Scotland's struggling economy means we could face spending cuts and even higher taxes – John McLaren

Scotland’s politicians need to face up to some very tough choices

After the publication of the latest Scottish Medium Term Financial Strategy and new UK data and forecasts, what does the future hold for households and governments? On the economy, while the labour market remains remarkably buoyant, growth remains elusive. In particular, and according to the latest forecasts by the National Institute for Economic and Social Research (NIESR), productivity growth – output per hour worked – is set to be negative this year and average only 0.5 per cent for the four years after that.

Part of the explanation for this is the continuing lack of investment by the private sector, which has been poor for some time, exacerbated by Brexit and the pandemic. But now that we have moved on from an era of effectively zero interest rates to one where such investments are not ‘interest free’, with rates having risen above four per cent, there is a further disincentive to invest.

Another blow has come from the emerging evidence about the impact of the pandemic and a shift to ‘working from home’ on productivity, which suggests it is neutral at best and more likely negative. While the full effects are yet to become clear, the hoped-for efficiency boost does not appear to have materialised.

Such outcomes suggest that the UK’s dismal productivity record will continue for the foreseeable future, possibly even worsening. This in turn severely limits the ability for earnings to grow, in real terms, ie adjusted for inflation. Households will be further hit by rising personal taxes. Wealthier ones will be especially impacted by ‘fiscal drag’, whereby rising nominal wages – growing in cash terms but still falling in real terms – drag more workers into a higher tax bracket. The Institute for Fiscal Studies estimates that this will mean a rise from the current 11 per cent of UK adults paying the higher rate of income tax to 14 per cent by 2027.

The upside of fiscal drag is that it gives governments badly needed extra funds to raise the budgets of many hard-pressed public services. Whether this is enough to balance the growing demands in relation to public sector wages, the NHS, social care and defence remains to be seen. Last week’s International Monetary Fund report suggested that the tax burden would have to grow in the future, putting further pressure on households’ disposable income.

In Scotland, meanwhile, the Scottish Fiscal Commission’s (SFC) updated view of the state of things to come is largely in line with the Office for Budget Responsibility’s (OBR) most recent forecast, although the latter already appears out of date. For example, the OBR forecast inflation to bottom out at zero in 2025-26. This seems increasingly unlikely and even the Bank of England has started to ignore its own economic model in this area and ‘hand craft’ future inflation predictions, hence it now stays above one per cent, rather than becoming negative.

The SFC foresees a minor improvement in economic performance this year but ongoing low growth rates, which will not be enough to fill the gap between expected future government funding and future spending in Scotland. Finance Secretary Shona Robison last week estimated that by 2025-26 the funding shortfall would amount to £1.4 billion on the resource, day-to-day spending, budget side and almost £1 billion on the capital, investment spending, side, or, combined, over four per cent of the total budget.

Humza Yousaf and Finance Secretary Shona Robison need to find ways to improve productivity (Picture: Jane Barlow/PA)

How to bridge the gap? Not by constraining the public sector wage bill, ie downsizing the workforce, as had been proposed in May of last year by then Finance Secretary Kate Forbes. The public sector workforce is now expected to grow by more than one per cent a year to 2027-28, rather than contract.

So far the ‘difficult’ decisions being made only relate to what spending areas will be protected, that is poverty-related ones, and, presumably, the NHS. None of this makes other promises, like a ‘New Deal for Local Government’ any the easier to keep.

Some possible future prioritisation trade-offs have been mooted, like a shift towards more targeted, rather than universal, provision of benefits and services. However, there is little so far on what role higher taxes might play in closing the gap, which will disappoint some, including the STUC.

Worryingly, on the capital-spend side – which should support productivity improvements – even under the Scottish Government’s ‘upside’ scenario, the funding shortfall remains around £800 million. Very tough decisions loom, at a time when transport infrastructure, housing and energy/net-zero related investment needs are mounting.

Prospects for clear, wise and decisive action are further undermined by the general lack of interest expressed around the Scottish Parliament on this topic. Presentation and discussion of the Medium Term Financial Strategy was allocated just 30 minutes and the parliamentary attendance for even this curtailed debate was pitiful. How can any political party or MSP claim to care about public services when they can’t even be bothered to turn up for one of the most important statements of the year? The equivalent in the House of Commons would see a packed house.

Overall, economically, we are currently doing better than many had anticipated. However, the underlying picture remains dismal. We have a slow-growing economy and near stagnant wages, along with rising personal taxes but insufficient government funds to match rising public service needs and demands, nevermind catch up on debilitating waiting lists.

The key to unlocking these interwoven problems, as has been said many times before, is the regaining of healthy annual productivity growth. At present, we remain no nearer to achieving this, which means, in the short term at least, facing up to even higher taxes and/or austerity in some public service areas. Given such an outlook, a greater recognition and engagement with the problem by Scottish politicians wouldn’t go amiss.

John McLaren is a political economist who has worked in the Treasury, the Scottish Office and for a variety of economic think tanks.