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

3. Scotland’s fiscal outlook

This chapter sets out three illustrative scenarios for available funding in future Scottish Budgets and discusses the impact and size of various funding risks. These scenarios strip out the direct short-term impact of COVID-19, and focus on underlying medium-term risks for the Scottish public finances.

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

• UK Government spending decisions/fiscal stance. Through the Barnett formula, the Scottish Government’s Block Grant is determined by the UK Government’s resource and capital expenditure in England on policy responsibilities devolved to the Scottish Parliament;
• Relative growth in Scottish Government and UK Government tax revenues. Under the Fiscal Framework, if Scottish revenues grow more quickly, the Scottish Budget is better off and vice versa. This means that Scotland’s budget is influenced not only by tax policy and performance in Scotland but also by tax policy and performance in the rest of the UK.
• Relative growth in Scottish and UK social security expenditure. Under the Fiscal Framework, if Scottish expenditure grows more quickly, additional funding has to be found within the Scottish Budget. If UK expenditure grows more quickly, additional funds are available within the Scottish Budget for other uses. Again this means that Scotland’s budget is influenced not only by policy changes within Scotland, but also what happens in the rest of the UK.

To manage short-term volatility, tax reconciliations and unforeseen shortfalls in social security funding, the Scottish Government also has limited powers to draw on the Scotland Reserve and to borrow.

Box 2: The Loss Of Funding Received From EU Programmes

During 2014-20, Scotland is estimated to have received over £5 billion in funding from the EU through the European Multiannual Financial Framework (MFF). Under the Withdrawal Agreement, the UK will continue to participate in programmes funded under the current 2014-2020 MFF until their closure. This funding has supported 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.

The Scottish Government has been clear that funding must be replaced in full to ensure no detriment to Scotland’s finances and to enable the benefits that EU funding has provided to many sectors across Scotland to be maintained. This is in line with promises made during, and following, the EU referendum campaign, that Scotland would not be worse off as a result of the UK’s exit from the EU.

On the replacement of pre-allocated programmes funding, fisheries and rural spending was included in the 2021-22 Spending Review settlements through non-Barnett allocations. The UK Spending Review provided £570 million to support farmers and land managers and £14 million to support fisheries in Scotland, which is insufficient to replace EU funding levels lost to Scotland.

It has now been confirmed by HMT that the replacement for the EU Structural Funds, the UK Shared Prosperity Fund, will be delivered from Whitehall, bypassing the Scottish Government. This is a clear incursion into devolved policy areas and overturns many years of established working practices. Unlike the UK, Scotland has already published clear plans for how we would use this funding and it is disappointing that the UK Government is preventing us from rolling these plans out.

On the replacement of competitive programmes funding, the UK Government sought to secure participation in a limited number of programmes including Horizon Europe and Erasmus Plus. Whilst the UK will have associated status for Horizon Europe, the UK Government have decided not to participate in Erasmus Plus and have provided little clarity on the replacement funding quantum or scope.

However, several key programmes were excluded, including European Territorial Cooperation, EU Health programme, Creative Europe, LIFE, the Connecting Europe Facility and Single Market Programme. Some of these programmes will not be replaced by the UK Government resulting in no extra funding being made available for a Scottish alternative.

The uncertain outlook on the replacement of EU programmes funding will continue well after the end of the Transition Period and are only exacerbated by provisions in the Internal Market Act and the decision to reduce the Spending Review to a single year. This means that there is extra funding risk over the five-year period set out in this document.

3.1 Central scenario

The scenarios focus on core spending, stripping out spend related to COVID-19. The central scenario is primarily determined by the expected Block Grant from the UK Government. The UK Government’s latest Spending Review provided budgets for 2021-22 only, and did not provide the information needed for long-term planning. This settlement forms the basis of the central scenario, which beyond 2021-22 assumes that the Scottish Government Block Grant grows in line with spending plans set out by the OBR. There remains significant uncertainty over future budget allocations. Although funding in response to COVID-19 has been guaranteed, there is no guarantee on core funding in future years. This was recently highlighted by the UK Government’s decision in November to cut £10 billion from non-COVID-19 UK resource departmental spending in 2021-22 compared to plans set out in March 2020.

After the Block Grant, the second largest part of the budget is the net tax position. The Fiscal Framework is designed to protect the Scottish Budget from symmetrical UK-wide macroeconomic shocks, but differences in either economic performance or in tax policy will affect the budget. Even when overall economic performance is broadly similar, there is a risk that differences in the composition of the tax base may result in faster or slower growth in tax revenues in Scotland, for example when earnings growth is unequally distributed (see Annex B).

Table 3: Funding Components (Nominal) – Central Scenario

£ million	2020-21	2025-26	Average annual growth
Total cash budget	39,972	47,826	3.7%
Resource budget limit1	30,928	37,603	4.0%
Net BGA and reconciliations	-22	612	-
New social security funding	3,203	3,988	4.5%
Capital budget limit	4,929	5,986	4.0%
Financial Transactions	611	0	-
Capital borrowing2	300	250	-3.6%

Note 1: Resource budget: Fiscal Resource Budget limit and the net BGA and reconciliations; updated for Supplementary Estimates; including additional adjustments for NDR, EU Replacement Funding, Scotland Act Implementation, and other smaller funding sources. Social security funding is not included and is shown separately.
Note 2: Chapter 5 sets out the Scottish Government’s policy for capital borrowing.

As well as the central scenario, upper and lower scenarios are shown, which bring together uncertainty across all the different funding sources, shown in Figure 1 below. Overall, the Scottish Budget is forecast to grow by £7.9 billion between 2020-21 and 2025-26 in the central scenario excluding the short-term impacts of COVID‑19. Broadly speaking, downside risks to the outlook slightly outweigh the upside risks, primarily reflecting risks around medium-term Income Tax reconciliations.

The differences between these scenarios are caused by divergent assumptions on the UK fiscal stance and Scotland’s relative tax performance and are discussed in more detail below.

3.2 UK fiscal stance

The Block Grant from the UK Government remains the single biggest determinant of funding for the Scottish Budget. The UK Government has rolled out fiscal stimulus measures worth at least £280 billion (14% of GDP) in 2020-21 as of November 2020^[28] in order to mitigate the immediate impact of COVID-19 on the UK economy. As discussed in detail in Chapter 1, it is imperative that this fiscal support is not withdrawn prematurely, thereby undermining the economic recovery. Due to the sheer size and importance of the Block Grant, an early fiscal tightening by the UK Government poses the biggest risk to Scotland’s funding outlook.

3.2.1 Lower scenario analysis

In the lower scenario, we assume that the UK Government adopts a tight fiscal stance in future years. Final UK spending in devolved portfolios would be lower than expected, either because of in-year underspends, due to a greater share of spending being directed toward reserved areas, or because of a reduction in overall spending. This would lead to lower Barnett consequentials, and a reduction in the Scottish Government budget. Growth in future years would then be slower than set out in the OBR’s November Economic and Fiscal Outlook by 1% a year, leaving funding around 5% lower by 2025-26.

3.2.2 Upper scenario analysis

In the upper scenario, we assume that the UK Government adopts a looser fiscal stance in future years. Final spending on comparable areas would be higher than expected, either because a greater share of spending is directed toward comparable areas, or because of an increase in overall spending, perhaps motivated by interest rates remaining persistently low, or to provide additional stimulus to an economy that is underperforming expectations. This would lead to higher than expected Barnett consequentials, and overall spending would grow faster than that set out in the OBR’s November Economic and Fiscal Outlook by 1% a year, leaving funding around 5% higher by 2025-26.

3.3 UK and Scottish relative fiscal performance

The devolution of tax powers means that the Scottish Government budget is increasingly determined by the performance of devolved taxes – most notably on non-saving, non-dividend (NSND) Income Tax and Land and Buildings Transaction Tax (LBTT).

If devolved Scottish tax revenue per head grows faster than in the rest of the UK, the Scottish budget will increase. This might happen if Scotland’s economy grows more quickly than the rest of the UK’s or if the Scottish Government introduces tax raising policy changes. However, even if economic performance is similar, structural differences in the tax base –such as the high concentration of high income earners working in Financial Services in London and the South East – may result in tax receipts growing at different rates, which can be both an opportunity and a risk.

That being said, the Scottish Government’s budget does not necessarily worsen as a result of reduced taxation income during an economic downturn. This is because in a very narrow sense, the Fiscal Framework effectively cushions Scotland against economic shocks that affect the UK as a whole. This has been seen during the current pandemic, which has seen forecasts of Scottish devolved tax receipts for 2020-21 revised down by £661 million since February. Despite this, the net tax position for the Scottish Government budget has improved slightly, as tax receipts across the UK have fallen by broadly the same proportion.

To date, there is no evidence that COVID-19 had a materially different impact on the Scottish and UK economies in 2020 – although the UK Government’s fiscal measures, and in particular the furlough schemes, might have masked any regional divergence.^[29] However, due to the largely sectoral nature of the COVID-19 economic crisis, differences in the sectoral composition of the Scottish and UK economies pose downside, as well as upside risks, for Scotland’s relative tax performance in the medium term. Drawing on the, as yet limited, lessons from Scotland’s historic Income Tax performance in 2017-18 and 2018-19, Scotland’s greater exposure to movements in global commodity markets and the oil price could act as a drag on earnings and Income Tax growth in the medium term. These risks and opportunities, which are discussed in further detail in Annex B, have informed the upper and lower scenarios.

In the central scenario, Scottish and rest of UK tax receipts perform in line with the forecasts set out by the SFC and the OBR.^[30] These are the forecasts that inform the Scottish Budget 2021-22. The lower and upper scenarios are discussed below. The scenarios also incorporate within them risk around future Income Tax reconciliation payments.

3.3.1 Lower scenario analysis

In the lower scenario, we assume for illustrative purposes that Scotland’s economy is hit by a number of headwinds, including a reduction in the tourism industry, a fall in international and intra-UK net immigration, and a sustained lower oil price. These factors would depress earnings and employment growth in Scotland relative to the rest of the UK^[31] as well as growth in devolved tax receipts from 2021-22 onwards. The main impact would be on Income Tax, with receipts growing 1.4 percentage points less each year than in the central scenario, although other devolved taxes would also be weaker.

While the experience of 2019-20 clearly shows that it is possible for Scottish earnings and RTI Income Tax receipts to grow faster than in the rest of the UK, in particular once policy divergence is factored in, there is not yet any evidence of sustained faster tax growth in Scotland. This means that it is possible for Scotland’s relative tax performance to be weaker than set out in the central scenario, particularly since the SFC have been clear that they do not expect Scottish tax revenues to perform significantly differently to UK-wide tax revenues in 2021-22. This risk is reflected in a larger downside than upside scenario to the net tax position, i.e. the risks around Scotland’s net tax position are thought to be asymmetric. This means that there is risk that the Scottish Budget will face negative reconciliations in the medium term.

In addition, a late UK Budget, as we have seen in both 2020 and 2021, would increase the tax policy risk. For example, should the UK Government introduce policy changes at its Budget on 3 March 2021, the Scottish Government would have limited time or means to respond to these changes. This could occur, for example, if the UK Government were to increase taxes to consolidate the public finances. This would increase the BGA and hence reduce the net position, unless the Scottish Government were to follow suit.

3.3.2 Upper scenario analysis

In the upper scenario, we assume that Scotland’s devolved taxes grow faster than in the rest of the UK, for example because Scotland’s economy is able to recover faster from the impact of the pandemic. These factors would support earnings and employment growth in Scotland, and stronger devolved tax receipts. The main impact is seen in Income Tax, which would grow 0.7 percentage points faster each year than in the central scenario, although other devolved taxes would also grow faster.^[32]

In addition, UK Government policies which reduce taxes in the rest of the UK might be favourable to Scotland’s net position if not implemented in Scotland as the BGA would decrease. Should Scotland adopt a similar tax cut, the impact on the net position depends on the exact design of the policy.

3.4 Summary of the scenarios

Table 4 provides a breakdown of projected Scottish Budget funding out to 2025-26 for the central scenario, as well as upper and lower scenarios.

Table 4: Summary Outlook For The MTFS

£ million (nominal)	2020-21	2021-22	2022-23	2023-24	2024-25	2025-26	Average annual growth
Overall budget1
Upper range	40,419	42,772	44,398	46,732	48,959	51,510	5.0%
Central scenario	39,972	41,803	42,888	44,309	45,943	47,826	3.7%
Lower range	39,524	40,787	40,833	41,996	42,910	44,059	2.2%
Resource budget2
Upper range	31,082	33,252	34,489	36,332	38,128	40,218	5.3%
Central scenario	30,928	32,663	33,467	34,825	36,099	37,603	4.0%
Lower range	30,773	32,020	32,294	33,095	33,758	34,643	2.4%
New social security
Upper range	3,203	3,342	3,571	3,783	3,986	4,182	5.5%
Central scenario	3,203	3,310	3,503	3,676	3,837	3,988	4.5%
Lower range	3,203	3,278	3,437	3,572	3,693	3,800	3.5%
Capital budget limit
Upper range	5,222	5,320	5,680	6,059	6,336	6,652	5.0%
Central scenario	4,929	4,973	5,260	5,558	5,757	5,986	4.0%
Lower range	4,637	4,631	4,852	5,079	5,210	5,365	3.0%
Financial Transactions3
Upper range	612	408	208	208	208	208	-19.4%
Central scenario	612	408	208	0	0	0	-
Lower range	612	408	0	0	0	0	-
Capital borrowing
Upper range	300	450	450	350	300	250	-3.6%
Central scenario	300	450	450	250	250	250	-3.6%
Lower range	300	450	250	250	250	250	-3.6%

Note 1 Overall budget: Total Scottish Government funding excluding non-cash elements.
Note 2 Resource budget: Fiscal Resource Budget limit and the net BGA including forecast reconciliations, reserve drawdown, and resource borrowing. Social security funding is not included and is shown separately.
Note 3: Financial transactions include £200 million of draw down from the reserve in 2021-22

3.5 Key points on funding outlook and risks

The scenarios illustrate the key role of the UK’s fiscal decisions on Scottish public finances. Future funding growth could be severely limited if the UK Government decides to consolidate the UK public finances and pursue a return to austerity.

COVID-19 and EU Exit have weakened the UK and Scottish economies. However, with regards to the net tax position, it is the relative performance of Scotland that determines Scotland’s funding position. For each budget, the OBR and SFC forecast the UK’s and Scotland’s respective tax projected intake, which determine the budget envelope.

As demonstrated in Chapters 2 and 3, the Scottish Government budget can fluctuate within year and between years as a result of decisions taken by the UK Government. This means our spending plans, discussed in the following chapter, need to be considered in the context of uncertain and volatile budgets - made even more challenging by the tight fiscal controls applicable and limited fiscal levers available to the Scottish Government.