Balancing an independent Scotland’s books

The SNP has said it would cut spending on defending Scotland ' on current plans, saving about �900m a year. Picture: Neil Hanna
The SNP has said it would cut spending on defending Scotland ' on current plans, saving about �900m a year. Picture: Neil Hanna
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An independent Scotland would face tough choices on cuts and raising taxes, write David Phillips and Paul Johnson

In the run up to general elections, politicians are often less than open about their plans for taxes and spending. They often claim that they will only know what is necessary when they attain office and “open the books”. This is, of course, nonsense. The UK government may not be a paragon of openness, but there is more than ample information available to know broadly what fiscal decisions are likely to be necessary after an election.

The referendum on independence is, of course, rather different to a general election. And the uncertainties regarding the medium-term economic position of an independent Scotland are significant. But we can already say quite a lot about the kinds of tax and spending decisions that may face a newly-independent Scottish nation.

Indeed, the basic facts are straightforward and, broadly, uncontested. Ignoring North Sea oil, taxes raised per head in Scotland are very similar to those raised in the rest of the UK. Given that incomes (again ignoring North Sea oil) per head are also very similar, this is not surprising. Spending per head on the other hand is 11 per cent higher. That greater level of spending is driven almost entirely by spending devolved to the Scottish Government and reflects relatively generous funding under the long-established Barnett formula. Indeed, public service spending in Scotland – that is broadly spending other than on social security and debt interest – is nearly 17 per cent higher per person.

In recent years, that gap – similar taxes and higher spending – would have been just more than “paid for” if North Sea oil and gas revenues were allocated to Scotland on a geographic basis. But that does not mean that an independent Scotland could avoid some sharp fiscal decisions.

First, the fiscal situation for the UK as a whole remains difficult. The UK is expecting to borrow about £120 billion this year, with national debt forecast soon to reach 85 per cent of national income. The Treasury is expecting to reach “structural balance” on day-to-day spending by 2017-18 only through the imposition of further significant spending cuts already announced for between now and 2015-16, and even bigger ones, the details of which have not been set out, in the subsequent two years. These cuts would hit Scotland just like the rest of the UK.

It is unlikely that an independent Scotland could run a looser fiscal policy than the UK as a whole. So, even starting from a position of parity with the rest of the UK, big fiscal choices would already be necessary for a Scotland independent from 2016.

Matching the fiscal tightening being planned by the UK would mean the government of an independent Scotland having to make cuts of about £2.5bn in its first two years (to get a sense of scale, spending on public services for Scotland was £42bn in 2011-12, the latest year for which data are available).

Second, estimates by the independent Office for Budget Responsibility suggest that oil revenues will decline over the next few years. On the central OBR estimate, this could increase the Scottish budget deficit by a further £3.4bn. Dealing with this would require spending cuts or tax increases of a similar magnitude on top of the £2.5bn implied by the UK government’s plans.

Of course, these estimates of future oil revenues are highly uncertain and other estimates suggest higher revenues, which in principle could (perhaps more than) remove the need for these additional £3.4bn of spending cuts or tax rises, at least in the short term. However, even in this case, it is very unlikely that Scotland could avoid all the spending cuts or tax rises planned for 2016-17 and 2017-18.

Two caveats are important in the eventuality that oil revenues turn out to be strong, though. First, no Scottish government could only plan on the assumption of high North Sea revenues. That would be incautious in the extreme. Plans would need to allow for lower revenues. Second, and related, over the medium term a Scottish government would almost certainly need to target a measure of budget balance that excluded all, or most, of North Sea revenues. These revenues are volatile and will eventually diminish.

Given the state of the UK public finances, government spending in Scotland, as in the rest of the UK, is set to fall and/or taxes are set to rise. Unless North Sea revenues rebound sharply, an independent Scotland would most likely need to see bigger spending falls and/or bigger tax increases.

The good news is that there is scope for change, and indeed some plans. On the spending side, the SNP has already said it will look to spend less on defence than the UK currently does “on behalf of” Scotland. On its current plans, that would save about £900 million annually. Even so, that would leave Scottish defence spending rather higher than that of most small, rich nations.

On the other hand, the SNP has indicated an aim to increase overseas development spending to a level that would make Scotland one of the most generous aid donors in the world relative to its size. That would be a big call for a newly-independent Scotland facing significant fiscal pressures.

Beyond that, on the spending side, the obvious place to look for savings might be where Scotland spends more per head than the rest of the UK. Here the picture is rather interesting. The devolved Scottish Government has not chosen to focus its additional resources on the two biggest public services – health and education. Indeed, despite additional support for the higher education sector, following the decision not to introduce top-up fees, spending on these two big services is now at a level not much higher than in the rest of the UK.

Rather, it is spending on a whole host of other services – transport, agriculture, social services, business support – that is proportionately very much greater than spending in other parts of the UK. Spending on these services is on average 50 per cent per head greater and the gap with the rest of the UK has been increasing over time.

Of course, there is no need to make any fiscal adjustment on the spending side alone. Despite the chariness of the Westminster-based political parties in talking about it, there is a good chance that taxes will go up across the UK after the next general election (as it did after 1992, 1997, 2001, 2005 and 2010).

An independent Scotland would face most of the same choices and trade-offs in deciding what to do if it wanted to raise taxes. Like the UK as a whole, it would get most of its revenue from income tax, VAT and National Insurance Contributions and would find it hard to raise significant sums without raising more from at least one of these sources.

On the tax side though, an independent Scotland would have exciting opportunities to reform, simplify and make a more efficient tax system: the UK’s system has become too complex and distorting and imposes unnecessary economic burden. How brave the government of a newly-independent Scotland would be in taking on really radical tax reform though we cannot yet know.

What is clear, however, is that in or out of the UK, hard fiscal choices are going to have to be made. Careful analysis of “the books” already available means we know the potential scale of these choices. But here remains much to debate about quite what choices will be made on taxes and spending both in an independent Scotland, and in a Scotland that remains part of the UK.

• David Phillips is a senior research eocnomist and Paul Johnson is director of the Institute of Fiscal Studies