Ronald MacDonald and Paul Hallwood: Grasp the nettle of our fiscal autonomy

AS IS evidenced by the large number of recent articles and letters in The Scotsman arguing for fiscal autonomy, and the upcoming Scotsman debate on the topic next week, it is clear that this issue is very much alive. However, the form of fiscal autonomy advanced in these pieces is in the mould of a proposal in our recent book, written before the recent financial crises.

Does this mean that the fiscal autonomy model that we and others have proposed still applies post-crises? We think not. So what would a new model that recognised the importance of the financial sector in the Scottish economy look like?

First, look at this recently reiterated model of fiscal autonomy. Given that most of the spending side of the fiscal equation has already been devolved to the Scottish Government, "fiscal autonomy" refers to the devolution of the other side of the equation, the tax or revenue raising powers. In this sense, fiscal autonomy could be very limited and refer to the system available to Scottish administrations since devolution with the ability to alter the standard rate of income tax upwards or downwards by three per cent, the so-called "tartan tax". What we had in mind in our previous work, and what others writing recently in The Scotsman have argued, is something much more substantial where all tax revenues which are possible to devolve within the context of Scotland remaining within the Union, are devolved.

In terms of the big ticket taxes, this would involve devolving income tax (base and rates) and corporation tax and diverting the revenues from North Sea oil to the Scottish Parliament. We would also allow the Scottish Parliament some borrowing powers to cover the short term and for long-term capital investment. Rules would have to be developed to harmonise Holyrood and Westminster budget deficits for macroeconomic policy purposes.

Let's label this "full" fiscal autonomy to distinguish it from other lesser forms of fiscal autonomy within the Union. It has also been referred to as "devolution max" by the Scottish Government in its 2009 white paper. The attraction to the SNP of devolution max is that it would have available almost the full panoply of economic levers although, as Bill Jamieson recently argued on these pages, Holyrood already has quite an impressive raft of economic powers at its disposal which have not been used.

The attraction to us of full fiscal autonomy as economists is that since it has little or no block grant element, it offers the hardest form of budget constraint possible to the Scottish Parliament. It transforms the Scottish Government from being a kind of fairy tale exercise into one which has to reflect the democratic preferences of the electorate and is truly accountable. It forces the Scottish Government to make hard choices between tax cuts and expenditure rises; it gives the government an incentive to grow the Scottish economy and it gives the ability to incentivise labour and capital. However, the fiscal autonomy game has changed in the aftermath of financial crisis. We need to ask how, if at all, full fiscal autonomy would work today. It is clear that the financial sector has an important and significant role in the Scottish economy, accounting for around 8% of gross domestic product (GDP) and the employment of more than 90,000 people in 2008, it grew by 60% between 2000 and 2007 compared to a growth of 14% in the overall Scottish economy over the same period, and in the crisis year of 2009 the losses sustained by the sector were colossal. For example, in 2009, the losses generated by the two big Scottish banks amounted to approximately 35 billion (with the RBS component of this - 24bn - being the largest loss in UK corporate history), which was larger than the money available in the Scottish budget in 2009 (33bn), is a very significant proportion of Scottish GDP in 2009 (with a GDP figure of 119bn) and would clearly overwhelm any borrowing powers the Scottish Parliament would have under full fiscal autonomy.

Indeed, if the kind of fiscal autonomy we advocate had been in place at the time of the crisis matters would have probably been much worse as the SNP has called for the slashing of corporation tax, along the lines of the Irish model, which could have resulted in financial institutions relocating their HQ to Scotland, exacerbating the whirlwind that Scotland would face (for example, Irish bank debts are more than 1000% of Ireland's GDP and the €85bn EU-IMF bail-out of November 2010 is about 50% of Irish GDP).

One response might be to say that the UK exchequer picks up the tab for this kind of crisis, much as has in fact happened. However, this undermines the hard budget constraint element of full fiscal autonomy and would not provide the Scottish Government with the appropriate incentives.

This indeed is the very recent experience of Ireland where, in exchange for cash injections, the EU and IMF have demanded harsh changes in fiscal policy.

Assuming the regulation of the Scottish banks headquartered in Scotland remains London based (although it probably doesn't matter who the regulator is given the scale of interbank lending - again the Irish case where the European Central Bank is now the main buyer of Irish government debt) we believe it would be a condition of a fiscal autonomy settlement that the Scottish banks are more closely regulated so that, for example, the banks have adequate capital ratios. We believe that even mildly tougher rules for the UK-based banks would be helpful for the UK as a whole and the fiscal autonomy-regulatory debate could well move the regulatory system in the UK forward.

An alternative to this idea would be to run with a system of fiscal devolution which has a substantial block grant insurance function left at its heart. The recent Calman Committee proposal - wherein the Scottish Government would finance an increased proportion of its public spending from Scottish own-sourced taxes - about one-third or somewhat more, may be about the best kind of fiscal solution for Scotland in the present era of financial storms. We say "era" because financial crises are frequent and experts on the matter do not think that new legislation around the world will help much in ending them.

So Scotland faces a trade-off - full fiscal autonomy, with its strong efficiency and democratic credentials, that unfortunately risks the sinking of the fiscally small Scottish open boat in the next financial storm; or, much lesser fiscal autonomy with its weaker democratic and efficiency incentives, but at least offers an insurance cover when the next storm comes around.

Where does this leave us in the fiscal autonomy debate and what are the key issues? First, the game of fiscal autonomy has changed post-financial crisis and, given the importance of the financial sector to the Scottish economy, needs to be factored into the design of a fiscal settlement for the Scottish Parliament. Second, how hard do we want the budget constraint to be under a new fiscal settlement? We have argued that it should be as hard as possible and only what we have referred to as full fiscal autonomy can achieve this. In this scenario, the regulation of the Scottish banks would need to be moved onto a different footing and it is unclear to what extent there is a willingness to do this. Others may say that this is too hard a constraint and that a proposal along the lines of Calman with its insurance function is preferable.

Perhaps the words that have been spilled on fiscal autonomy are in vain if no Scottish Government will ever use the tools devolved to it.In that regard, the fact that the current administration has let the tartan tax lapse is surely hugely symbolic, given that the Scottish electorate has voted to have the tax.

• Ronald MacDonald is Adam Smith Professor of Political Economy at the University of Glasgow. Paul Hallwood is Professor of Economics at the University of Connecticut. The Political Economy of Financing Scottish Government by Paul Hallwood and Ronald MacDonald, is published by Edward Elgar, 2009.