Fiscal Policy and Tax, Labour Market

Weekly update: inflation, earnings, and budget windfall

Its been a busy week for economic statistics, with new data on the labour market and inflation released, and details of public sector pay deals announced. The UK and Scottish governments also confirmed that they have resolved a long-running fiscal dispute. The issue is a somewhat technical one, but its resolution will result in a significant additional transfer of resources to the Scottish budget in this financial year.

High employment and falling real earnings

Labour market data released this week covered the three months from March to May. This reaffirmed the recent trend of strong headline numbers for the employment and unemployment rate, and continued strong demand from businesses for workers. The employment rate in Scotland of 75.4%, and unemployment rate of 3.5%, are on a par with the UK as a whole. On these headline metrics at least, the labour market is back to where it was pre-pandemic.

There is a much less positive story on pay. Across the UK as a whole, nominal pay including bonuses rose 6.2% over the past year. But taking account of inflation, real pay actually fell by 0.9% over the year. A recent trend is that firms appear to be placing greater emphasis on bonus payments to attract and retain staff. Regular pay (excluding bonuses) has fallen by 2.8% in real terms in the last year.

Behind these headline numbers there are also differences across sectors, most notably between the public and private sectors. In real terms, regular pay (excluding bonuses) fell 2.1% in the private sector but 5.1% in the public sector.

So whilst the current labour market looks similar to the pre-pandemic labour market in some ways, it looks very different in others. One pandemic trend that seems to be sticking, at least for now, is the increased emphasis on homeworking. a paper just published by colleagues in the Department of Economics here at Strathclyde looked at 47 million job ads to understand how opportunities for homeworking have been evolving through the pandemic. With the purchasing power of workers’ wages are being eroded by rising inflation, homeworking opportunities may help workers to offset some of the impact of rising transport costs. But as that paper demonstrates, it is often better paying jobs that are more likely to offer some form of homeworking. The low-paid are being disproportionately impacted by the living standards squeeze, both because their real pay is declining more rapidly than the higher paid, and because they are less likely to be able to offset this wage squeeze by homeworking.

This week’s inflation data showed a further increase in CPI inflation, which reached 9.4% for the 12 months to June 2022. The increase in the inflation rate compared to May was driven by increases in energy costs and petrol prices. Inflation is likely to increase further in coming months not least given the lifting of the energy price cap in October.

Public sector pay – implications for public services and fiscal policy

This was the context into which the UK government endorsed pay deals for 2.5 million public sector workers that will average around 5% in 2022/23, although often with higher awards for lower paid public sector workers. These pay deals are higher than the UK government had budgeted for (inflation was around 3% when it published its Spending Review in October) but still well below the rate of inflation.

The UK deals will influence devolved public sector pay settlements in Scotland to varying degrees depending on the sector. It has already been announced for example that NHS medical and dental staff in Scotland will receive an equivalent 4.5% uplift to that announced for England. Meanwhile, the UK government policy will influence ongoing pay negotiations for police, council workers and teachers in Scotland – all of which are currently facing pay settlements below 5%.

A major challenge for the Scottish government of course is that its budget is determined by UK government spending decisions. There is a good case for providing public sector workers with a settlement that aligns more closely with current rates of inflation. But providing higher pay awards within a fixed budget would inevitably mean fewer resources for other elements of public spending – equipment, repairs, training, recruitment, and so on.

So far, the UK government has resisted calls to reopen the departmental spending plans it set in October. The implication is that the UK government’s higher-than-budgeted pay awards – despite being well below the rate of inflation – will need to be accommodated within existing budget settlements.

It will be for the incoming Prime Minister to decide whether to revisit the existing spending settlements in light of the substantial increases in inflation since October. Doing so would result in additional resources flowing to the Scottish budget. But one of the remaining two candidates for PM seems more likely to use an early budget to cut taxes rather than increase spending. The case for using any fiscal headroom to cut taxes rather than increase spending will be fiercely contested over the coming weeks.

Resolution of a long-running fiscal dispute

Amidst much economic doom, there was some good news for the Scottish budget this week. The UK and Scottish governments announced that they have resolved a long-running dispute about the fiscal framework. Resolution of this dispute will result in the UK government transferring £375 million to the Scottish government this financial year.

The dispute relates to the setting of the Personal Allowance for income tax, and the effect that the level of the Personal Allowance has on the Scottish budget.

Recall that whilst the setting of income tax rates and bands is devolved to the Scottish government, the Personal Allowance is ‘reserved’. At times in recent years, the UK government has increased the Personal Allowance in real terms (i.e. above the rate of inflation). A real terms rise in the Personal Allowance constitutes a tax cut for most taxpayers – and this reduces government revenues. But it is a tax cut that affects Scottish government revenues proportionately more than it effects UK government revenues. This is because Scotland has proportionately fewer high income taxpayers. High income taxpayers (those with incomes above about £125,000) do not receive a Personal Allowance, and hence a rise in the Personal Allowance does not reduce those taxpayers’ liabilities.

The Scottish government has argued that the UK government’s policy of raising the Personal Allowance disadvantages the Scottish budget because Scottish revenues decline relatively more than the decline in the ‘block grant adjustment’ (which is calculated on the basis of what happens to rUK revenues). It has sought recompense under the terms of the fiscal framework, which make provisions for either government to be compensated where the policy decisions of the other government created negative fiscal ‘spillover’ effects.

The resolution of this specific issue comes several years after it was first raised by the Scottish government. It is at the moment unclear exactly how the £375 million figure was calculated and agreed upon.

But before people get too excited about lobbying the government with proposals for how it should spend this windfall, prepare for an important caveat. The government’s budget plans for 2022/23 already included an assumption about how much it might receive from the resolution of this dispute and various other sources. Taking account of these assumptions, the windfall in practical terms amounts to just under £100m of additional resource, relative to what had been budgeted for.

In the context of the previous discussion, a £100m windfall is sufficient to fund a further 0.5% pay increase across the devolved public sector paybill of £22 billion.

Issues around public sector pay and the fiscal implications are likely to be a recurring theme of policy debates throughout the rest of the summer.


David is Senior Knowledge Exchange Fellow at the Fraser of Allander Institute



Head of Research at the Fraser of Allander Institute

Emma Congreve is a Principal Knowledge Exchange Fellow and Deputy Director at the Fraser of Allander Institute. Emma's work at the Institute is focussed on policy analysis, covering a wide range of areas of social and economic policy.  Emma is an experienced economist and has previously held roles as a senior economist at the Joseph Rowntree Foundation and as an economic adviser within the Scottish Government.

Mairi is the Director of the Fraser of Allander Institute. Previously, she was the Deputy Chief Executive of the Scottish Fiscal Commission and the Head of National Accounts at the Scottish Government and has over a decade of experience working in different areas of statistics and analysis.