Wales and Scotland on diverging fiscal course

Gerry Holtham explores the way the SNP success is affecting prospects for a Welsh financial settlement






George Osborne, Chancellor of the Exchequer

Before the victory of the SNP in the Scottish Parliamentary election we were already in an odd situation. The UK coalition government was apparently interested in devolving taxation powers to Wales, similar to those in the Scotland Bill now before the House of Commons, while First Minister Carwyn Jones has declined any interest in such powers. Instead the Welsh Government wants reform of the formula driving the block grant to Wales and there the UK government has ruled out reform.

Now along comes Alex Salmond to decry the Scotland Bill, based as it is on the report of Scotland’s Calman Commission, set up by the three main Unionist parties. He wants additional powers of taxing and borrowing immediately, and eventually wants complete fiscal autonomy for Scotland if he cannot get independence.

Steps on the road to fiscal federalism

Tomorrow Eurfyl ap Gwilym argues that without at least some fiscal powers the Welsh Government is still a long way from being a real government.

Meanwhile, the UK government is committed to giving Wales its own Calman-style Commission to consider the fiscal settlement even as the Scottish government will be trying to supersede Calman and consign it to history.

Scotland and Wales diverge further

One thing is clear. The interests of Scotland and Wales continue to diverge. The whole basis of finance in the Union has been to allocate expenditures largely on the basis of need and to take no account of where tax revenues originated. The regional distribution of public expenditures within England, for example, is determined by a series of needs-based formulae with little or no formal influence from which regions pay most taxes.

The Barnett formula for the devolved authorities’ block grants was a partial divergence from this in that it took no account of taxes but no account of need either. Welsh claims for reform are based on pointing out this divergence and arguing that consistency and fairness means the block grant should be needs-based too. The Independent Commission on Finance for Wales, which I chaired, showed in that case Wales would get several hundred million pounds a year more.  Scotland would get several billion pounds a year less.

Mr Salmond does not argue about that. Instead he wants to change the rules of the game entirely. He wants all taxes collected in Scotland to stay in Scotland, including those on North Sea oil production. That would move UK finances from a union basis to a federal basis.

When the oil price is high, as at present, ‘Scotland’s’ tax revenues are not very different from total public spending in Scotland, central and devolved – so long as oil revenues are kept on a geographical basis. Moving to fiscal autonomy therefore removes the need to justify Barnett spending allocations. If this pattern became general each devolved region would keep its own taxes and there would be some transfers – from region to centre to pay for central functions like defence and perhaps from centre to region if there is a scheme to balance up revenue inequality among the countries of the UK. This is normal in most federations.

Such a development would not suit Wales. While Wales is under-financed on the basis of relative need it runs a bigger per capita deficit than any other part of the UK. Welsh tax receipts are perhaps £19 billion, the Welsh government’s budget is £15 billion but total government spending including social security benefits in Wales is £25 billion.

Therefore Wales runs a £6 billion deficit, some 14 per cent of Welsh GDP. If the size of transfers per head rather than a consistent estimate of need is used as the basis for deciding resource allocation, Welsh claims for more resources would evaporate. To the extent that Alex Salmond succeeds in changing the way the UK government thinks about devolution finance and moves it towards federalism, he reduces likely transfers and forces Wales into more reliance on its own, currently relatively feeble, resources.

The Barnett floor

However, in the next few years at least, the system is likely to continue as it is.  The UK government may make concessions to Mr Salmond but it will not abandon Calman and overturn the present system before a Scottish referendum.  Yet the UK government is surely even less likely to reform Barnett than before – that would be a red rag to the Scottish bull. The most that Wales could get on that score is an addition to Barnett, the introduction of a ‘floor’ that limits the squeeze on expenditure per head imposed by the formula.

The idea is that the squeeze should stop when a country is getting the same spending per head as it would get if subject to English needs formulae.  Currently the squeeze goes on in principle until expenditure per head is the same as the English average. The floor, while a general principle, would in practice apply only to Wales, since Scotland and Northern Ireland receive substantially more spending per head than they would if part of England anyway. Therefore the cost to the Treasury would be relatively small and would not be incurred for some years since there is no squeeze unless public expenditure is growing.

The Chancellor the Exchequer has said he is prepared to consider such a floor and Wales will surely continue to press for it. The immediate effect would be very small but over a decade or two it could save Wales several billions.

Concessions that may be made to Scotland in the meantime are the more rapid extension of borrowing powers and, conceivably, the devolution of corporation tax, both demanded by Mr Salmond.  Recall that the Calman report opposed corporation tax devolution.

Borrowing

Carwyn Jones has already claimed borrowing powers for Wales on the grounds that Scotland is getting them and Northern Ireland has them already. The Treasury does not like the extension of borrowing powers to Scotland and will surely oppose Wales getting them, perhaps arguing that they go along with taxation powers, which the Welsh government says it does not want.

However, there may be a way forward. Northern Ireland gets a meagre £200 million a year borrowing capacity because the government there carries out certain functions that in Great Britain are handled by local authorities. Local authorities can borrow so the Irish dispensation is to give the Irish government the same borrowing powers for the functions in question.

Now Welsh local authorities can borrow too, more than they do. In principle that unused borrowing capacity could be used by the Welsh Government. It could ask the local authorities to borrow on its behalf and repay them from its own revenues. There is the possibility that should Wales get its act together and start doing that on any scale, the Treasury would move the goalposts. Devolution finance is not completely governed by legislation so the Treasury can change many rules as it sees fit. If the Welsh Government cannot negotiate its own borrowing quota it should at least demand the Treasury does not veto local authority borrowing carried out for joint projects with the Welsh Government.

Corporation tax

On corporation tax the Prime Minister has said he will listen to what Mr Salmond has to say. He could hardly do otherwise since his government has already promised to consider devolving corporation tax to Northern Ireland, ostensibly on the grounds that it competes closely with the Republic of Ireland where corporation tax is much lower.

If the UK government treats this issue on an ad hoc basis it will be both extremely unfair and a recipe for a fiasco. It is not sensible to devolve corporation tax without an adequate framework for determining where tax liability is incurred and the permissible variation in tax rates. Without that framework there could easily be a race to the bottom that cannibalises the UK corporate tax base without net advantage to anybody. One such framework was set out in the report of the Independent Commission on Finance for Wales.

Firstly tax liability must be determined by a formula, as in the United States, which takes account of the geographical distribution of a company’s payroll and, perhaps, its capital assets. Tax liability cannot be determined simply by the location of the registered office since that would result in brass plates moving to the area of lowest taxation with no effect on the location of economic activity but a large negative effect on the UK tax base and tax receipts.

Secondly, some limits on permissible tax changes are in order to prevent on-shore tax havens and unacceptable erosion of the tax base. Some tax-competitive advantage could be allowed to relatively poor or peripheral areas on grounds of equity and regional development without allowing the advantage to be so great as to be seriously distortionary.  The Independent Commission on Finance for Wales proposed that the UK allow reductions in corporation tax by devolved authorities proportional to their shortfall in GVA (gross value added) per head compared with the UK as a whole. The advantage of that approach is that it is self-limiting. If a devolved authority attracts more business and raises GVA,  that in itself would limit or reduce the concession.

The political difficulty with this approach is that it would allow both Wales and Northern Ireland the opportunity to cut corporation tax substantially if they chose since their GVA is little more than 75 per cent of the UK average. However, Scotland would not be able to cut much at all since its GVA is some 95 per cent of the UK average.  That would be reasonable but would provide a lot of material for aggrieved speeches from Mr Salmond.

The attitude of successive UK governments to Barnett reform indicates that the ability to make political waves is more important than notions of fairness and consistency in determining treatment of devolved authorities. Given all the difficulties, the most likely outcome is still that the Treasury succeeds in scuppering any devolution of corporation tax. Whether a deal is done and whatever its precise form, the Welsh Government must argue fiercely for a system that treats all devolved areas fairly and consistently.

What could a Wesh Calman Commission achieve?

If the Calman-based Scotland Bill is passed in its present form, as still seems certain, what about the UK government’s proposal to set up a Calman for Wales?  The sort of technical work that underlay Calman’s proposals in Scotland has already been done by the Independent Commission on Finance for Wales.  Indeed, the work of the Welsh Commission influenced the Scottish Parliament’s response to the Scotland Bill and the Secretary of State for Scotland has acknowledged its influence.

But the Independent Commission on Finance for Wales was an advisory and technical report that did not commit politicians. The point of a Welsh Calman would be its political function in trying to get cross-party support and consensus on the way forward.

The UK government seems to have accepted the argument that if the Scottish Parliament needed tax powers to be properly accountable, the same applies in Wales. However, Welsh politicians, especially Labour ones, are suspicious of the government’s motives.  Does it want tax devolution in order to reduce the Welsh block grant and could this be a tactic to reduce total resources going to Wales?

That could be presented so as to play well in England but could the UK government impose tax powers on a Welsh Assembly that did not want them and do so without a referendum? Although polls suggest a referendum on taxation powers could be won, no-one wants another referendum in a hurry and it surely would not be carried if opposed by the Welsh Labour Party. Constitutionally, of course, the UK Government could pass a law and impose any settlement it liked but would it be worth the political trouble? Westminster surely has enough on its hands at present.

Could Welsh Labour be induced to take taxation powers in exchange for other concessions such as progress on Barnett reform? That could be greatly to Wales’ advantage but the odds are long against such a settlement and just got longer.  Why would the UK government offer a deal that gave Wales more resources unless it could recoup the expense elsewhere? And surely the SNP’s success makes Barnett reform even less likely than it was.

Piecemeal changes seem much more likely than a radical shift in the way that Wales is financed. The SNP’s success has reduced rather than promoted the chances of rapid reform. But the situation is as unsettled and as changeable as Welsh weather so who knows what surprises may be in store.

Gerald Holtham is an IWA trustee and chaired the Independent Commission on Finance for Wales.