Fiscal Responsibility Andrew Hughes Hallett (University of St Andrews and George Mason University) Reform Scotland 14 December 2010

Fiscal Responsibility vs. new Scotland Bill The key difference: Fiscal Responsibility (autonomy) gives the economy the policy levers to generate growth and employment, and Scottish ministers the responsibility to use those levers to create a better economic performance, better services, and a better business environment. Calman (the new bill) does not. It is designed to generate a certain level of funding, and adds a minor role (a maximum of 9% of public spending in Scotland) for Scottish Ministers to determine the revenues to be spent. Barnett by another name: Calman contains no levers by which Scottish Ministers can themselves create growth, or protect services. Calman: accountability without responsibility (even if you want it). Autonomy: accountability with responsibility.

The new bill: structural flaws…. The Scottish Parliament sets half the lower income tax rate; and one- quarter, one-fifth of next two rates: in total, 44% of income tax revenues. Revenues equivalent to those taxes at the UK rate to be subtracted from the Barnett grant, and the revenues yielded by the Scottish rates added. Five major flaws identified by the UK Treasury: a)You cannot know these revenues in advance exactly (or up to 4 years later): so replace with forecasts of UK income tax revenues. b)Such calculations are not transparent or verifiable. Reconciliation by adjusting the grant 1-2 years later: endless uncertainty and squabbles with London over the correct (or likely) deductions. c)Income tax revenues are volatile (like North Sea revenues). Calman would have lost us £900m in 2009/10. Borrowing is minimal (0.1% of GDP for max 4 years, 60% less than now) so planning for committed expenditures becomes a nightmare - creating boom and bust. d)Boom, bust cycles internally unstable. e)Any changes in the tax base, thresholds or tax bands in UK taxes will reduce Scottish revenues. “No detriment” compensations to grant: permanent and cumulative, so erodes the tax powers away.

… and forecasting difficulties….. By construction, Scottish decisions cannot be used to benefit the Scottish economy. The gains, if any, will go to the UK Treasury. The new funding formula will be (Treasury ): Barnett grant + net adjustment = 0.39(0.074)(ts – tu)[forecast UK income tax take] where ts = Scottish income tax base rate; tu = UK income tax base rate; and savings/investment income has been excluded. Hence Scottish revenues rise only if Scottish taxes are set higher, ts>tu, creating a general loss in competitiveness. Otherwise, if ts ≤ tu, losses in revenue. If lower tax rates increase competitiveness, any extra revenues from growth and new jobs will go to UK Treasury, not Scotland. That represents a permanent loss – subsequent forecasts of UK income tax will not be revised up as the Scottish contribution is too small to make a difference. Income taxes in the UK have barely risen compared to GDP (0.04% p.a. since 1965) as thresholds adjust with incomes. This makes Calman tax a “poll tax”. In addition income tax revenues rise 0.2% slower than UK spending, so the Scottish tax rate must rise 0.2p each year to keep pace with England/Wales (Murphy gap).

….lead to fiscal autonomy. The fiscal autonomy “tax and remit” proposal: Transfer of competence over all taxes (except VAT) arising in Scotland (eg income tax, corporation taxes, business taxes, national insurance, excise duties, natural resource taxes, user fees, Crown estate fees, green taxes/licences) including related allowances, tax bands and thresholds; Transfer the ability to determine, and finance, all welfare programmes that impact on Scotland’s labour market (so, not pensions); Scotland’s government to have conventional borrowing powers to issue debt, under the excessive debt protocol below; Scotland to remit an agreed annual payment to cover shared services (eg defence, foreign and security policies, EU contributions, pensions, financial regulation, plus contributions to a UK “cohesion fund”); The last allows all taxes, unlike in Calman, to be collected in one single system and the balance remitted to London. Cheaper and simpler.

..…Plus Supporting Institutions A central UK budget remains; risk sharing and automatic stabilisers are restored. A Scottish Fiscal Policy Commission to oversee the government’s fiscal plans and their impact on structural debt and the deficit; A graduated excessive debt procedure with increasing penalties that would ultimately place Scotland’s government “in administration” (under the UK Treasury), to enforce all debt and deficit limits. A UK grants commission to jointly manage economic policies: -- consistency with the overall UK macroeconomic framework -- regulate inter-government flows of funds -- facilitate debt management, revenue forecasts, the debt protocol -- manage emergency interventions or loans (a mini-IMF). Representation at the Bank of England, EU Commission (ECFIN). This is not fiscal independence: links to UK budget, oversight by UK grants commission, remit payments, UK monetary and financial regulation, UK markets, joint debt management all still apply.

Advantages of Fiscal Autonomy Fiscal Autonomy is for the long term. It is not a quick fix for the short term. However it will help in the current recession because: It contains policy levers to promote growth and jobs, unlike Calman; It allows the Scottish government to use taxes/spending to incentivise specific sectors of the economy; to maximise growth, develop new tax bases, replace North Sea revenues etc. Can focus policies on reducing unit costs, raise productivity, and explicitly raise competitiveness. Allows us to design taxes and spending to suit Scotland’s specific needs, without being tied to policies designed for elsewhere: -- with respect to future opportunities, and the current recession -- short term gains in employment, long term gains in trend growth -- efficiency gains in public spending through increased accountability -- the ability to adapt the welfare system to Scotland’s labour market. Given differences in structure, and timing in Scotland’s responses, there is no way policies designed to suit the UK as a whole could deliver the right incentives, or tax and spending mix, for Scotland.

Tax Powers Can Improve Recovery: Assuming public spending growth returns to the UK rate in 2015, we get the picture below. Mid-range estimates show decentralising tax powers by 1% can increase GDP by 0.6% to 1.3% after 5 years (Feld et al, 2007). A 10% increase in fiscal responsibility could cut the recovery time from 16 years to 12……

It may seem radical, but….. The UK Treasury now recognises that this scheme could work. Many countries already operate similar schemes with great success: Spain (Basque lands, Navarra); Switzerland; Canada; parts of Italy; Hong Kong in China; even the smaller jurisdictions within the UK. What fiscal autonomy can deliver in practice: In Navarra income per head has grown from 25.9% to 29.3% above the average of those regions without autonomy, and from 19.3% to 34.2% above that average in the Basque-lands, since fiscal autonomy was introduced in Unemployment in those regions fell to half the Spanish average, and stayed there even in the recession. These provinces can borrow: the Basque-lands had a AAA credit rating, while Spain had only AA (until recently). In the recession, the fall in growth was 1% point smaller and the increase in unemployment half that in the rest of Spain. So, although it is no short term fix, fiscal autonomy is especially useful in recessions.(Source: INE Statistical Office data, Madrid, March 2010)

Additional Evidence A 10% reduction in corporation tax rates increases an economy’s investment rate 2.2% points on average (on an average rate of 21%) -- A 10% reduction in corporation tax rates increases entrepreneurs who form companies from 3 to 5 per 100 population. -- A 10% reduction in corporation tax rates increases the rate of company start ups by 20% -- Multiple tax jurisdictions, multiple tax forms etc had no effect on these investment rates or start up rates: example, Germany. (Djankov et al, American Economic Journal, 2010, data from 85 countries) 2. A 6% greater devolution of the tax burden secures a 9% increase in the average US state’s business climate index and growth (a 7 place improvement): Sobell et al, World Bank (2010) 3.Ireland’s 12.5% corporate tax rate yields revenues of 2.9% of GDP, Germany’s 30-33% corporation tax rates yield only 1.1% of GDP. 4.Ireland’s FDI from the US (£165bn) are larger, in proportion, than US FDI to Brazil, Russia, India and China all combined.