Fiscal federalism

Hints from the Prime Minister on future funding options for the Scottish Parliament are rare and usually Delphic in their meaning. So close attention was paid to Gordon Brown’s relatively unambiguous remarks on the theme in a speech delivered to a CBI Scotland dinner in Glasgow in early September.

Although observing that on the whole devolution had worked pretty well, he said he did see one problem: fiscal accountability. As he put it: “The Scottish Parliament is wholly accountable for the budget it spends but not for the size of its budget. And that budget is not linked to the success of the Scottish economy.

“That is why we asked the Calman Commission to look carefully at the financial accountability of the Scottish Parliament. And this is a critical part of Calman’s remit.”

The commission, chaired by Glasgow University Chancellor Sir Kenneth Calman, a former Chief Medical Officer for Scotland, began work in April. Established by the Opposition parties in the Scottish Parliament, it was their response to the minority SNP government’s call, in July 2007, for a “national conversation” on Scottish independence. Given its provenance, it is unsurprising that the Calman Commission’s remit specifically rules out independence. However, it is reviewing whether more powers might be devolved and, in particular, matters that “would improve the financial accountability of the Scottish Parliament”. It is due to produce an initial report by the end of the year and a final report some time during 2009.

This week a commissioned report submitted to the Calman Commission by an expert group of economists, advocates extending the Scottish Parliament’s fiscal autonomy by giving it greater responsibility for raising taxation. However, it stops short of “full fiscal autonomy”. As one member of the group, Jeremy Peat, a former chief economist at the Royal Bank of Scotland and former economic adviser at HM Treasury, put it: “We are clearly drifting towards more fiscal devolution, if that can be fitted in with managing the macro-economy effectively.”

Gordon Brown’s remarks have led seasoned devolution watchers to conclude that the Westminster Government is now resigned to giving up decades of opposition to changing the Barnett Formula. Since 1979 this has determined changes in the level of the block grant funding given by Whitehall to the devolved administrations in Scotland, Wales and Northern Ireland. Now, it seems, Westminster is contemplating an element of fiscal federalism, in which the devolved administrations will become responsible for raising through taxation a significant proportion of their expenditure.

Hitherto, despite pressure from Wales and some northern English regions, which have believed they have been short-changed, successive Westminster administrations have refused to open up a debate on changing the Barnett formula, largely because of pressure from Scotland which is generally acknowledged to have been a beneficiary.

However, tensions have risen since the SNP took power in Edinburgh last year, with the Nationalists introducing a series of ‘giveaways’, including the phasing out of prescription charges and freezing council tax. This has prompted accusations that the Barnett formula means English taxpayers are ‘subsidising’ Scotland for services that are not available south of the border.

So it is significant that even some leading Scottish figures are now calling for change. These extend to some in the Scottish Conservative party who are calling for the Scottish Parliament to be made fiscally responsible in raising the money it spends. Sir Kenneth Calman himself has given the broadest of steers that his Commission is considering altering or even scrapping the Barnett formula. Asked if the formula was fair to British taxpayers, he said, “It’s pretty good for Scotland – it depends if you think that’s fair or not. But I don’t think it reflects the needs.

“It depends where you live in England. Its quite important you don’t think about England as a single place – you can break down the regions quite nicely. If you look at London, for example, you would see London does pretty well.”

That doesn’t apply in Wales, which is why the Welsh Assembly Government, a coalition between Labour and Plaid Cymru, has established its own Commission to investigate the Barnett formula and come up with recommendations for change. It is a small expert group, chaired by Welshman Gerald Holtham, a hedge fund manager and former Director of the Institute for Public Policy Research think tank. It also includes Professor David Miles, a managing director and chief UK economist at Morgan Stanley, and Paul Bernd Spahn, an Emeritus Professor at the Goethe University, Frankfurt am Main, who has advised the Treasury of Bosnia and Herzegovina.

Announcing the Commission in October Welsh First Minister Rhodri Morgan said:
“You would be astonished at the way the debate has already been framed strictly in terms of the relationship between the UK and Scotland. You can imagine what a dangerous scenario that is for Wales. We do not believe we are over-funded. We believe we are probably – in some sort of gut feeling – under-funded, but we need an evidence base to demonstrate that.”

Although Northern Ireland is generally reckoned to have done well out of the Barnett formula (see Table 1), even here there have been calls for a review. Last year the Northern Ireland Assembly’s Committee for Finance and Personnel called on the Executive to examine the implications of the Barnett formula and scenarios for reform.

The Barnett formula, named after Joel Barnett who was Chief Secretary to the Treasury the year it was established in 1978, determines the increase (or decrease) to a baseline block grant for each of the devolved administrations at each comprehensive spending review. The change is calculated by considering three elements:

• The changes in spending for England by UK departments.
• The ‘comparability percentage’, which essentially refers to the extent to which a programme or service is devolved.
• Size of population compared with England.

The result is known as the Barnett consequential, with the calculation being made for each UK government department. Put another way, the formula means that for every pound of extra spending in England each year on a service which is devolved, Scotland, Wales and Northern Ireland will get an increase in their block grant proportionate to their populations. Originally the proportions were set arbitrarily at 85:10:5 for England, Scotland and Wales. So, for every 85p of extra spending in England, Scotland would get 10p added to its block grant, and Wales 5p. These population proportions were too generous to Scotland (and too mean to Wales) until altered by Michael Portillo, as Chief Secretary to the Treasury, in 1992, to the correct population proportions.

In practice, the changes have been complex. So, for example, pre-1992 for Scotland, for programmes other than law and order the proportion was calculated at 10/85ths which corresponded to a 11.76 per cent increase. Following 1992 this was reduced to 10.66 per cent. For Wales, pre 1992 5/85ths amounted to a 5.88 per cent increase in expenditure. Following Portillo’s review this was upped to 6.02 per cent to reflect Wales’s relative increase in population. These small chang
es in percentages have significant consequences in terms of reductions and additions to the block grant, though it is fair to say that the Scottish Parliament’s share has been persistently high in relation to the other devolved institutions.

Now they are rebased for the following two or three years after every spending review. Table 1 provides the break-down for spending per head for 2007-08 across the UK, together with the percentage deviation from the UK average.

The Barnett formula is not based on any assessment of relative need, or of costs of services, which is pointed to by its critics as one of its main drawbacks. Table 1 gives a snapshot of the relative inequities. Wales, for example, is especially aggrieved that Scotland and Northern Ireland received 21 pr cent above the UK mean in 2007-08 compared with its own 8 per cent. It argues that the distribution would be markedly different if a greater emphasis were given to fairness in terms of need, taking into account levels of economic performance (GVA per head) and levels of poverty (households below 60 per cent median income levels).

Both Scotland and Wales also complain that the process by which the Treasury determines whether spending is subject to the Barnett formula or not is at best unclear, and at worst arbitrary. They are certainly not underpinned by any published criteria. So, for example, there are currently disputes between the devolved administrations and the UK treasury regarding the Olympics being classified as being of the benefit to the UK as a whole and therefore not subject to a Barnett consequential. Plaid Cymru’s economics spokesman, Carmarthen East MP Adam Price, claimed that as a result Wales was being robbed of £437 million, saying it is “a disgrace that the poorest part of the UK is effectively funding a massive regeneration project in London, officially the richest city in Europe.”

For its part the SNP Scottish Government claims it is being financially penalised by the failure to attach a Barnett consequence to the £1.2 billion increase in spending on prisons in England and Wales, in response to the Carter Review and pressure on prison places.

A further drawback to the Barnett formula is that it institutionalises what the political scientist Anthony King has dubbed an “infinite blame potential”. The devolved administrations have virtually no control over the size of the block grant that is available to them. When things go wrong, or there is a cutback in spending, they simply blame Westminster and Whitehall. It is not a recipe for accountability and responsibility in spending.

However, it is one thing to criticise the formula, quite another to come up with an alternative designed to achieve acceptance across the competing nations and regions of the UK. There are broadly three options for change:

1. Implementing a needs-based system for calculating the block grants of the devolved administrations. To ensure credibility this task should be carried out by an independent body, such as the Australian Commonwealth Grants Commission, established in 1933 to assess claims made by the Australian states for financial support from central government.

2. Devolving fiscal autonomy to the devolved administrations to raise their own revenue to meet their own expenditure, and at the same time making a contribution to the central Whitehall government for functions such as defence, the welfare state and international aid. This is broadly the case in the Basque Region’s relationship with the Spanish government in Madrid, probably the most extreme example of fiscal federalism.

3. A hybrid approach combining greater fiscal autonomy with the equity of a needs-based grant.

The likelihood is that the Calman Commission, together with the Holtham Commission in Wales, will opt for the third, hybrid solution. Certainly, this was the recommendation of the report Fair Shares? Barnett and the politics of public expenditure produced by the Institute of Public Policy Research in July 2007. However, this still leaves the hard question of what category of tax to allow the devolved institutions to deploy. The choice is assigning taxes, where the proceeds of certain taxes are attributed to the area where they are raised, or allowing the devolved administrations to vary certain taxes, whether income tax, corporation tax or VAT.

Possibilities explored by the expert group of economists that this week reported to the Calman Commission include letting Scottish Ministers set income tax. Currently they are only able to vary the standard rate of income tax by up to three pence in the pound, an option that has never been utilised in a decade of devolution. Other possibilities include devolving VAT, introducing an US-style sales tax, and devolving National Insurance contributions.

None of these options is straightforward. Yet the balance now seems to have tipped in favour of moving away from the Barnett formula in favour of a reform that would combine an element of devolved taxation with a needs-based equalising block grant. Despite the political problems in opening this ‘can of worms’, the arguments for change are gathering momentum. It is noteworthy, for instance, that even the author of the formula himself, Lord Barnett, now a Labour peer, has pronounced that he is amazed it has lasted as long as it has. He says it should be scrapped and replaced with one that reflects needs rather than population.