Income tax outturn 2018/19 & implications for the budget

So now we know. The Scottish block grant in 21/22 will face a downwards reconciliation of £309m to account for income tax forecast error in respect of 18/19. How does this come about and what does it mean?

The reconciliation reflects income tax forecast error made when the 2018/19 budget was set. However the reconciliation does not reflect the error of one forecaster, but the interaction of forecast errors made by both the SFC and OBR.

How come? First, a recap of some background.

Revenues and the BGA

What matters for the Scottish budget is not just the revenues raised from income tax in Scotland, but also the ‘block grant adjustment’ (BGA).

The BGA is an estimate of the revenues the UKG has foregone as a result of transferring income tax to Scotland.

The BGA is calculated by assuming that, if income tax had not been devolved, income tax revenues raised in Scotland would have grown at the same per capita rate as in rUK.

The key point to remember is that, if Scottish income tax revenues are higher than the BGA, the Scottish budget is better off than it would have been without tax devolution.

(The whole BGA thing may seem abstruse, but the BGA serves some important functions: it protects the Scottish budget from UK-wide revenue shocks; and it ensures that the revenue effects of rUK tax policy changes, that don’t apply in Scotland, don’t feed through to the block grant.)

The 2018/19 forecasts

So, back to December 2017.

When the Scottish budget 2018/19 was set, Scottish IT revenues (forecast by the SFC) were forecast to be £428m higher than the BGA (forecast by the OBR).

This gap largely came about because of the anticipated revenue impact of the Scottish Government’s income tax policy. As a result of the tax policy, Scottish revenues per capita were forecast to grow more quickly than rUK revenues per capita. (Implicitly, the SFC’s forecasts for Scotland and the OBR’s for rUK implied that the Scottish IT base would grow at about the same rate as in rUK.)

The reality of outturn

In reality, the outturn data reveals that Scottish revenues in 18/19 were only £119m more than the BGA, not £428m. (Both revenues and the BGA are lower than forecast. This reflects an absence of any baseline Scottish tax data when the two forecasts were published – but is largely irrelevant to the budget, as it is the gap that matters).

The difference between £428m and £119m is £309m. The 2018/19 budget was planned on the basis of it having £309m more resources available to it than have now been shown to be the case, hence the need for reconciliation.

(For what its worth, a relatively greater part of this reconciliation comes about because the OBR underestimated the growth of rUK income tax revenue growth, and a relatively lesser part comes about because the SFC overestimated Scottish income tax growth.)

Income tax revenues BGA Difference
Budget forecast (Dec 2017) £12,177m £11,749m £428m
Outturn (Sep 2020) £11,556m £11,437m £119m
Reconciliation £309m

£309m may seem small in the context of recent budget increases, but will add to pressure on the budget for public services spending. In reality, the government will probably borrow £300m (its maximum permissible amount) in 2021/22, spreading the cost of this reconciliation over future years.

 

Impacts of tax policy v. tax base growth

The Scottish budget in 18/19 is still better off than it would have been without IT devolution, to the tune of £119m. (Implicitly this means that Scottish tax revenues per capita have grown slightly more quickly than in rUK, although you would expect that given the tax increases in Scotland).

However the government might have hoped that, as a result of its tax policy, the gap would be closer to the £428m originally forecast.

Why are Scottish revenues only £119m higher than the BGA rather than £428m?

Implicitly, what has happened is that a large proportion of the anticipated revenue impact of the Scottish tax policy in driving a gap between revenues and the BGA has been offset by slower growth of the Scottish tax base compared to the rUK tax base (mainly reflected in slower earnings growth) between 2016/17 and 2018/19.

Known risks

The risk of this sort of outcome arising was known when the fiscal framework was agreed. And it is worth remembering that the method used for calculating the BGA is the approach favoured by the Scottish Government when it negotiated the fiscal framework.

In effect, the system is working as was intended – the Scottish budget is exposed not only to the revenue impacts of its devolved tax policies, but more widely to the (relative) growth in the tax base of those taxes. This is what having devolved tax responsibility means.

But it can also be argued that the assumption that implicitly underpins the fiscal framework – that in the absence of tax devolution, per capita revenues would have grown at the same rate in Scotland as in rUK – is unrealistic; especially knowing with hindsight what we do now about what has happened to the oil and gas sector since 2015.

Whether the current approach to calculating the BGA is reasonable will be subject to further intergovernmental discussions.

Conclusions

To summarise:

  • The need for a reconciliation comes about because the forecasts underpinning the 2018/19 budget did not foresee the extent to which the Scottish tax base would grow relatively more slowly than the rUK tax base.
  • As a result, the Scottish budget in 2018/19 was £119m better off than it would have been without tax devolution, rather than the £428m that was forecast at the time.
  • In the context of a tax policy that was hoped to increase revenues relative to the BGA by more than £119m this is clearly disappointing, but reflects an accepted risk of devolving tax.

 

Authors

David leads the FAI's work on fiscal policy and the Scottish budget.

 

 

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