 – Resource expenditure central scenario

7.92. Clearly, the other two funding scenarios set out in Chapter 6 of this paper result in different shares of the overall budget being committed to these key government priorities. Under the "upper scenario" the proportion of the budget utilised by the commitments grows from 55-62 per cent over the period and under the "lower scenario" it grows from 57-66 per cent. These positions are set out in Chart 7.2 and Chart 7.3.

Chart 7.2 – Resource expenditure upper scenario

Chart 7.3 – Resource Expenditure Lower Scenario

7.93. In setting the annual budget each year, the Scottish Government has to make careful choices in the prioritisation of commitments and expenditure in order to reach a balanced budget position – which has been delivered in every year since the Scottish Parliament came into existence.

7.94. That process will continue over the years covered within this document, and the decisions that will be taken will include consideration of the balance of funding that will be allocated to the range of priorities, to local government and to support other key public services across Scotland.

7.95. The central funding scenario that is set out in this document indicates that, as is the case in almost all annual budget processes, that decisions around prioritisation of spending, options for increasing revenues, delivery of efficiencies across all budget areas and considering options for reform will need to be undertaken to accommodate these priorities and continue to support high quality public services across Scotland.

7.96. The required level of efficiency will vary depending on the choices that are made as to the extent of reform and reprioritisation that is undertaken, and the final level of funding that is available in each year – all key considerations that will form part of annual budget processes and the next Spending Review. It is, however, clear that even under the most optimistic scenario, if no reprioritisation or reform were agreed and no additional revenues generated, then efficiency savings of 5 per cent per year could be required. While future efficiency targets (rightly) will be challenging, the decisions we take will ensure they are manageable. The Scottish Government's Efficiency Outturn report for the last 3 years indicate that efficiency savings within a range of 3-6 per cent annum are deliverable. The most recent report was published in May 2018. ^[16]

7.97. The decisions taken in setting the budget will ultimately be dependent on the size of the overall budget for each financial year. We will gain greater certainty on the block grant that the Scottish Government expects to receive from the UK Government through the 2019 UK Spending Review and anticipated levels of tax receipts will continue to be refined.

7.98. This paper provides a range of potential funding scenarios that may emerge in future years. The next budget setting process will be taken at a time when there is greater clarity and certainty on funding levels.

7.99. The Scottish Government will be carefully considering the prioritisation choices required as part of the forthcoming 2019-20 annual budget process (and those that follow) and crucially through the next Spending Review which is expected to take place following the UK Government's Spending Review in 2019. The Scottish Government will set out its approach to the next Spending Review following the conclusion of the UK process next year.

Choices on capital budget and other forms of infrastructure investment

7.100. A crucial foundation to building and supporting a successful and economically buoyant Scotland is maximising investment in infrastructure. This is central to the Scottish economy and the Scottish Government's vision for a prosperous, fair and well-connected Scotland.

7.101. In addition to the capital grant from HM Treasury, there are a number of additional approaches which the Scottish Government uses to support the economy through infrastructure investment.

7.102. This includes utilising borrowing powers to provide additional investment to support the overall capital programme and a revenue-financed hub programme to deliver schools and community health facilities. This provides additional investment and is paid for through resource budgets over a long-term period.

7.103. Non-Profit Distributing ( NPD) and revenue-financed hub programmes provide ways of financing additional projects over and above those that could be supported through capital grant alone. Such projects may also have a capital funded element. The revenue-funded element is paid through unitary charges for a period of 25-30 years once the project is completed and is funded from resource budgets.

7.104. The annual estimated unitary charges are published on the Scottish Government website. ^[17]

7.105. As part of the assumptions that underpin this paper, the Scottish Government currently plans to borrow a further £450 million in 2019-20 to support additional infrastructure investment. Final decisions on future borrowing levels will be taken as part of the 2019-20 and subsequent budget processes. These decisions will be taken annually in light of the economic outlook at the time, weighing the cost of borrowing and the opportunity cost of using up more of the overall £3 billion borrowing limit against the potential benefits of economic stimulus.

7.106. Innovative financing approaches such as Tax Incremental Financing and Growth Accelerator are also used in partnership with the Scottish Futures Trust and local authorities to attract private investment. This is paid for through increases in non-domestic rates or other economic growth metrics and the provision of guarantees to boost investment such as the Rental Income Guarantee Scheme to increase the supply of houses available for rent.

7.107. In order to maximise the government's investment in infrastructure, leverage of other funding is pursued where possible. Examples of this include the City Region Deals where it is estimated that the Glasgow City Region Deal will lever in an additional £3.3 billion of private sector investment into the proposed infrastructure investment programme, the Inverness Deal which is expected to unlock an additional £800 million of private sector investment and the Aberdeen City Region Deal anticipating around a further £500 million of leverage from the private sector and other economic partners.

7.108. Publicly funded social housing and mid-market rented ( MMR) housing also attracts matching private investment. There will be variations for individual projects but social housing grant pays approximately half the unit build cost with the remainder being funded by lenders. For many MMR schemes the private finance leverage can be much higher, generating significant investment at scale.

7.109. The Scottish Government's planned investment in infrastructure is set out in the Infrastructure Investment Plan ^[18] which was published in December 2015 and is refreshed regularly.

7.110. This plan sets out why the Scottish Government needs to invest; how it will invest and what strategic investments are planned over the medium to long term. The following guiding principles are applied to infrastructure investment:

• delivering sustainable economic growth through increasing competitiveness and tackling inequality;
• managing the transition to a more resource efficient, lower carbon economy;
• supporting delivery of efficient and high quality public services; and
• supporting employment and opportunity across Scotland.

7.111. Key commitments in the 2015 Scottish Government Infrastructure Investment Plan include:

• transforming Early Learning and Childcare – expansion to 1,140 hours per year;
• increasing housing supply in Scotland – 50,000 affordable homes;
• creating a new, overarching energy strategy for Scotland;
• delivery of super-fast broadband across Scotland;
• investment in healthcare infrastructure, including the establishment of several new diagnostic and treatment centres;
• continued investment in Scotland's Schools for the Future Programme – which will deliver 117 new schools by March 2020; and
• investment to improve transport infrastructure including measures to improve journey times and connections ( e.g. through the dualling of the A9), reduce emissions and improve the quality and accessibility of public transport.

7.112. A number of these commitments already have published multi-year profiles of anticipated capital expenditure, including long term resource planning assumptions for the affordable housing programme (out to 2020-21), and capital funding to support the expansion of Early Learning and Childcare (until 2020-21). The profile of these two key commitments is set out in Table 7.5 out to the end of their existing commitment periods. Decisions beyond 2020-21 will be taken in future budget processes once capital budgets for that period have been provided by the UK Government.

Table 7.5 – Multi-year capital funding allocations

£m	2018-19	2019-20	2020-21	2021-22	2022-23
Affordable Housing Resource Planning Assumptions	532	592	630	-	-
ELC Expansion	150	175	121	-	-
TOTAL	682	767	751	-	-

7.113. Other capital commitments have a total quantity of investment confirmed for them, but the profile of that expenditure will be confirmed as part of future annual budget processes – examples include expenditure on the R100 Broadband project (£600 million by the end of 2021-22); a four year investment commitment in energy efficiency and heat decarbonisation (£500 million over 2017-18 to 2020-21); a commitment to expand the Golden Jubilee Hospital and develop five elective care centres in Aberdeen, Dundee, Edinburgh, Inverness and Livingston (£200 million); and planned investment in the Building Scotland Fund spread over 2018-19 to 2020-21 (£150 million – of which £70 million was allocated in 2018-19).

7.114. There are also a range of other commitments that are time-bound, but funding profiles for future years beyond 2018-19 have still to be agreed in future Scottish Budgets. These commitments principally relate to individual significant projects ( e.g. the final profile of the remaining work to dual the A9) and detailed information on project costs and spend, and anticipated costs for future planned projects in the pipeline is released every six months, including to the Scottish Parliament Public Audit and Post-legislative Scrutiny Committee and is placed on the Scottish Government website. ^[19]

Local government capital

7.115. The Scottish Government funds capital investment for local authorities through providing a General Capital Grant and a small number of specific grants. In addition to the settlement, other specific grants are paid to local authorities by Scottish Government agencies and other public bodies such as Non-Departmental Public Bodies.

7.116. Specific Capital Grants are paid for specific projects or to fund specific policy objectives. The terms and conditions of each grant are set out in the offer letters for these grants. The General Capital Grant supports the delivery of a council's Single Outcome Agreement and contributes to the National Outcomes. Councils determine how they use these resources to meet local and national prioritiess.

7.117. In 2018-19, the amount of capital funding provided to local authorities was £876 million. The level of local authority capital grant for future years will be considered alongside all other capital requirements in the 2019-20 budget process.

Financial Transaction budgets

7.118. In recent years the Scottish Government has also made use of Financial Transactions ( FTs) as part of its overall approach to capital investment. FTs can only be used to support loan or equity investment in bodies outside the public sector. FTs also 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 current planned FT repayment profile to HM Treasury is set out at Annex A.

7.119. FTs have been used to support a number of housing initiatives, including equity stakes in Help to Buy and other shared equity schemes, as well as innovative financing schemes to increase the supply of homes available for mid-market rent. We have also used FTs to provide loan funding to small and medium enterprises, to provide support for energy efficiency programmes, to establish the Building Scotland Fund and to increase loan funding available for low carbon vehicles.

7.120. The Scottish Government's 2017 Programme for Government committed to establishing a Scottish National Investment Bank to boost Scotland's competitiveness and realise the Scottish Government's ambitions for the economy by providing patient capital to finance growth. This commitment was made on strong international evidence that national investment banks of scale can lead to a strong, positive impact on investment, innovation and long-term economic growth.

7.121. In 2018-19, it was announced that £340 million of FTs would be set aside over 2019-20 and 2020-21 (profile of investment still to be confirmed) to provide the initial capitalisation of the Scottish National Investment Bank. The Implementation Plan for the Bank (which was published in February 2018) indicated that there should be an aim to provide a target level of public capital for the Bank at a minimum of £2 billion over the first 10 years (2019-20 to 2028-29).

7.122. Taking the sums above along with the £150 million of planned investment in the Building Scotland Fund (as a precursor to the establishment of the Bank in 2019), the overall plan is therefore an initial investment in the Bank of almost £0.5 billion in the first three years.

7.123. It is our intention to continue to support similar types of schemes into the future through the use of the on-going profile of Financial Transactions out to 2022-23 (subject to confirmation in the 2019 UK Spending Review that the funding will continue beyond 2020-21).

7.124. The Scottish Government has an ambitious capital expenditure programme and it is simply not possible to progress everything at once due to the size of the overall capital budget. Projects will be prioritised and progressed both to deliver upon the key commitments that have been made and to align with the overall availability of the approximately £4 billion per year of capital funding in the Scottish Budget.

7.125. Decisions on the content of the capital programme for 2019-20 and beyond will be made up of a combination of expenditure on maintaining our existing asset stock, continuation of projects that are currently underway and the commencement of new projects. Final details of the content of the programme (for both capital and Financial Transactions) will be confirmed in the 2019-20 Scottish Budget, in December 2018.