Scottish budget risks and uncertainties – implications of Covid-19

The Scottish Budget 2020/21 was published and agreed before Covid-19 was perceived as posing a significant health risk to the UK. This post examines how the policy response to Covid-19 will affect the size of the Scottish budget, the outlook for devolved revenues, and the financial risks the budget is exposed to. It also considers longer-term implications for the devolved fiscal framework.

Unforeseen uncertainties

In what feels like a different age, but was in fact earlier this year, the Scottish Government had expressed concern over the uncertain environment in which it had to prepare and publish its budget plans for 2020/21. Linked to this was a concern that parliament might scrutinise draft spending plans that were subsequently subject to substantial change.

These risks had nothing to do with a perceived threat of Covid-19 (the budget published on 6 February makes not a single reference to coronavirus or covid-19), but reflected the necessity to publish Scottish tax and spending plans a month before the UK budget.

As it happens the outlook for the 2020/21 budget has turned out to be far more uncertain that anyone could have anticipated, not because of surprise fiscal announcements from a buoyant new Westminster government, but from the necessity to shutdown large swathes of the economy to mitigate the impacts of Covid-19, and the resultant policy response.

It goes without saying that the tax revenue forecasts that underpinned budget spending plans have been left in tatters. Revenues from income tax and LBTT will shrink following the collapse in economic activity, while revenues from Non-Domestic Rates will fall as a result of the expansion of temporary reliefs announced since budget plans were made.

On the spending side, the Scottish Government has made a variety of substantial commitments in the last month or so, from support to third sector organisations that help the most vulnerable to grants for SMEs and increased pay for social care workers (see the SFC’s latest publication for a good overview). Other plans have been delayed, including rollout of new Scottish disability benefits, the roll-out of the new Scottish Child Payment, and the commitment to deliver in full increased childcare provision this year.

What does this mean for the affordability of the Scottish Government’s tax and spending plans in 2020/21? How can it afford its new policy commitments? What new risks does the budget face? How will these risks be monitored and scrutinised? Does the fiscal framework need to evolve in response to the unprecedented nature of the economic and fiscal shock?

A £3.5bn increase in grant funding

Many of the most significant economic policy responses to Covid-19 are implemented UK-wide by the UK Government (including the Job Retention Scheme, the Self-Employment income support scheme and changes to Universal Credit).

Where elements of the UK Government’s response to Covid-19 and the economic shutdown apply to England only, the Scottish budget receives a population share of the resulting increase in UK Government spending. This applies in particular to additional funding to English local government and to the NHS in England.

Since the Budget Bill was passed in February, announcements by the UK Government have resulted in a further £3.5bn in funding flowing to the Scottish budget for 2020/21. That’s an 11% increase in the resource budget since it was published. Chart 1 puts these changes in context.

Around one billion of this results from business support grants, and a further billion or so results from expansions to NDR reliefs in England (these generate consequentials for the Scottish budget because they imply that a larger share of English local government spending is coming from the UK Government rather than business rates, which are devolved). The remainder is accounted for by increased allocations to local government, NHS and third sector organisations in England.

Chart1

So that helps explain how the Scottish Government has been able to fund substantial new spending commitments.

But what about revenues from income tax (and LBTT)? At what point will the inevitability of lower-than-forecast revenues impact spending plans? (Revenues from income tax and LBTT were forecast to raise £12.4bn and £641m respectively at the time of the Scottish Budget, accounting for 37% and 2% of planned resource spending respectively).

Scottish revenues: insured against some risks but not others

A core principle of tax devolution, enshrined by the Smith Commission, was that ‘the UK Government should continue to manage risks and economic shocks that affect the whole of the UK’. Clearly the pandemic is a risk not just to Scotland but the UK (indeed the global) economy too.

How is this principle operationalised in practice? Grant funding arrangements effectively mean that a decline in devolved Scottish tax revenues, assuming it is matched by a proportionate decline in equivalent rUK revenues, is offset by an increase in Scotland’s block grant. The risk of a shortfall in the Scottish budget due to a UK-wide economic shock is borne by the UK Government.

So that means there is no risk to Scottish spending plans in 2020/21 from the pandemic and its fallout? Unfortunately not. Whilst the Scottish budget is protected against the risk of fiscal shocks that impact Scotland in proportionately the same way as the UK, it is not insured against the risk that the virus might have a disproportionate fiscal impact on Scotland.

What is the likelihood that the virus has a disproportionate impact on Scotland? So far there is no indication that the health impact of the virus will be higher in Scotland than in the UK as a whole (although it is early days and Scotland is believed to be 2/3 weeks behind London in terms of the health incidence, so this could change).

But it’s possible that Scotland’s economy might be less resilient to the economic fallout from Covid-19, both in relation to policy measures or global economic developments. It’s possible for example that if Scotland’s economy is relatively more reliant on shutdown sectors like leisure and tourism, its income tax revenues might fall proportionately more than those of rUK. And it’s possible that policy decisions about the extent of the economic shutdown, or its duration, could be applied more stringently in Scotland. But perhaps the more real danger comes in the form of the collapse of the global oil price.

The collapse of oil prices (Brent Crude had fallen to an 18-year low at the end of March and has fallen further since as demand for oil continues to fall and storage facilities reach capacity) is likely to weaken prospects for investment in the North Sea, and the wage and employment prospects of Scottish taxpayers working in the sector and its supply chain.

If this sounds far-fetched, consider what happened when the oil price slumped at the end of 2014 and into 2015 (Brent Crude fell from $110 to $40 per barrel over the course of 12 months). Scottish PAYE income tax revenues per taxpayer grew at a quarter of the rate as the UK in 2015/16, slower than in any other UK nation or region. Luckily this occurred in the days before income tax was devolved, although the shakeout lasted several years . The risk of an asymmetric hit to Scottish income tax revenues is clear.

The good news is that, even if Scottish revenues do decline disproportionately more than rUK revenues in 2020/21, this in itself will not affect this year’s spending plans. It is only when outturn data is available that we will know whether the risk of an asymmetric hit to Scottish revenues has materialised, with any budgetary reconciliation not taking place in 2023/24.

Disproportionate shocks to LBTT revenues will in contrast hit the Scottish budget in ‘real time’ during 2020/21, although the Scottish Government is able to borrow to mitigate the impact of weaker than anticipated revenues on 2020/21 spending plans

Enhanced funding flexibility?

Some, including the IFS and the Wales Governance Centre, have argued that the unprecedented situation created by the Covid-19 virus creates a case for the UK’s devolved governments to be given greater flexibility – at least temporarily – around borrowing and cash management.

There are two aspects to this.

First, the IFS points that there is a possibility for lags between a UK Government policy announcement and consequential funding being confirmed and allocated to the devolved governments. This funding uncertainty could cause delays to policies being introduced in the devolved nations, which could be mitigated if the devolved government had enhanced borrowing powers (currently, the Scottish Government can only borrow to address errors in forecasts of tax revenues or social security spending).

If the ability of the Scottish Government to respond to the virus is being constrained by issues around the timing of the confirmation of resources from Westminster, then the case for enhanced budget management flexibilities is a reasonable one to make. But it’s not currently obvious that issues around confirmation of funding is a binding constraint, or if the key constraints relate to the administrative practicalities of delivering support to the people and businesses who need it.

Second, the Wales Governance Centre makes the case for the Welsh Government to have enhanced abilities to borrow ‘to meet the possible additional demands on Welsh public services not covered by the Barnett formula’.

Is there a case for allowing the Scottish Government to borrow to fund additional public spending interventions today, if it believes that resources from Westminster are not sufficient to fund the response that is required? Enabling the Scottish Government to borrow to fund public services spending generally, as opposed to address forecasting errors, would be a radical departure from the existing fiscal framework. One school of thought argues that the absence of genuine borrowing powers is an important omission from the fiscal framework, one that limits the government’s accountability and financial responsibility.

If the government did have the ability to borrow to fund additional public services spending today, it would have to balance the perceived benefits against the costs – which might include having less resources available in future budgets to support the recovery. And the government would be conscious that, having borrowed £207m in 2020/21 to address income tax forecast error in respect of 2017/18, it faces a likely reconciliation of around £600m in next year’s budget, and the risk of forecast errors on LBTT or social security spending during this financial year is reasonably high. So, it might be reticent about using additional borrowing powers, at least before it was clear that Scotland was being affected disproportionately by the virus fallout.

Rebalancing the way budget risks are shared?

The fiscal framework was already due to be reviewed in 2021/22. That review will now have the benefit of knowing how well the framework responds to a major economic crisis. The extent of any perceived strengths or weaknesses of the framework will be influenced by what happens over the course of the next 12 months.

The fact that the fiscal framework protects the Scottish budget from the effects of pan-UK economic shocks will presumably be seen as a strength.

But what is the logic of the Scottish budget being fully protected from UK-wide economic shocks but exposed in full to any disproportionate impact in Scotland? The implicit principle underlying this is a view that the Scottish Government can and should be held accountable for differential fiscal impacts in Scotland.  But clearly the Scottish Government has little influence in reality on whether the fallout from the Covid-19 outbreak has a disproportionate impact in Scotland, either in terms of health impacts or because of the underlying structure of the economy.

Recognising this, both the IFS and the Wales Governance Centre have argued that funding for Covid-19 activities should be based on funding need, if impacts are not symmetric across the UK. A similar point was recently made by Scottish Finance Minister Kate Forbes when she tweeted that Scotland ‘could do a lot more’ in relation to business rates if ‘funding from the UK Gov was based on business need rather than population share’. (This is presumably a reference to the fact that a given package of NDR support to the tourism and leisure industry in Scotland costs proportionately more than the same package of support in England, given the proportionately greater significance of that sector in total revenues in Scotland).

Whilst from a UK perspective there is a strong equity case for basing funding allocations on needs, the obvious risk from a Scottish perspective of arguing that funding for Covid-19 should be needs based is that it would become much more difficult to resist calls for a need-based approach in ‘normal’ times. Indeed, how do you determine what is Covid-19 funding and what is not? It is generally accepted that allocating funding on the basis of need, rather than through the Barnett Formula, would result in less resource flowing to Holyrood. So whilst the needs-based perspective might continue to be pushed by the Welsh Government, the Scottish Government will be very wary of what that might imply for the longer term.

Concluding thoughts

The fiscal framework was not designed explicitly to deal with the degree of economic turmoil and uncertainty that now exists. But the framework seems to have performed reasonably resiliently since the virus took hold in the UK. The Scottish budget is protected from the risk of major falls in devolved revenues as a result of the pandemic (assuming the impacts are proportionately similar in Scotland as rUK).

As a result the Scottish Government has been able to focus its efforts on deciding how to allocate an additional £3.5bn of resources in 2020/21 since it its budget was agreed, rather than having to worry about how it might fund a deterioration in its revenue position.

But that does not mean the Scottish budget faces no risk from the effects of the global pandemic and its fallout. It remains to be seen whether, and to what extent, the fiscal impact of the virus might disproportionately affect Scotland. (An interesting hypothetical scenario is one where aspects of the economic ‘lockdown’ last longer in Scotland than in rUK on the basis of scientific advice, and what that would mean for the funding of both UK Government administered support such as the Job Retention Scheme, and Scottish measures such as business rates relief).

Depending on what pans out, this may change the assessment of how the balance of different fiscal risks is shared between the Scottish and UK Governments when the fiscal framework is reviewed next year.

A key challenge now is to understand how the rapidly changing health and economic will influence the budget risks and constraints that the government faces throughout the rest of 2020/21 and beyond.

This challenge will be made more difficult by the fact that some of the key channels through which these issues would normally be scrutinised have been shelved. The Government’s Medium Term Financial Strategy, which sets out risks associated with spending, revenues and borrowing and is normally published in May, has been postponed to allow the government to concentrate on other priorities. The SFC has been absolved from updating its forecasts of tax, spend and borrowing in May. And the parliament’s Finance and Constitution Committee, which would normally play the lead role in scrutinising these issues, has effectively been furloughed for all but urgent legislative matters.

It is therefore imperative that the Scottish Government provides regular and comprehensive updates about changes to its funding position, its spending decisions, and the evolving budgetary risks.

It is perhaps ironic that for all the concern about uncertainty in the lead-up to the Scottish budget, the ultimate source of uncertainty was not foreseen. But uncertainty should not be allowed to justify a lack of transparency.

In future work we will consider in more detail the longer-term outlook for the UK public finances and consequently the Scottish budget.

Authors

The Fraser of Allander Institute (FAI) is a leading economy research institute based in the Department of Economics at the University of Strathclyde, Glasgow.

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