Scotland's Fiscal Outlook: The Scottish Government's Medium-Term Financial Strategy

2. Scotland’s economic outlook

This chapter provides an overview of the current economic outlook for Scotland from the Scottish Fiscal Commission (SFC), the Scottish Government’s official independent economic and fiscal forecaster and the Office for Budget Responsibility (OBR), the official forecaster for the UK Government. The forecasts help highlight the potential medium-term risks and opportunities to the economy and underpin the forecasts of devolved tax revenue and social security expenditure.^[22]

2.1 State of the economy

There have been unprecedented falls in economic activity in Scotland, the UK and other nations around the world as a result of COVID-19 and the restrictions imposed to manage and reduce its spread. In response to this, there has been an equally unprecedented level of support offered to households and businesses, with Scottish Government support for businesses and the self-employed reaching almost £3 billion.

The Scottish economy has begun a fragile recovery from the falls in spring 2020 and the roll-out of a large scale vaccination programme brings a welcome boost of optimism but the scale and speed of any recovery remains both fragile and uncertain.

To date, economic activity in Scotland is still around 5.7% lower than in February 2020, prior to the direct impacts of the COVID-19 pandemic. At the end of October, 195,200 employees in Scotland were still on full or part-time furlough. In effect, the Job Retention Scheme continues to support jobs and businesses but it may be masking the true impact of the crisis on the official unemployment rate which is still at a relative low of 4.2%.

However, there is evidence that the labour market is still in a precarious and relatively fragile state. HMRC’s Real Time Indicator data suggests there are now around 75,000 fewer employees in Scotland relative to this time last year.^[23] Data from the Office for National Statistics (ONS) shows that there are almost 935,000 fewer workforce jobs across the whole of the UK, relative to March 2020.^[24] Furthermore, surveys on employers’ intention to recruit remain subdued and the number of advertised vacancies across the UK are still around a third lower than at the start of 2020.

These figures emphasise the underlying challenges in the labour market caused by the pandemic as well as the importance of ongoing support to help mitigate the worst of the impacts and protect household incomes until the vaccination programmes can be fully rolled out. It is also why the Scottish Government has acted to support and protect businesses during the pandemic through business grants for those impacted by restrictions or packages of support for sectors that have been particularly affected during the crisis.

Given the scale and far-reaching impact of the pandemic, the latest forecasts from the SFC show a sombre outlook for the Scottish economy. GDP is now forecast to fall by 10.7% in 2020 as a whole and not recover to pre-pandemic levels until the start of 2024. After beginning to recover at the end of 2020, GDP is now forecast to fall again in 2021 Q1. The technical criteria for a Scotland-specific economic shock have also been met. As discussed in Box 1, the SFC note that this results from their forecasts being produced at a different time using different information than the latest OBR forecasts.

Over the longer term, the SFC expect a degree of longer-term scarring, with economic activity around 4% lower at the beginning of 2025 than their previous forecast published in February last year. Unemployment is expected to rise in 2020 and peak at 7.6% in 2021 Q2 (after the expected unwinding of the Coronavirus Job Retention Scheme) and will likely remain higher than pre-pandemic levels throughout the forecast horizon.

2.2 Economic risks and opportunities

The COVID-19 pandemic has either started, or accelerated, changes that are likely to result in permanent differences to the way that we live our lives, thus challenging us to rethink the way we shape our cities and communities.

It is already evident that this economic crisis has had different sectoral impacts. Retail, hospitality and leisure industries have been hit particularly hard by physical distancing measures, whilst industries that are able to use home working have been more sheltered. Areas of the country that rely on tourism have had a bruising year. Although some areas may have seen a cushioning effect from a rise in domestic “staycationing”, research from the IFS has highlighted that, particularly in rural and coastal areas with a disproportionate reliance on tourism related activities, the persistence of physical distancing and travel restrictions will continue to cause challenges. The same is true of some cities such as Glasgow which have large hospitality industries.^[25] Likewise, the steep fall in the global oil price, and continuing lower levels of demand as a result of the economic downturn are likely to weigh heavily on the Oil and Gas industry and supporting supply chains based in Aberdeen and the North East.

While for many sectors the impact of these changes has been severe, the changes we have had to make to adapt to COVID-19 have also presented opportunities for some sectors of our economy. The need for physical distancing has increased the reward from investment in new technologies to allow us to remain in contact with colleagues, clients and friends and family. Scotland’s existing strong and innovative technology sector means that we are well placed to maximise this new opportunity. This is why we commissioned Mark Logan, former Chief Operating Officer of Skyscanner, to undertake a review of the Scottish tech sector, creating a blueprint to raise it to world-class status. We are now working to take forward his ambitious recommendations, including the establishment of a national network of hubs for tech start‑ups, offering world‑class training programmes, intensive mentoring, and access to funding opportunities.

The pandemic has also accelerated changes in behaviour that may have permanent effects on the economy. It seems likely that home or flexible working will become more common, with more than 15% of companies already indicating that they will make more use of home working in the future.^[26] These changes to working patterns will also lead to changes in the ways that people spend their money, and we may continue to spend more online or in local communities rather than in city centres. This provides us with an opportunity to build on the work we have already done to deliver 20-minute neighbourhoods, enabling people to live better, healthier lives and supporting our net zero ambitions. With more employers seeing the benefits of flexible working, this could have a transformative impact for our ambitions for fair work and equality at work. As part of this, we are committed to supporting local supply chain development and continuing to deliver on Community Wealth Building, ensuring that local people and businesses have a genuine stake in producing, owning and enjoying the wealth they create.

Scotland has a highly skilled workforce, substantial natural resources and a long-standing reputation for innovation to help us adapt to any new circumstances in a post-COVID-19 world. We have notable strengths in sectors such as Food and Drink, Finance and Business Services as well as areas such as Life Sciences – a high wage, high productivity sector that generated over £300 million worth of business research and development for the Scottish economy alone in 2019.

We are pursuing a green recovery in the aftermath of COVID-19, capturing the opportunities of a transition to net zero and creating new jobs in the green energy sector. This is at the heart of the 2020-21 Programme for Government and our updated Climate Change Plan, both of which seek to capitalise on our strengths in natural capital, our skilled energy sector workforce and strong links with universities to set Scotland at the forefront of growing global markets such as renewable energy.

2.2.1 Scotland’s relationship with Europe

The end of the transition period with the EU, and the new trading relationship that has replaced it, pose a significant challenge.

People living in Scotland can now no longer work, study or travel freely in the EU and it is likely that fewer people would now migrate to Scotland than if full membership had been retained. This makes our economy, culture and wider society poorer than it otherwise would have been.

New trading regulations are reducing the viability and competitiveness of Scottish exporters. This is particularly true for those sectors most exposed to the changes with the EU such as manufacturing, food and drink, agriculture, forestry and fisheries. These sectors face some of the sharpest increases in trade frictions, such as the introduction of customs controls, rules of origin and non-tariff barriers.

Already we have seen the impacts of additional trade requirements impacting on our exporters, particularly in the fishing industry. We are seeing delays in deliveries due to new non-tariff barriers and certification requirements, causing significant damage to businesses, particularly those trading in high-value, but perishable and short-shelf-life produce. This could, in turn, have a disproportionate impact on areas with a high degree of reliance on the fishing industry.

Some regions of Scotland may prove more resilient to leaving the EU Single Market than others, which in large part will be driven by existing differences in the sectoral composition of the regional economies. However, the new and diminished trading relationship with the EU will still have a detrimental impact across the wider economy. Whether this is through lower levels of migration, increased barriers to trade, or detrimental impacts on future productivity and investment, there is substantial evidence that households and businesses across Scotland are likely to be worse off than if we had retained full membership in the EU. For example, Scottish Government modelling estimates that, even with a deal of the kind that the UK has negotiated, Scotland’s GDP could be around 6% lower by 2030 than it would have been had we retained full EU membership.^[27]

2.2.2 Vaccines, restrictions and recovery from the pandemic

A key determinant of the trajectory towards recovery is the speed at which restrictions are lifted across the country. This will depend on the success in suppressing the spread of COVID-19. Doubtless, the roll-out of the vaccination programme will also play an important part in this during 2021. In order to inform their forecast, the SFC have assumed that the vaccine will be rolled out to the majority of the adult population over the course of 2021, with vulnerable groups, including the over 50s, receiving their first dose by the end of May 2021. They are anticipating that such a timetable would allow for a gradual easing of restrictions, with stricter measures in place for Q1 2021 and some form of remaining restrictions in place until the final quarter of the year.

Box 1: The “Scotland-Specific Economic Shock”

The Fiscal Framework has provisions for a ‘Scotland-specific economic shock’ to be triggered. When this happens, the Scottish Government has access to increased borrowing and reserve flexibility.

This provision is triggered when onshore Scottish GDP growth is below 1% in absolute terms on a rolling four-quarter basis, and 1 percentage point or more below UK GDP growth over the same period. This can be either on the basis of outturn data, or on the basis of forecasts.

The SFC’s forecasts, published on 28 January, show that the technical requirements for this provision are triggered in 2021-22. The SFC has, however, made clear that the outlook for Scottish and UK GDP is broadly similar, and that these conditions are met due to respective forecasts being produced at different points in time, with the SFC forecast reflecting the impact of the latest restrictions in response to the spread of the new variant of COVID-19.

The OBR forecasts, produced in November, had assumed that the UK would remain in restrictions broadly equivalent to Tier 3 in England until the spring, followed by an easing of restrictions. This would have seen the economy continue to grow throughout 2021. With the reintroduction of lockdowns across the UK, the outlook for the economy has changed significantly. The latest ONS data show that the UK economy contracted by 2.6% during November, after restrictions were reintroduced or strengthened across all four nations of the UK. The SFC now forecast that the Scottish economy will contract by 5.2% in the first quarter of 2021, before returning to growth in the second quarter, as the vaccine roll-out allows for a gradual easing of restrictions.

This divergence in the short-term outlook for the economy between the SFC and OBR forecasts, as a result of the differences in timing between them, triggers the Scotland-specific shock provision, rather than a significant difference in the performance of the Scottish economy. There is no evidence that Scotland’s economic or tax performance has been materially different from that of the rest of the UK in 2020-21. Prior to the announcement of the recent lockdowns across the UK, the most recent data suggest that Scotland’s economic performance has been broadly in line with that of the UK. Scotland’s economy expanded by 16.0% in 2020 Q3, the same as the UK, following large falls in March and April.

The SFC has noted that it is entirely possible that the criteria for a Scotland-specific shock may no longer be met when the OBR publish updated forecasts in March, or when outturn data are published. More generally, the pandemic has led to unprecedentedly large swings in economic output, swings that have not been witnessed in modern history. This in turn leads to greater forecasting volatility and increases the likelihood that conditions such as those of the Scotland-specific shock will be met.

The triggering of this provision of the Fiscal Framework allows the Scottish Government to borrow £600m rather than £300m per year for forecast error on tax receipts and social security expenditure, and removes the limits on drawdown from the Scotland Reserve. This applies in the financial years 2021-22 until 2023-24. These flexibilities will not be withdrawn retrospectively should revised forecasts or outturn data indicate that the central criteria for a Scotland-specific economic shock are not met. The Scottish Government’s approach to borrowing is set out in chapter 5.

2.3 Fiscal Implications of the economic outlook

Table 1 summarises the latest forecast for Scotland and the UK. It clearly shows the impact of the pandemic on economic activity, with Scottish GDP falling by 10.7% in 2020. As discussed in Box 1, Scotland has a weaker short-term GDP outlook than the UK as a whole, and therefore a different trajectory toward recovery, which the SFC have primarily attributed to the different timings of the Scottish and UK forecasts. With restrictions now expected to persist for most of 2021, the economy recovers only slowly in this year, and it is not until 2022, when the SFC assumes that strict health control measures are no longer required, that the economy begins to rebound toward pre-pandemic levels. After 2023, Scottish and UK growth rates become more similar. However, as discussed above, it is not until 2024 that Scottish GDP returns to pre-pandemic levels, and GDP in 2025 remains 4% lower than was forecast in February last year.

Table 1: Headline Economy Forecasts

		2020	2021	2022	2023	2024	2025
GDP Growth (%)	OBR (UK)	-11.3	5.5	6.6	2.3	1.7	1.8
	SFC (Scotland)	-10.7	1.8	7.5	1.6	1.6	1.7
Employment Growth (%)	OBR (UK)	-0.4	-2.2	0.8	1.5	1.2	0.5
	SFC (Scotland)	-2.4	-1.5	1.2	0.9	0.4	0.2
Unemployment Rate (%)	OBR (UK)	4.4	6.8	6.5	5.4	4.5	4.4
	SFC (Scotland)	6.0	7.1	5.9	5.0	4.7	4.5
Nominal Average Earnings Growth (%)	OBR (UK)	1.2	2.1	2.0	2.4	3.0	3.5
	SFC (Scotland)	2.5	2.6	2.4	2.7	3.0	3.3

Source: Scottish Fiscal Commission; Office for Budget Responsibility

Despite these divergences in the outlook for GDP, the extension of the Coronavirus Job Retention Scheme means that the labour market outlook for Scotland and the UK have remained more similar.

Table 2 below summarises the outlook for Scottish taxes and the associated BGAs. Although the labour market outlook is similar for Scotland and the UK, overall, the net tax position is forecast to improve from +£307 million in 2020-21 to +£611 million by 2025-26. This change is driven by improvements in the net Income Tax position, which is forecast to exceed the BGA by around £600 million a year from 2022-23. In part, the improvement in the Income Tax position reflects the recent positive outturn data for Income Tax, which came in above forecast in 2018-19. This feeds through into the change in expected Income Tax reconciliations, which have improved for future years.

Table 2: Latest Forecasts of Tax Revenues and BGAs

£ million		2020-21	2021-22	2022-23	2023-24	2024-25	2025-26
Income Tax	Revenue	11,850	12,263	12,907	13,481	14,080	14,718
	BGA	-11,677	-11,788	-12,294	-12,840	-13,475	-14,105
	Difference	173	475	613	641	605	613
LBTT1	Revenue	517	586	629	664	701	740
	BGA	-391	-515	-544	-601	-666	-723
	Difference	126	71	85	63	35	18
SLfT1	Revenue	95	88	86	72	74	61
	BGA	-87	-95	-91	-79	-74	-80
	Difference	8	-7	-5	-7	0	-19
Total	Revenue	12,462	12,937	13,623	14,217	14,855	15,519
	BGA	-12,154	-12,398	-12,930	-13,520	-14,215	-14,908
	Difference	307	539	693	697	640	611
Estimated Income Tax reconciliation2		-177	-319	74.3	126.8

Note 1: The 2017-18 LBTT and SLfT revenue and BGA 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.

However, the increase in the net tax position is greater than can be explained by the better-than-expected outturn data and strong earnings and real time information (RTI) tax data in 2019-20. The SFC highlight that they do not expect Scottish tax revenues actually to perform significantly differently from UK tax revenues in 2021-22, and that the improved net tax position largely arises because of the significant uncertainty around COVID‑19 in both forecasts. In particular, the SFC and OBR have made different judgements on the outlook for earnings and employment, and place weight on different data sources for the labour market impacts of COVID-19.

Finally, the SFC are clear that they and the OBR have made their forecasts at a period of exceptional uncertainty, where the relationship between the economy and tax receipts is changing. Given that even minor differences in the forecast determinants can have a large impact on the net tax position, the SFC note that it is not unexpected that there is greater divergence between their and the OBR’s forecasts.

While the triggering of the ‘Scotland-specific shock’ provision may provide some further flexibilities in the coming years, the volatile forecasting context may in turn increase the scale of likely future reconciliations. We discuss the resulting challenges for risk management and the need to smooth spending trajectories in more detail in Chapter 5. We have also developed a framework for analysing the impact of forecast error on the expected reconciliation, full details of which can be found in Annex A. These challenges highlight the volatilities within our fiscal settlement, which are explored further in the fiscal outlook scenarios in Chapter 3.