The Scottish Government's Medium-Term Financial Strategy

Annex D: Summary of Fiscal Risks

Risk / What this risk might mean for the Scottish Government

Risks to the Funding Position

Changes to UK Government spending plans.

The Block Grant is the core source of the Scottish Government's funding. It is not only determined by how much the UK Government expects to spend in total but also how it priorities resource departmental spending (RDEL) and capital departmental spending (CDEL) across devolved and reserved spending areas within a given funding envelope.

Changes to UK Government spending plans remain the most significant source of funding risk for both resource and capital funding.

Based on an analysis of historic trends, a high scenario illustrates an annual growth in resource funding 2.7% higher each year than in the central forecast, and 3.1% higher for capital funding.

In a low scenario, annual growth could be 1% lower than in the central scenario.

The overall impact of tax devolution on the Scottish Budget depends on the performance of tax receipts per person in Scotland relative to the rest of the UK.

The performance of the Scottish economy, alongside Scottish and rUK tax policy decisions influence the scale of the tax revenues.

Income tax performance remains a major risk to the funding position.

As highlighted by the SFC, recent improvements in the Income Tax net position are partly driven by differences in the independent forecasters' judgements, in particular in relation to earnings growth. The SFC highlight that were earnings growth to be more similar in Scotland and the UK, the Income Tax net position would be materially lower than is currently projected.

Forecast variations and income tax reconciliations.

Having official independent forecasts is vital as it reduces bias and improves overall fiscal transparency. However, forecast error is an inherent part of forecasting. The way the fiscal framework was designed heightens the impact of forecast error, as it uses forecasts from two independent organisations and the differences in timing, judgement and methodology between the OBR and SFC continue to present a risk for the Scottish Government's funding outlook and contribute to continuing volatility in the fiscal outlook.

Volatility in forecasts introduces a challenge to forward planning and efforts to smooth the funding outlook over time. This is because forecasts for the anticipated reconciliation to be applied in future budgets inform decisions on future resource borrowing and spending.

Risks to Spending Position

Volatility in demand-led budgets, in particular the demand-led nature of social security.

Demand-led expenditure appears across the public sector and will always carry a degree of forecast risk. Budgets reflect expected levels of demand but expenditure will vary according to the number of people who are eligible for, and choose or need to use the service and will be effected by behavioural and economic factors. This has become a more significant feature of the Scottish Budget with the devolution of Social Security, which is now the third largest area of public spending in Scotland, after Health and Local Government. These programmes must all be managed within the resource budget and the Scottish Government has limited levers to manage demand-led volatility. Increases in demand-led expenditure therefore reduce funding the Scottish Budget has available for other programmes.

Expenditure on social security spending is variable, as it is determined by the number of eligible people who apply for support, all of whom must be paid at the rate set in the respective policy.

Budget allocations are based on the SFC's forecasts rather than spending limits, and the Scottish Government must meet social security expenditure as it arises, even if it differs from the SFC forecast used to set the initial medium-term spending plans or the Budget.

Demographic change.

Scotland's population is expected to undergo significant change over the medium- and longer-term. Some of this change creates risks to aspects of funding and spending that the Scottish Government will need to manage going forward.

Like many western countries, the Scottish population is ageing. An ageing population is likely to put further pressures on public expenditure, in particular on health, social care, and social security.

In comparison, the reduction in the number of younger people means that some of these expenditure pressures may be offset by reduced demand in other areas, such as education.

Risks to Both Funding and Spending

Continued inflationary pressures and the cost of living crisis.

Inflationary pressures continue to create a cost of living crisis for households and businesses across the country and increase pressure on public services.

Scotland is set to experience a record fall in living standards, with average real disposable incomes falling from 4.1% from 2021-22 to 2023-24, in the face of high inflation, and are not set to recover to pre-pandemic levels until around 2026-27.

Experience of the financial years 2022-23 and 2023-24 has illustrated the significant impact sustained high inflation may have on the spending outlook.

Across the public sector, and particularly on infrastructure programmes, we – like businesses and organisations across Scotland – have seen high inflation erode our buying power during the cost crisis. As a result, the costs we pay for the largest elements of our budget – employees and social security benefits – have increased.

Any additional expenditure arising as a result of sustained inflation must be managed within the limits of the Scottish Government's existing fiscal powers.