Scottish Government's Medium Term Financial Strategy: May 2019

2. Funding Outlook

Under the Fiscal Framework, three key factors determine the Scottish Budget: 

• UK Government overall fiscal stance – the block grant from the UK Government remains the single biggest determinant of funding for the Scottish Budget. Changes in the grant are determined by changes in the spending of UK Government Departments through the Barnett formula, so remain entirely outside the control of the Scottish Government;
• UK Government tax performance – changes in UK Government tax policy can result in UK Government tax receipts growing at different rates from devolved tax receipts. Through the Block Grant Adjustment process, the Scottish Budget is adjusted for the amount of tax raised per capita in Scotland compared to the rest of the UK. For example, increases in property taxes in England may result in property tax income increasing faster in the rest of the UK than in Scotland, which would increase the Block Grant Adjustment and reduce the size of the Scottish Budget; and
• Scottish fiscal performance – if Scottish tax revenue per head for devolved taxes grows faster than in the rest of the UK, through better economic performance, the Scottish budget will increase. If the Scottish Government makes tax policy decisions that increase or decrease tax revenue, these will also have a direct impact on the Scottish Budget.

2.1 UK Fiscal Stance - A Decade of Austerity

This Strategy is being produced at a time of unprecedented austerity. At the end of 2018, UK public spending as a share of national income had fallen for the ninth successive year, the first time that this has happened since the Second World War. Contrary to suggestions that austerity has come to an end, the Office for Budget Responsibility’s independent forecasts show that public spending as a share of GDP is forecast to continue to fall further in the coming years.

The UK Government’s austerity agenda has hurt the poorest and most vulnerable in our society. In particular, the UN Special Rapporteur on Extreme Poverty and Human Rights has argued^[2] that the UK Government’s policy on austerity was a political choice, and that alternatives to austerity could have transformed the situation of millions of people living in poverty.

The decision to reduce public spending in the UK in 2010 was a response to the financial crisis in 2008. In part, this reflected pressure on governments internationally to reduce the pace of growth in public spending, as the global economy grew more slowly after the financial crisis. However, the reduction of spending in the UK was larger than that in most other similar countries. It was also larger than other countries that saw a similar impact on economic output. This clearly demonstrates the degree to which the scale of public spending reductions seen in the UK since 2010 were a political choice, rather than an economic necessity.

Chart 1: Changes In G7 And EU15 Economic Growth And Public Spending Since 2008

* Data for Japan only available since 2005; Source: OECD and Scottish Government analysis

By failing to deliver on the pledge to end austerity, the UK Budget in October 2018 missed the opportunity to provide much-needed direction and leadership for our longer-term finances and the wider economy. The UK Government needs to address this failure and, instead, set out a path for investing in public services. The Office for Budget Responsibility (OBR) has forecast that the Chancellor will have an additional £26.6 billion available in 2020-21 to invest in public services, whilst still meeting his fiscal rules.

Inevitably, Scottish public services have been affected by UK austerity. The resource block grant given to the Scottish Government by the UK Government is currently £2 billion lower in real terms than it was in 2010. The decision to pursue a path of austerity by successive UK Chancellors has meant that over £12 billion less has been invested in Scottish public services over the last nine years. The limited powers afforded to the Scottish Government over devolved taxation are not enough to offset entirely the decisions imposed on our budget from Whitehall. By 2023-24, the Scottish Government expects total resource spending (excluding social security) to have been £18.3 billion less than if spending had remained at 2010-11 levels.

Chart 2: Scottish Government Real-Terms Resource Funding Since 2010-11

Funding for fiscal resource expenditure, excluding social security; source: Scottish Government

2.2 Impact of other UK Government Decisions on the Funding Outlook

In addition to a decade of austerity, and the ongoing uncertainty over the UK’s exit from the EU, Scotland’s funding outlook has also been affected by a number of UK Government policy decisions that have had a detrimental impact on Scotland’s public finances.

Additional Funding to Northern Ireland - Following the General Election in 2017, the Conservative Party agreed a confidence and supply arrangement with the Democratic Unionist Party (DUP), which resulted in a £1 billion allocation to Northern Ireland. Had the well-established arrangement set out in the Statement of Funding Policy been followed, Scotland would have received almost £3 billion of additional funding. This issue is yet to be resolved, and the UK Government has since announced that Northern Ireland has received an additional £140 million for its 2019-20 Budget. These funds were allocated directly to devolved matters, but did not result in additional funding for Scotland or Wales.

Employer Pension Contributions – The UK Government’s decision to change the discount rate for public sector pension schemes has resulted in significant increases in employer contributions for the Scottish Government. This creates unsustainable pressures, and proposed levels of funding from HM Treasury do not meet the additional costs for any of the pension schemes, with a total shortfall across Scotland of over £100 million. A large part of this total is NHS pensions, where the UK Government explicitly committed to fund 100 per cent of the cost increases. Failure to fully fund these costs will have a significant and detrimental impact on the delivery of essential front-line services in Scotland.

Police and Fire Services VAT – The change in VAT status for Police and Fire services in Scotland has enabled communities in Scotland to directly benefit from an additional £35 million in spending power for our vital emergency services. However, the settlement did not address the inequitable treatment suffered by Scotland’s emergency services between 2013 and 2018, since the £175 million paid to HMRC over that period has not been returned.

2.3 Tax Revenue

Income Tax

Ahead of the 2018-19 Budget, the Scottish Government published an income tax discussion paper exploring options for how Scottish income tax powers could be best used. The Scottish Government subsequently introduced a revised, fairer income tax system for Scotland, using the powers available to us as a lever to counter ongoing UK Government austerity and support sustainability in our public services. 

Decisions made in the 2019-20 Budget ensure that Scottish income tax continues to meet the four tests of raising additional revenue; protecting lower earning taxpayers; improving progressivity; and supporting economic growth.

Fifty-five per cent of income taxpayers in Scotland in 2019-20 will continue to pay less than people earning the same income in the rest of the UK, while still raising the revenue needed to support investment in the Scottish economy and public services. 

Had we applied UK income tax policy in 2019-20, our own analysis shows that we would have over £500 million less to spend in 2019-20. The additional revenues raised as a result of our policy choices are part of what allows us to sustain our social contract with the people of Scotland and deliver on our key medium-term policy commitments.

Changes to the Income Tax Personal Allowance 

The UK Government’s decisions to increase the Personal Allowance for 2018-19 and 2019-20 have a relatively larger impact on Scottish income tax liabilities, because Scotland has proportionally more Basic Rate taxpayers than the rest of the UK. As a result, the Scottish income tax base and income tax receipts are reduced proportionately more than the rest of the UK income tax base and the Block Grant Adjustments. The Fiscal Framework contains provision for a compensating transfer where this sort of ‘spillover’ effect takes place. The Scottish Government has requested that a spillover be considered in relation to these increases. 

VAT

The Scotland Act 2016 allows for receipts from half of the VAT raised in Scotland to be assigned to the Scottish Government. However, the power to set VAT rates will remain reserved to the UK Government. With no direct policy levers for the Scottish Government, this is purely assigning a proportion of funds to the Scottish budget with a corresponding Block Grant Adjustment.

UK and Scottish Government officials have worked together to develop the draft VAT assignment model, but significant concerns remain around the potential volatility associated with it and the impact on the Scottish budget. The backdrop of EU exit may create additional uncertainty. Robust VAT forecasts cannot feasibly be constructed in this uncertain environment. This is particularly relevant as, under current plans, the baseline year for VAT receipts coincides with the current timetable for exiting the EU. Additionally, the lack of an actual receipts-based outturn figure means that the accuracy of the estimate-based outturn figure will never be known. Similar concerns have been raised not only by the Scottish Parliament’s Finance and Constitution Committee, but also by stakeholders such as Audit Scotland, the Fraser of Allander Institute and the Chartered Institute of Taxation.

In this context, it is only prudent for the Scottish Government to seriously consider postponing the assignment of Scottish VAT and commit to reviewing the position at the time of the Fiscal Framework review.

Air Departure Tax

The Scotland Act 2016 devolved powers over Air Passenger Duty, enabling the Scottish Government to make arrangements for the design and collection of its replacement, Air Departure Tax (ADT). 

Following updated advice from the UK Committee on Climate Change – and the new 2045 target for net-zero emissions proposed as a result – the Scottish Government has taken the difficult decision that reducing ADT is no longer compatible with Scotland’s new emissions reduction targets. 

The Scottish Government remains committed to taking on the power. The UK and Scottish Governments have agreed that introduction of ADT will be deferred beyond April 2020 to ensure that it is not devolved in a defective state. To protect rural communities, a solution has to be found to the Highlands and Islands (H&I) exemption issue before the tax can be taken on. 

The Scottish Government will continue to work with the UK Government and the H&I Working Group to find a solution. The UK Government will maintain the application of Air Passenger Duty in Scotland in the interim. 

Aggregates Levy 

Since the passage of the Scotland Act 2016, the devolution of Aggregates Levy has been prevented by ongoing European and domestic legal questions regarding aspects of the UK levy. 

The UK Government recently announced that these questions have been resolved and subsequently published on 13 March a discussion document outlining plans for a review of the UK levy. The Scottish and UK Governments will be discussing the review and its implications for the timing of devolution.

In preparation for the eventual devolution of the levy, the Scottish Government appointed the environmental consultancy Eunomia in 2018 to review, model and analyse options for a Scottish-specific Aggregates Levy. 

Tax Forecast

Table 2 shows the forecast net position for each tax, using the latest Scottish Fiscal Commission (SFC) forecasts for Scottish tax revenues and the most recent forecasts for the Block Grant Adjustments from the UK Government’s Spring Statement 2019. There are no Block Grant Adjustment forecasts for 2024-25, because the OBR only produced forecasts of corresponding UK Government receipts required for the Block Grant Adjustments up to 2023-24.

Table 2: Latest Forecasts Of Tax Revenues And Block Grant Adjustments

£ million		2017-18	2018-19	2019-20	2020-21	2021-22	2022-23	2023-24	2024-25
Income Tax	Revenue	11,005	11,486	11,703	12,332	12,831	13,374	13,985	14,613
	BGA	11,127	11,665	11,709	12,380	12,825	13,300	13,805	n/a
	Difference	-122	-179	-5	-48	6	74	180	n/a
LBTT1	Revenue	557	553	616	655	691	724	759	794
	BGA	584	547	535	568	611	651	705	n/a
	Difference	-27	6	81	88	80	73	54	n/a
SLfT1	Revenue	148	143	109	87	12	14	15	15
	BGA	113	105	92	86	92	84	72	n/a
	Difference	35	38	17	1	-80	-71	-57	n/a
Total	Revenue	11,710	12,182	12,429	13,075	13,534	14,112	14,758	15,421
	BGA	11,824	12,318	12,336	13,034	13,528	14,035	14,582	n/a
	Difference	-114	-136	93	41	7	77	176	n/a
Estimated income tax reconciliation2					-229	-608	-188

Note 1: The 2017-18 LBTT and SLfT revenue and Block Grant Adjustment are outturn figures.

Note 2: Estimated income tax reconciliations are only available for years when a budget has already been produced. The 2020-21 reconciliation relates to 2017-18 income tax; the 2021-22 figure relates to 2018-19 income tax; the 2022-23 figure relates to 2019-20 income tax. See Annex C for details.

Figures may not sum due to rounding.

The SFC forecasts for income tax have increased in every year from 2018‑19 of the forecast period, relative to their forecasts last December. Cumulatively, this is an increase of over £490 million between 2017-18 and 2023-24, driven largely by an improved outlook for earnings. 

The latest BGA forecasts made in March have grown faster since the previous forecast in October 2018, when compared with the increase in SFC revenue forecasts between December 2018 and now. This has resulted in a projected reduction in available funding relative to the previous comparable sets of forecasts. 

Changes to estimates for tax revenues for 2019-20 do not have any immediate impact on the current budget position.^[3] The updated forecasts for future years provide an indication of the level of revenues that the SFC anticipates, but these figures will not be used to set the 2020-21 budget in December 2019, which will make use of the next set of forecasts that the SFC produces.

Final revenues and Block Grant Adjustments for income tax are recalculated when outturn data is available, around 16 months after the end of the financial year, and a budget adjustment is then agreed for the following budget year. This means that the difference between forecast and outturn income tax for 2017-18, the first year of the current powers, will be accounted for in the 2020-21 Scottish Budget. The expected reconciliation adjustments are shown in Table 2, with details provided in Annex C.

2.4 EU Funding

During the 2014-20 EU budget round, Scotland is estimated to receive over £5 billion in funding from the EU. This supports a wide range of activities across Scotland, delivering infrastructure, sustaining rural communities, providing valuable support for the farming and fishing industries, and delivering research funding for universities.

As a result of the UK Government’s chosen route for exiting the EU, the UK will pull out of large elements of this funding without consultation and without setting out clear alternatives. UK Government commitments on successor arrangements are still not defined. 

In their post-EU exit spending forecasts, the OBR has assumed that any reductions in contributions to the EU will be recycled into substitute spending by the UK Government^[4]. However, how that will translate into allocations under Barnett to the Scottish Budget is still unclear. 

The amount of future funding that Scotland will receive beyond EU exit and any transition period will therefore be dependent on the outcomes both of the UK Government’s future spending plans, and any discussions between the UK Government and devolved administrations on future financial settlements to reflect EU exit. 

In the absence of firm commitments to the amounts that will be provided under alternative arrangements, we cannot yet quantify levels of funding in the future and any impact this will have on the Scottish Budget.

However, the Scottish Government has been clear that, given Scotland voted overwhelmingly against leaving the EU, funding levels should not be reduced as a result of the UK’s exit. All lost EU funding must be replaced in full, so that the benefits that EU funding has provided to many sectors across Scotland can be maintained. 

2.5 Medium-Term Funding Paths 

Modelling Scottish Government funding scenarios is challenging, as the Fiscal Framework is still relatively new and there is limited information available on the performance of forecasts relative to outturn data. In addition, under the current UK Government Spending Review, the UK Government has not yet set budgets for UK Departments and devolved administrations beyond 2019-20 (2020-21 for capital), but has indicated an intention to undertake a Spending Review in summer 2019.

Table 3 shows how each funding component is projected to change over the next five years in the Scottish Government’s central scenario.

Table 3: Funding Components (Nominal)

£ million	2018-19	2023-24	Average annual growth
Total cash budget	32,049	41,508	5.3%
Resource budget1	27,624	32,151	3.1%
New social security spending	178	3,876	85.0%
Capital budget limit	3,596	4,971	6.7%
Financial Transactions	401	519	5.3%
Capital borrowing	250	n/a2	n/a

Note 1: Resource budget: Fiscal Resource Budget limit and the net Block Grant Adjustment and reconciliations; updated for Supplementary Estimates; including additional adjustments for NDR, Scotland Act Implementation, Migrant Surcharge, Queen's and Lord Treasurer's Remembrancer (QLTR), Rail Resource Grant. Social security funding is not included and is shown separately.

Note 2: Chapter 3 sets out the Scottish Government’s policy for capital borrowing. The funding outlook includes planned borrowing of £450m in 2019-20 and £350m in 2020-21. Over the remaining period of the National Infrastructure Mission, our policy is to borrow between £250 million and £450 million annually to ensure that investment increases overall year-on-year but this is not included in this modelling.

Table 4 provides a breakdown of projected Scottish Budget funding out to 2023-24 for the central scenario, as well as upper and lower ranges.

The central scenario analysis suggests that, by 2023-24, the Scottish Budget (excluding non-cash and Annually Managed Expenditure) could be around £41.5 billion. However, this remains uncertain, and the scenario modelling indicates that the size of the Budget could range between £39.2 billion and £43.8 billion. This reflects the uncertainty around the block grant and Scottish devolved tax income, and the impact of economic uncertainty, such as the UK's exit from the EU. 

This uncertainty translates into very different outlooks for growth in the Scottish Budget between 2018-19 and 2023-24, with growth projected to be between £7.2 billion and £11.7 billion (in cash terms). In the central scenario, the budget is projected to grow by £9.5 billion over the five-year period, of which £3.7 billion relates to the transfer of additional Social Security powers, and around £2.3 billion derives from Health consequentials.

The funding trajectory shows significant growth mainly because of the devolution of Social Security powers to Scotland. As this additional funding is accompanied by new Social Security responsibilities for the Scottish Government, the change does not increase spending power. Social Security-directed funding will increase from 2019-20 onwards, with a particularly large increase in 2020-21 when the remaining powers will be devolved to Scotland.

Ten of the eleven benefits being devolved to Scotland are demand-led: spend is driven by the number of people who have a claim as set in legislation, rather than by the amount allocated in a budget. Budgets for these benefits are based on Scottish Fiscal Commission forecasts, rather than spending limits. The Scottish Government will need to manage any differential between the Scottish Fiscal Commission’s forecasts and actual benefit expenditure.

The capital outlook assumes that the maximum amount of capital borrowing (£450 million) will be undertaken in 2019-20 and £350 million in 2020-21. As set out in chapter 3, our policy is then to borrow between £250 million and £450 million over the remaining period of the National Infrastructure Mission, but this is not included in modelling of the capital outlook. Final decisions are always taken within the relevant budget year, depending on circumstances.

Chart 3: Outlook For Resource And Capital Scottish Budget (Nominal, Including Social Security)

 

Chart 3 shows how the range around the central projection evolves over time. In 2023-24, the variability amounts to around ±5 per cent of the overall budget. It also highlights how differences can cumulate over a relatively short period. The single largest source of future variations in the Scottish Budget is likely to be the Block Grant Adjustment, although Barnett consequentials will remain a significant source of uncertainty. Further detail is provided in Annex A.

While the Scottish Government budget is increasing in nominal terms, the outlook for Scottish Government spending remains constrained by UK Government fiscal policies. The UK Government has failed to deliver its pledge to end austerity, with the OBR forecasting that public spending as a share of national income will continue to fall.

Chart 4: Growth In Resource Spending (Nominal)

In Scotland over the next five years, the budget for resource spending on day-to-day public services (after excluding the transfer of new social security powers) is expected to grow by 3.1 per cent a year in nominal terms but only 1.1 per cent a year in real terms. 

Despite the measures introduced by the Scottish Government to support public services, decisions by the UK Government will mean that austerity will continue in Scotland. The Chancellor’s spending plans imply continued real-terms cuts to public spending outside health, as the Institute for Fiscal Studies has highlighted.^[5] This means that funding available to other public services in Scotland will continue to be constrained over the coming years.

Chart 5: Outlook For Resource Spending (Excluding Social Security)

As shown Chart 5, Scottish Government resource spending (excluding social security) has fallen from 20.5 per cent of GDP in 2010-11 to 16.5 per cent today and is expected to remain around this level until at least 2023‑24.

Table 4: Summary Outlook For The Medium-Term Financial Strategy

£ million (nominal)	2018-19 (outturn)	2019-20	2020-21	2021-22	2022-23	2023-24	Average annual growth3
Overall budget1
Upper range		34,007	38,568	39,839	41,909	43,767	6.4%
Central scenario	32,049	33,644	37,503	38,099	39,857	41,508	5.3%
Lower range		33,388	36,720	36,311	37,803	39,247	4.1%
Resource budget2
Upper range		28,582	29,366	30,342	31,962	33,326	3.8%
Central scenario	27,624	28,384	28,857	29,526	30,952	32,151	3.1%
Lower range		28,186	28,348	28,709	29,942	30,976	2.3%
New social security
Upper range		318	3,489	3,715	3,935	4,150	87.7%
Central scenario	178	313	3,370	3,521	3,694	3,867	85.0%
Lower range		309	3,251	3,326	3,453	3,584	82.3%
Capital budget limit
Upper range		4,032	4,475	4,792	4,976	5,254	7.9%
Central scenario	3,596	3,978	4,320	4,534	4,693	4,971	6.7%
Lower range		3,924	4,165	4,276	4,409	4,687	5.4%
Financial Transactions
Upper range		625	888	989	1,036	1,036	20.9%
Central scenario	401	519	606	519	519	519	5.3%
Lower range		519	606	0	0	0	n/a
Capital borrowing
Upper range		450	350	n/a	n/a	n/a	n/a
Central scenario	250	450	350	n/a	n/a	n/a	n/a
Lower range		450	350	n/a	n/a	n/a	n/a

Note 1 Overall budget: Total Scottish Government funding excluding non-cash elements. 

Note 2 Resource budget: Fiscal Resource Budget limit and the net Block Grant Adjustment including forecast reconciliations; updated for Supplementary Estimates; including additional adjustments for NDR, Scotland Act Implementation, Migrant Surcharge, Queen's and Lord Treasurer's Remembrancer (QLTR), Rail Resource Grant. Social security funding is not included and is shown separately.

Note 3: The expected average annual inflation rate (GDP deflator) over the five years is 1.9 per cent.