Scottish Government's Medium Term Financial Strategy: May 2019

3. Fiscal Principles and Policies

Despite the current challenging economic climate, the Scottish Government has maintained a strong record of fiscal discipline, balancing its budget every year since 2007. As this climate persists, and as we progress with the implementation of the powers from the Fiscal Framework, the Scottish Budget will be subject to greater levels of uncertainty and volatility than ever before.

In this context, the Scottish Government recognises the importance of setting out the principles and policies to guide the use of its fiscal powers, to manage budget volatility, to enhance budget flexibility and to borrow to support capital investment.

3.1 Overarching Principles

The use of our powers will depend on a number of factors, including the economic and fiscal circumstances at the time. While a greater proportion of the Scottish Government budget now comes from devolved revenues, more than half is still determined by UK Government spending decisions. This means that the circumstances in which we use our powers will often depend on decisions that are outwith our control. In view of this uncertainty, and the constraints of the existing Fiscal Framework, the Scottish Government considers a principles-based approach to be appropriate to support the effective use of the Scottish Government’s reserve and borrowing powers. 

The following principles will guide decisions on the use of our fiscal powers: 

• Sustainability – Sovereign countries generally seek to achieve this by having a broadly balanced budget position over the economic cycle. Under the current constitutional setting, the Scottish Government is constrained to a stricter standard of achieving a balanced budget annually, with only limited ability to borrow and use a reserve. Within its limited borrowing and reserve powers the Scottish Government will achieve sustainability through:
  ° Stability – Use of the powers will be taken with a view to achieving steady funding and expenditure trajectories.
  ° Budget flexibility – The powers will be applied in a manner that ensures flexibility for future budgets and the ability to respond to unforeseen events.
• Intergenerational fairness – The Scottish Government will seek to use these powers in a way that ensures future taxpayers only bear the cost of spending that benefits them.
• Value for money – Borrowing and other sources of revenue-finance investment will achieve value for money for the taxpayer.
• Transparency – The Scottish Government will set out clearly its planned and actual use of these powers.

3.2 Application of the Principles to the Reserve and to Borrowing

Scotland Reserve

The Scotland Reserve allows the Scottish Government to smooth spending within and between years, and assists in the management of tax volatility. The Reserve is capped in aggregate at £700 million, or only 2.1 per cent of the Scottish Budget in 2019-20, falling to 1.7 per cent in 2023-24, based on the central projection in this document. Annual drawdowns from the Reserve are limited to £250 million for resource and £100 million for capital. This severely restricts the Scottish Government’s ability to build up a medium-term reserve and draw down from it.

The Scotland Reserve will be used in a way that balances the principles of Flexibility, Stability and Value for Money.

• Even with tight financial management, it is important to retain flexibility. Managing expenditure across financial years often uses up a substantial proportion of the £250 million resource and £100 million capital limits. 
• Within these limitations, the Scottish Government intends to build up the balance in the Scotland Reserve over time, as resources allow, in order to have a financial cushion available, while ensuring that the Reserve retains sufficient capacity to have the flexibility to manage any underspend across financial years.
• We will use the Scotland Reserve as far as possible to smooth resource funding over time, including in relation to potential reconciliations for Income Tax under the Fiscal Framework, and to achieve a stable spending trajectory. 
• We will seek to use the Scotland Reserve in a manner that keeps the economic cost of revenue-funded investment and resource borrowing as low as possible, to achieve value for money. 
• We will operate this policy within the limitations on the overall size of the Reserve and the drawdown limits which severely restrict the scope to use the Scotland Reserve to smooth the funding trajectory.

Annex C sets out information on use of the Scotland Reserve in 2018-19 and 2019-20.

Resource Borrowing

The Scottish Government can borrow to support resourcing costs only in very specific circumstances: for in-year cash management; and for forecast error on devolved and assigned taxes and on devolved social security expenditure (and on corresponding UK forecasts for the Block Grant Adjustments). The borrowing is subject to annual limits for each scenario, and an aggregate annual limit of £600 million within a statutory overall limit for resource borrowing of £1.75 billion. ⁶

The resource borrowing powers will be used in a way that balances the principles of Flexibility, Stability and Value for Money:

• Resource borrowing is an important tool to help achieve stable funding and spending trajectories, in order to ensure macroeconomic stability. Repayment terms would be as short as possible, to minimise servicing costs, subject to the need to smooth resource spending over time. 
• In the context of the constraints outlined above, the scope for reductions in spending and/or use of any funds held in the Scotland Reserve would generally be considered first, before any decision is taken on resource borrowing. 

No resource borrowing has been undertaken to date and none is planned in 2019-20.

Capital Borrowing

The capital grant funds the majority of direct capital investment by the Scottish Government. In addition to the capital block grant, the Scottish Government can increase capital expenditure through borrowing up to £450 million per year up to a maximum total of £3 billion. While these powers enable the Scottish Government to support the capital investment programme and promote economic growth in Scotland, there are limitations to their use. 

The capital borrowing powers will be used in a way which balances the principles of Flexibility, Stability, Value for Money and Intergenerational Fairness and supports the delivery of the National Infrastructure Mission: 

• The 2019-20 Budget sets out the baseline for the National Infrastructure Mission (NIM) in 2019-20 of £5.2 billion, which will increase by £1.56 billion by the end of the next parliament in 2025-26. In order to achieve this increase in investment, capital borrowing will be required as part of a combination of funding sources that also include capital grant, financial transactions and alternative revenue-finance models, including private finance.
• Capital borrowing from the National Loans Fund is a lower-cost alternative to privately financed investment, so this source of borrowing can help achieve value for money. However, there is both an annual limit and an overall cap on use of this borrowing.
• The term structure of borrowing will be chosen to strike the right balance between flexibility (requiring shorter term lengths), value for money (requiring shorter term lengths), and stability (suggesting longer term lengths) and intergenerational fairness (term length corresponds to asset life).
• A contingency reserve of £300 million of the capital borrowing limit will be left unused, to provide the flexibility to undertake capital borrowing if an unforeseen need arises to stabilise the spending trajectory, recognising that we do not yet have capital budgets beyond 2020-21. The annual £450 million drawdown limit would still apply, potentially limiting the immediate use of the contingency borrowing.
• Over the period of the NIM, our policy is to borrow between £250 million and £450 million annually to ensure that there is sufficient investment planned to support economic growth, and that investment increases overall year-on-year. The decision on the term would be taken at the appropriate time in each year, dependent on factors prevailing at the time such as interest rates and the impact on the resource budget. Borrowing of £450 million is expected to be required in 2019-20 and £350 million in 2020-21.

Scenario modelling of borrowing options is set out in Annex B. This indicates that a range of options could be undertaken over the course of the next parliament, leaving the £300 million contingency reserve and remaining within the five per cent resource limit. These options include borrowing between £250 million and £450 million each year until 2025-26. The modelling also demonstrates that there is less sensitivity to interest rate movements than to the term of loan or amount borrowed. Annex B also sets out borrowing that has been undertaken to date, as well as planned borrowing in 2019-20 and 2020-21.

Revenue-Finance Investment

The Scottish Government uses revenue finance to deliver additional high-value infrastructure projects, which could not be delivered with capital grant alone. Previous tools used have included the Non-Profit Distributing (NPD) model; the revenue-finance Hub programmes, tax incremental financing and growth accelerator; and guarantees such as the Rental Income Guarantee Scheme. Some of these projects may also have had some capital grant-funded element. Such infrastructure projects are financed through annual payments or increased tax revenue, typically over a 25- to 30-year period.

Within this framework, the affordability and sustainability of all Scottish Government long-term revenue commitments, including repayment of debt stock, are assessed as part of the Budget process and are kept within a maximum of five per cent of the resource Budget available (excluding social security). This was tightened at Budget 2019-20 from the previous limit of five per cent of the total Scottish Budget.

The commitments included in the five per cent calculation are the Scottish Government’s share of the ongoing costs of: previous Public Private Partnership (PPP) contracts that are now operational; Non-Profit Distributing (NPD) and Hub programmes; growth accelerator; and cost of borrowing. This self-imposed limit ensures that we do not overly constrain our budget choices in future years. Annex B sets out more detail on the funding of infrastructure in the National Infrastructure Mission.

3.3 Review of the Fiscal Framework

The Fiscal Framework will be reviewed by the Scottish and UK Governments following an independent report produced by the end of 2021. This Review will ensure that the Framework is ‘fair, effective and transparent’, in line with the Smith Commission’s principles. Whilst the scope of the Review is undefined, apart from the need to agree a Block Grant Adjustment mechanism, a broad Review should be undertaken using these guiding principles. It should also focus, as a minimum, on the issues below:

Fairness – The Review should examine whether the current Block Grant Adjustment mechanism accurately reflects the loss in revenues to the UK Government of devolving Scotland Act 2012 and 2016 tax powers, as intended through the ‘no detriment’ principle. The Personal Allowance issue, highlighted in Chapter 2, is an example of the drawbacks of indexing the Block Grant Adjustments to the rest of the UK tax base and VAT Assignment.

Effectiveness – Chapter 3 shows the very limited flexibilities that the current Framework provides to the Scottish Government to manage budget volatility and support investment in Scotland. The Review should re-evaluate the current limits and once again examine the merits of a prudential borrowing regime as recommended by the Commission. 

Transparency – Chapter 2 highlights the uncertainty of basing VAT assignment on a methodology-generated, rather than receipts-based, outturn figure. The Review should consider whether there are more transparent ways of assigning VAT revenues to Scotland. The Commission also recommended a more productive, robust, visible and transparent relationship between the UK and Scottish Governments. The additional funding to Northern Ireland shows the continuing lack of transparency around UK Government decisions on funding issues. The Review should also consider whether current governance structures allow for transparent and consensual decision-making on all aspects of the Fiscal Framework.