Comment: We must still count on trouble ahead

Smith's proposals affect the block grant. Picture: Alex Hewitt

Smith's proposals affect the block grant. Picture: Alex Hewitt

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WE ENTER 2015 in better shape than many forecasts allow. There is momentum behind the upturn – in employment, investment and household earnings. Company finances are strong and more new businesses are being formed. Inflation is subdued. And interest rates are unlikely to rise until late in 2015. We should count our blessings more than we do.

But there is good reason, too, for apprehension. There are deep-seated and intractable problems not far from the surface. Four in particular compel attention in the year ahead.

Arguably the most immediate is the impact of the oil price plunge. Brent crude is hovering around $60 a barrel, good news for energy consumers, but deeply worrying for the North Sea oil industry with the prospect of major cost reductions and investment cutbacks.

The latest Office of Budget Responsibility (OBR) projections show oil revenues set to hit £1.25 billion in 2016/17 instead of the £6.9bn predicted by the SNP during the referendum campaign. Whatever party or combination emerges to form the UK government after the election in May will have to contend with an annual tax revenue shortfall of some £5bn unless the price recovers dramatically.

This comes on top of already formidable constraints on public expenditure over the next few years. Either the spending axe will have to cut deeper or taxes will have to be raised elsewhere.

The second intractable problem is a ballooning UK current account deficit. In the three months to the end of September this swelled to £27bn. This was the largest quarterly deficit on record, and at 6 per cent of GDP was wider than that which triggered sterling’s ejection from the ERM in 1992.

So far overseas investors have overlooked this deficit to invest in UK assets. But how long might this continue? The risks of a sharp fall in the pound are considerable if foreign investors feel the risks outweigh the benefits. This need not be triggered by worsening trade figures, but if UK political fundamentals were to weaken – a gridlocked election, for example.

While a sharp fall in sterling might work to rectify the trade deficit, swift correction cannot be counted on: the near 25 per cent fall over the 2007-9 period did not bring any identifiable improvement in the UK current account.

And there is a limit to how long the Bank of England would be willing to allow the exchange rate to take the strain. It could not overlook the impact of weak sterling on import prices and UK inflation. Interest rates might then have to be raised not, as currently envisaged, when wage costs pick up, but when external inflation pressures intensify.

The third risk is more diffuse, but no less troublesome: the consequences of a gathering move away from debt-based economics. Over the past 20 years, output growth across the advanced western economies became increasingly dependent on debt. The rise in debt became unsustainable and led to the global financial crisis and recession. But to combat this, governments embarked on a scale of debt creation without precedent. While this may have been rationalised at the time as the lesser of two evils, today, as growth has returned, this policy too has tested the limits of sustainability and policy is now swinging towards public debt reduction.

Securing voter acceptance is tough enough. Resistance to public spending retrenchment is vocal, deep-seated and growing. And even if finally accepted, the problems do not end there. This spells major long-term consequences: lower levels of economic growth, lower long-term interest rates, a change in the role of banks, a shift in housing preferences away from owner occupation towards rental accommodation and, above all, a smaller role for the state and a permanently reduced public payroll.

This is tough across the UK after decades of expansion, but is proving particularly painful in Scotland with its proportionately higher level of government spend.

Finally, there are the demands for early implementation of the Smith Commission proposals for more powers for the Scottish Parliament. Political attention is focused on the delivery of these powers against a background of high voter expectation of substantial change. Very little attention has been paid so far as to how the tax and welfare changes will be implemented.

Of particular difficulty will be an issue not tackled by the Smith Commission – how the block grant given to Scotland will be adjusted when more taxes and spending powers are devolved.

When a tax is devolved to Scotland, the block grant should be reduced by the amount of revenue being transferred to Scotland. But what determines the size of adjustments in future years? One option is to index the block grant reduction to what happens to revenues from the equivalent tax in the rest of the UK. This would insulate the Scottish Government’s budget from revenue or spending shocks that hit the whole of the UK.

But trying to insulate Scotland from such risks while still providing it with the right incentives is complicated: it would, says a recent Institute of Fiscal Studies (IFS) paper, involve isolating the effect of Scottish policy (which the Scottish Government should bear) from other factors affecting devolved tax revenues and spending. Nearly all policy decisions could have knock-on effects on the revenues or spending of the other government. “But”, notes the IFS, “calculating what these are is inherently difficult, with much room for disagreement over the methods used – and different effects of the same policy might go in opposite directions.”

No less problematic is the proposal that changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK. But what if the UK government wanted to spend more money on defence or state pensions, or wanted to increase taxes to reduce borrowing? If, for example, taxpayers in the rest of the UK were paying more in income tax to reduce the budget deficit, it would be only fair that Scottish taxpayers also contribute to deficit reduction.

The scope for disagreement and dissension is immense and getting this through a divided UK parliament problematic. But this is only one of a set of killer spikes that could tear into economic confidence in the year ahead. «

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