Scottish Government's Medium Term Financial Strategy: May 2019

Annex A: Methodology for Calculating the Funding Outlook 

The modelling looks at each component of the Scottish Government budget in turn, and projects these individually. The main focus of the projection is on the cash budget limits provided by HM Treasury. These are then supplemented with projections of:

• Income from devolved taxes;
• Block Grant Adjustments;
• Social Security funding; and
• Capital borrowing.

Table A.1: Tax Revenues And Block Grant Adjustments For Funding Outlook

Note 1: The BGAs shown are calculated using the Indexed Per Capita (IPC) indexation method. This method in practice determines the BGAs applied to the budget.

Note 2: This includes the net impact of non-tax income (fines, forfeitures and fixed penalties & proceeds of crime) reconciliations for fully devolved taxes on the budget.

Figures may not sum due to rounding.

For revenue and Block Grant Adjustments, we use the figures that determined the Scottish Budget positions for each Budget Act for the years up to and including 2019-20. We use these figures because they informed the funding outlook for each of these years.

For 2020-21 onwards, we use the May 2019 Scottish Fiscal Commission forecast for each devolved tax. The Block Grant Adjustments are from the UK Government’s 2019 Spring Statement.

The uncertainty which is captured in the forecast derives from two key factors: uncertainty relating to forecasts of the devolved Scottish taxes and the resulting net block grant position, and uncertainty around the future budget limits from HM Treasury.

Uncertainty Relating to Devolved Tax Forecasts

It is still too soon to have a clear understanding of the uncertainty around Scottish-specific forecasts. The Scottish Fiscal Commission (SFC) published its first evaluation of its forecasts in September 2018, which highlighted the challenges of evaluating forecasts with such limited data. In its latest May forecast, the SFC suggests that it might expect an average error in its one-year ahead tax forecasts of around 3.3 per cent, or around £530 million.

As with last year’s publication, the approach to modelling uncertainty is to look at the historical variations in per-person income tax growth rates in Scotland and the rest of the UK. These are used to estimate their probability of further differences over time, and their impact on the Scottish Budget. By way of comparison, this approach results in a one-year ahead forecast uncertainty of 2.3 per cent around the devolved taxes forecast, increasing to 6.4 per cent by 2023-24.

Uncertainty Relating to Future Budget Limits

Uncertainty around budget limits is based on analysis of changes to previous budgets as a result of Barnett consequentials at previous fiscal events. Consequentials for resource, capital and financial transactions are calculated separately. In addition, a further adjustment is made for uncertainty around future budget limits related to social security. As this funding is still very new, no time series of changes to it exist. Instead, work is based on analysis of Office for Budget Responsibility (OBR) uncertainty, which suggests that social security spending forecasts are twice as uncertain as departmental spending forecasts.

Presentation of Results

Rather than present a small number of funding scenarios, the uncertainty from all sources is combined to illustrate a range of possible future paths that the Scottish Government budget may take. Differences from the central projection could occur for a broad range of reasons, such as changes to economic performance, UK Government policy, or changes in labour market behaviour. This range is presented as a fan chart.

Limitations to the Projections

There are a number of risks to the Scottish Budget which have not yet been captured within this modelling and scenario development, such as the assignment of VAT. It is expected that further information will be built into modelling in future years as information and understanding increases, including future UK Government funding once a new Spending Review is undertaken.

The modelling assumes that the current Fiscal Framework methodology (indexed deduction per capita) is used across the entire five-year period.

Further uncertainty in the funding outlook is introduced through the forecast process itself and through divergence in economic performance. Risks around Scottish Government income differing from forecast can be twofold:

• Scottish devolved tax is different from forecast; or
• the rest of UK tax is different from forecast.

Tax forecasts are often linked to economic forecasts. Economic variables such as employment and incomes will be important in determining decisions such as whether households purchase a house, or whether businesses choose to invest. For example, the income tax forecast can be affected by a range of potential factors including:

• employment growth;
• wage growth;
• changes in income distribution in Scotland and the rest of the UK; and
• impact of policy changes.

To this extent, the tax forecasts are often viewed as being closely linked to the economy forecast, with the overall business cycle effects on employment and wage growth likely to be key drivers in the short term, although other factors such as the distribution of incomes and policy choices also play a role. Towards the end of the five-year period, longer term underlying trends such as productivity, demographics and labour market participation may also begin to affect the forecast.