The Scottish Government's Medium Term Financial Strategy

3. Scotland's Spending Outlook

The purpose of this chapter is to provide an update on the overall spending outlook and its component parts, including:

• The Capital Spending Review and progress against the National Infrastructure Mission (NIM)
• Key drivers of spend such as pay and demand-led social security spend, which may present risks to our spending position in the future
• The Resource Spending Review framework.

3.1 Capital expenditure outlook

3.1.1 Infrastructure investment

Our Infrastructure Investment Plan 2021-22 to 2025-26^[8], published on 4 February 2021, focuses on three core strategic themes for guiding investment decisions in Scotland:

• Enabling the transition to net zero emissions and environmental sustainability
• Driving inclusive economic growth
• Building resilient and sustainable places

Our investment in infrastructure is targeted to maximise wider economic benefits and the delivery of the National Outcomes. The investment is often made by the Scottish Government or in partnership with Local Government. Where possible, however, the Scottish Government looks to create opportunities and the right conditions to leverage additional private sector investment across Scotland.

Delivery of the National Outcomes requires input from across Scottish society, and the challenges set out in the Infrastructure Investment Plan cannot be met without input from the private sector. Our long-term vision for infrastructure is strongly aligned with our plans on mobilising private investment alongside public investment as a critical part of our economic recovery.

As well as investing in physical infrastructure, the Scottish Government, in part through its Enterprise Agencies and the Scottish National Investment Bank, uses its capital budget to invest directly in businesses, supporting them to grow and develop. This sort of investment supports research and development, innovation and creativity, with capital grant being allocated to universities and other public sector research institutions.

3.1.2 National Infrastructure Mission

The National Infrastructure Mission announced in the 2018 Programme for Government is a commitment to increase annual investment by 1% of 2017 Scottish GDP by the end of this Parliament.

The NIM was introduced with an aim of raising Scottish infrastructure investment to internationally competitive levels; boosting broadband, transport, and low-carbon energy; and supporting inclusive economic growth. This level of investment in our vital economic and social infrastructure will protect and create jobs in the short term, and support growth and productivity in the long term.

The Scottish Government's Capital Spending Review (CSR), published in February 2021, underpins the five-year Infrastructure Investment Plan and sets out a five-year budget and vision for all infrastructure investment choices.

At the time of the CSR publication, there was uncertainty around UK allocations; OBR forecast figures were therefore used as the basis for our future planning for portfolio allocations throughout the CSR period. The UK Spending Review, published on 27 October 2021, has confirmed capital allocations that are considerably lower than our modelling, and will therefore reduce the level of capital investment we are able to deliver.

Table 4: National Infrastructure Mission Baseline

	2019-20 NIM Baseline	2021-22	2022-23	2023-24	2024-25	2025-26	5 Year Total
Capital Grant 1	4,105	5,582	5,329	5,574	5,498	5,718 2	27,701
Capital borrowing	450	400	450	300	250	250	1,650
Financial Transactions 3	652	410	592	316	306	130	1,754
Revenue Finance 4	90	50	200	750	1,000	1,000	3,000
Total Investment	5,297	6,442	6,571	6,940	7,054	7,098	34,105
Audit Scotland modelled NIM trajectory (rounded)		5,700	6,000	6,200	6,500	6,800	31,200

1 Capital grant figure includes UK Capital Allocation, Additional Whitehall Transfers, Estimated Capital Receipts, Fossil Fuel Levy in 2022-23 only and excludes Reserve drawdown.
2 Estimated UK Capital Allocation is from MTFS Central Scenario figure.
3 Includes FT Consequentials and FTs Recycled and excludes Reserve drawdown.

The UK Spending Review also set out the level of Financial Transactions available to the Scottish Government over the next 3 years. FTs can only be used to provide loans to or make equity investment in the private sector and need to be repaid. The Scottish Government has in previous budgets allocated FTs across a number of portfolio areas, including to capitalise the Scottish National Investment Bank, support investment in housing and businesses and invested in low carbon and energy efficiency schemes.

The revenue-financed investment noted in the table above includes Growth Accelerators, Green Growth Accelerators and the Learning Estates Investment Programme, which can be summarised as follows:

• Growth Accelerator is a funding mechanism in which local authorities invest in public sector enabling infrastructure to stimulate private sector investment and deliver outcomes that grow the wider economy. On achievement of pre-agreed key milestones and targets, the Scottish Government pays a grant to the local authority equivalent to the investment (including financing costs) over a set time period (typically 25 years).
• Where targets are not met, the local authority is paid a percentage of the grant, depending on how close it was to achieving the target.
• The Green Growth Accelerator follows the principles of the Growth Accelerator and aims to unlock £200 million of additional local government investment in infrastructure projects to support Scotland's transition to an inclusive, net-zero emissions economy.
• Learning Estate Investment Programme is an outcomes-based approach to deliver high quality, well maintained, digitally enabled learning environments that achieve ambitious energy targets.
• Mutual Investment Model is a profit-sharing form of public-private revenue finance that has been developed by the Welsh Government and further developed for adoption by Scottish Government for use on specific types of infrastructure delivery, as outlined in the 2019 MTFS. As noted in the 2021 Capital Spending Review, the market is aware of the potential deployment of a Mutual Investment Model for the remaining stages of the A9 dualling programme and its use is still being explored.

As highlighted in section 2.4, there is uncertainty around the level of funding in 2025-26. Although we would still meet the NIM under the low scenario, this scenario would fail to live up to our ambitious infrastructure plans and would constrain our ability to meet our net zero targets. Should the UK Government continue to invest in local and regional infrastructure without consulting the Scottish Government, as is the case with the Levelling Up Fund investments, thereby reducing what would have otherwise come through as capital grant, achieving our NIM target could be at risk.

3.1.3 Supply Chain Challenges

There has been an upsurge in construction sector activity following a global drive to stimulate the economic recovery from COVID-19. As a result, demand for some resources is greater than the available supply, reduced productivity resulting from COVID-19 effects and mitigations has also created challenges in global supply chain logistics. In addition, the UK's exit from the EU has generated supplementary procedures for goods and materials inbound to the UK from the EU.

Such issues are affecting both the costs and delivery times of some materials. This increases the risk of projects running over budget and/or behind time. This could lead to a reduction in the quality of materials used to maintain budgets or programmes, financial disputes with contractors and a risk that private sector contractors may be less willing to bid for public sector contracts without safeguards against cost increases.

3.1.4 Next steps

Given the updated financial position following the UK Spending Review, and the ongoing pressure facing the construction sector relating to market conditions, a targeted review of the Scottish Government's CSR will be undertaken in early 2022. In conducting such a review, the Scottish Government remains committed to the principles set out in the Infrastructure Investment Plan and the recommendations of the Infrastructure Commission for Scotland - maintaining our vision for future infrastructure to support and enable an inclusive net zero emissions economy.

3.2 Resource Spending Outlook

The Scottish Government must live within a funding settlement that is largely driven by the spending decisions of the UK Government. We have limited ability to expand it through borrowing, or to carry forward funding to spread investment and build contingency for the future.

If funding falls below expectations, the Scottish Government must adjust its spending plans accordingly. Similarly, if funding is higher than expected, the Scottish Government is able to invest more in public services that financial year, but has very limited ability to carry forward a surplus to support future spending.

In reality, our spending trajectory must mirror the funding trajectories set out in Table 2 in section 2.1.

Whilst Table 2 suggests a large increase in baseline funding from 2021-22 to 2022-23 following the UK Spending Review, block grant funding has been cut by 7% in real terms as COVID-19 funding has been withdrawn despite the ongoing effects of the pandemic. The block grant is lower than 2021-22 in every year of the UK Spending Review period.

Within this funding envelope, the Scottish Government will act to mitigate the effects of the pandemic, which we know has exacerbated inequalities across society. We will rebuild our public services, including taking vital steps to increase social care capacity and establish a National Care Service. We will ensure that our spending choices support progress towards meeting our ambitious child poverty and climate change targets, and secure a stronger, greener, fairer economy.

Those are the priorities of the Resource Spending Review set out in the framework which is published alongside this MTFS. The Resource Spending Review will develop multi-year spending plans which deliver effective services for the people of Scotland and maintain sustainable public finances. It will require us to decide how we prioritise spend and where we allocate resources to shape public services which most effectively meet the needs of an evolving population. There will be difficult choices about reprioritisation to make. As well as a tight financial envelope, there are volatility risks to the spending outlook and changing patterns of demand which will influence how we develop flexible, effective and sustainable spending plans.

The risks to the resource spending outlook are set out below. The Resource Spending Review Framework considers the impact of these as key drivers of public spending and explores the challenge and opportunities that these risks pose for the Scottish Government over the spending review period.

3.3 Risks to the spending outlook

3.3.1 Demand-led spend volatility

Expenditure on social security benefits is variable, as it is determined by the number of people who apply for support, with those considered eligible paid at the rate set in the policy. Furthermore, it depends on successfully ensuring that those eligible are able to claim their entitlements. The Scottish Government will have to meet this expenditure as it arises, even if it differs from the forecast used to set the initial Budget.

As the majority of benefits expenditure is demand-led, with budget allocations based on SFC forecasts rather than spending limits, this introduces in-year volatility and uncertainty to the Scottish Budget. The SFC reported a 3% variation from their original forecast for 2020-21^[9], which, if replicated in 2022-23, would amount to over £119 million, as the SFC has forecast that social security expenditure will approach £4.0 billion in 2022-23. The continuing economic and social impacts of COVID-19 recovery add to the volatility risk associated with benefits expenditure.

Social security expenditure is forecast to rise gradually to over £5.3 billion by 2026-27, and any additional expenditure resulting from volatility will have to be managed within the limits of the Scottish Government's existing fiscal powers. In Scotland, all benefits expenditure is funded through our overall Resource budget, as opposed to a dedicated AME (Annually Managed Expenditure) budget that would be better suited to funding demand-led expenditure on this scale, as is the case in England. The review of the Fiscal Framework must provide Scotland with the powers and fiscal flexibilities necessary to manage fully the inherent risks in demand-led social security expenditure.

In 2022-23 over 90% of social security benefits expenditure will be funded through Block Grant Adjustments (BGA), which are based on OBR forecasts of benefit expenditure in England and Wales at the time the Scottish Budget is set. This will gradually reduce to around 80% by 2026-27 as additional new and replacement benefits launch, and expenditure diverges further from BGA. Once outturn data is available, reconciliations are made to the Scottish Budget to ensure that the funding available ultimately corresponds to the BGAs based on the outturn data. If expenditure in England and Wales is ultimately higher than forecast, a positive BGA reconciliation (i.e. an addition) will be made to the Scottish Budget to reflect these changes, and vice versa.

Changes between actual and forecast Scottish expenditure, and the BGA reconciliations, are managed by the Scottish Government's budget management processes, in line with the principles and policies on the use of borrowing and reserve powers as set out in Chapter 4. Further information on the BGAs and reconciliations is set out in Annex B.

The Scottish Government will continue to manage any variance between actual and forecast expenditure or BGAs, in a competent, responsible and balanced way as part of the annual budget process, in line with the principles and policies set out in the Medium-Term Financial Strategy.

3.3.2 Pay

Pay is a key driver of public expenditure and makes up around £21.1 billion or over half of the Scottish resource budget. The Scottish Government pay and reward policies are distinctive, fair and progressive and apply directly to 50 public bodies and act as a reference point to all of the devolved public sector workforces (including Health, Teachers, Police, Fire and Further Education Colleges) and will negotiate new pay deals in 2022-23.

The Scottish Government is committed to exploring with Trade Unions and employers further opportunities for developing non-pay benefits. Work has been ongoing towards standardising the 35 hour working week across public bodies where the pay policy directly applies, the introduction to the right to disconnect with an option to explore the 4-day working week. In the long term, this could be an opportunity to lessen the cost burden of pay awards to employers, act as a lever to improve productivity, optimise the role of automation and digitalisation of services, while creating high value job opportunities and contributing to the wellbeing economy.

In designing our pay policy, we must balance economic, fiscal and social factors and in particular the:

• changes to the cost of living (CPI Inflation 3.1% in September 2021)
• the effect of the recent 1.25% increase of National Insurance Contributions for employee and employer contributions.
• average pay in the public sector has been higher than in the private sector in recent years, with a pay 'premium' of just over 3% in the years prior to 2020.
• Labour market conditions have continued to improve. The number of payrolled employees is now above pre-pandemic levels, having fallen almost 4% during 2020.

The affordability of pay uplifts, consistency across the industrial relations landscape and recognition of performance across public services contribute to a fair and fiscally sustainable approach to public sector pay. This is crucial given it accounts for half of the Scottish Government resource budget.

The 2022-23 Public Sector Pay Policy was announced alongside the Scottish Budget, continuing the progressive principles of recent years. Specifically, it outlined a cash uplift of £775 for public sector workers earning up to £25,000, £700 for workers earning between £25,000 and £40,000, and a cash uplift of £500 for those who earn above £40,000 alongside the adoption of a £10.50 public sector wage floor by April 2022 – building on the impact of the real Living Wage.

In addition to the main single-year pay policy option, we have also offered the option for public sector bodies to choose a multi-year approach. This would be supported by multi-year spending plans and is connected to public service reform and broader changes to terms and conditions.

To illustrate the potential future paybill costs, we have modelled three theoretical public sector pay award scenarios – which exclude pension costs (see Table 5).

Table 5: Illustrative cumulative paybill costs (£ billion)

	Baseline (2022-23)	2023-24	2024-25	2025-26	2026-27
Illustration of 1% pay award
Total	21.1	21.29	21.50	21.71	21.93
Additional cost including Basic Award		0.21	0.21	0.21	0.21
Illustration of 2% pay award
Total	21.1	21.29	21.71	22.14	22.58
Additional cost including Basic Award		0.42	0.43	0.43	0.43
Illustration of 3% pay award
Total	21.1	21.50	22.14	22.78	23.43
Additional cost including Basic Award		0.63	0.64	0.64	0.65

Note: This is the cost of the basic award including employer on-costs but excluding pension costs. The paybill costs include all bodies within the Scottish Devolved public sector. The central scenario of 1% workforce growth is based off the average previous five-year growth of the Scottish Devolved public sector.

To give context to pension costs to employer the table below sets out the employer contribution rates for each of the defined benefit pension schemes in operation in Scotland.

Table 6: Current employer pension contribution rates

	Civil Service	NHS	LGPS	Teachers	Police	Firefighters	Judicial
Employer	26.6 – 30.3%	20.9%	20.5% (average)	23%	29.4%	39.1%, 24.5%, 26.8%	51.4%

3.3.3 Growth in the public sector workforce.

The size and distribution of the workforce in the devolved public sector directly influences the Scottish Budget position. As of 2021 Q2, 583,100 individuals, representing around 22% of all Scottish workers, worked in the public sector. Around 48% of these workers are in Local Government and 34% in the NHS. The Scottish public sector is proportionally larger than the UK average of 18%, with the average in England being 17%.

Public Sector Employment (Office for National Statistics); Public Sector Employment in Scotland (Scottish Government)

Over the last 5 years the number of Public Sector devolved workers has increased by 1% per year on average. Over the coming years, further public services will be introduced such as an expansion in Social Security and NHS National Care services. As a result, we anticipate that the public sector in Scotland will continue to grow. The relative larger and growing size of the Scottish public sector carries with it a greater fiscal risk to the Scottish Budget.

To illustrate the potential future costs, based solely on historical trends on growth, we have modelled three scenarios based on assumptions around the pay award and future workforce growth.

Table 7: Illustrative cumulative pay award and workforce costs (£ billion)

	Baseline (2022-23)	2023-24	2024-25	2025-26	2026-27
Low Scenario - 1% pay award, 0.5% workforce growth
Total	21.1	21.4	21.7	22.0	22.4
Difference from Central Scenario		-0.32	-0.64	-0.96	-1.29
Central scenario - 2% pay award, 1% workforce growth
Total	21.1	21.7	22.3	23.0	23.7
High Scenario - 3% pay award, 1.5% workforce growth
Total	21.1	22.0	23.0	24.0	25.0
Difference from Central Scenario		0.32	0.64	0.96	1.29

Note: This is the cost of the basic award including employer on-costs but excluding pension costs. The paybill costs include all bodies within the Scottish Devolved public sector. The central scenario of 1% workforce growth is based off the average previous five-year growth of the Scottish Devolved public sector.

3.3.4 Public service pensions – a mandatory workforce cost

Within the UK, policy is largely reserved to Westminster in respect of public sector pensions and wholly reserved in respect of state pensions, private sector pensions, and pensions taxation policy. Public sector pensions are an important element of current and future Scottish Government obligations. Pension scheme membership is also provided as part of public servants' terms and conditions.

Employers pay pension contributions on their employees' pensionable pay and total costs increase with workforce size, paybill and number of employees who are pension scheme members. Pension costs are part of an employer's on-costs and are taken into account when assessing the affordability of pay awards and in workforce planning. Scottish Ministers remain committed to public service pensions that are affordable, sustainable and fair to Scotland's public servants and the communities they serve.

Employer pension contributions, along with the those paid by scheme members, are used to meet the cost of pensions in payment. Scheme cash flow shortfalls are met through UK Government funding mechanisms (Annually Managed Expenditure or AME) in the case of the NHS and Teachers' schemes, or through Scottish Government resource budget in the case of the Police and Firefighters' schemes.^[10]

The figures in the Scottish Budget represent "net public pensions expenditure" for the Teachers' and NHS pension schemes. The contributions paid into the scheme by members and employers are effectively converted to AME, with HM Treasury providing additional AME when required to meet expenditure. Actual amounts vary year to year, and a pension scheme may be in surplus or deficit (so, having more income than expenditure versus requiring additional AME from HM Treasury). This AME budget is ring-fenced for Teachers' and NHS pensions.

UK Government decisions on overarching policies, such as the discount rate used to value scheme liabilities as part of quadrennial scheme valuations, affect the Scottish public service pension schemes. For example, the UK Government's 2018 announcement of a decrease to the discount rate contributed to increased employer pension contribution rates from 1 April 2019, which increased pension contribution costs across relevant public sector employers in Scotland by more than £500 million for 2019-20. The Scottish Government received Barnett consequentials to cover some of this cost and provided additional funding itself to help make up the shortfall for employers.

In the medium-term, the upcoming round of public service pension scheme valuations – the 2020 scheme valuations – is the next pension event that could change pension costs for employers participating in the Scottish NHS, Teachers', Firefighters' and Police pensions schemes, and in the reserved Civil Service and Judicial pension schemes. In 2021, HM Treasury ran a consultation on the methodology for setting the discount rate. The discount rate to be used in the 2020 scheme valuations will be set by HM Treasury in due course. The employer pension contribution rates set in 2019-20 for these schemes will remain in effect until new rates are set and implemented from 1 April 2024.

3.3.5 Ageing is a significant driver of public service expenditure

An ageing population puts increasing pressures on public expenditure, in particular pensions, health and social care. The predominant portion of a person's health care is required in old age and, in particular, the year and months before death. The Scottish population is ageing; by mid-2043, it is projected that 22.9% of the population will be of pensionable age, compared to 19.0% in mid-2018. At the same time, as the proportion of working-age population decreases, this means that public services and social security payments for all need to be funded on a smaller active economy.

Equally, as medical research and advancement allow, people are living longer, fuller lives. While these scientific and medical advancements are worth celebrating, they also fundamentally alter the demographic make-up of our society, our tax base and the needs that public services will need to meet. While we are living longer, we are also experiencing higher and more complex care needs, with the incidence of comorbidity increasing. While these changes are gradual and not necessarily significant over the period of this MTFS, policy interventions are required early in order to maintain the affordability of health care and the pension system over the long term. For health, this requires both more efficient service delivery and sustained and concerted action to manage demand through self-care, prevention and health improvement.