David Melding welcomes tax autonomy but worries about potentially lethal borrowing powers
There is much to commend in the Silk Report. Its analysis of the fiscal situation in Wales and the potential for fiscal devolution is excellent. Once again, a Welsh commission has produced a lucid report which itself illustrates the latent capacity in Wales to take on greater responsibilities. Welsh devolution continues to be a story of progress to a more robust constitutional settlement that reflects the essentials of the British parliamentary model: a legislature and executive situated in the same institution and one with substantial responsibility for raising some of the revenues that fund its public spending.
Empowerment and Responsibility
This is the fourth of a series of articles debating the recommendations of last week’s Silk Commission report on tax and borrowing powers for Wales. Tomorrow: the Chair of the Commission, Paul Silk, responds to the issues raised.
In focussing on income tax as the most useful tax to share between Westminster and Wales, the report confirms the views of most commentators who have examined this issue in depth, Holtham being the most coherent. I have also addressed these issues in the latest chapter of my e-book being published on this site The Reformed Union: Britain as a Federal State. In arguing for the power to vary each rate of income tax separately, Silk bravely follows Holtham and without doubt presents the best prescription to tackle Wales’ longstanding and accelerating relative economic weakness.
Silk is much less assured when considering borrowing powers. Its arguments in favour of giving the Welsh Government access to international markets represent a hazard to robust fiscal devolution. There are a number of dangers, as I see them, should Silk’s recommendations on borrowing powers ever be implemented.
Borrowing for capital projects rarely raises many concerns in the minds of policy makers. However, there is seldom an effective firewall between borrowing for capital and revenue purposes. Powers aimed at facilitating capital investment morph all too readily into elaborate machinations to plug holes in the revenue account. And while many capital projects add to economic capacity, there is no rule of inevitability. Japan spent lavishly on capital projects during its so called lost decade, to little advantage. When borrowing leaks into the revenue account the very principle of tax powers to enable accountable public spending is fundamentally undermined.
The literature on fiscal devolution has grown significantly in the last twenty years as the pace of fiscal decentralisation has increased. As the American political scientist Jonathan Rodden has observed, fiscal devolution can lead to substantial debt accumulation and significant failures in macro-economic management. When sub-state governments are viewed as truly sovereign entities there is little danger of acute debt accumulation because creditors, voters and the markets will monitor borrowing carefully. However, sub-state governments are rarely seen as financially autonomous by the markets.
Own source tax revenues seldom generate half of the funding required for the expenditures made by sub-state governments – indeed, they are often substantially less than half. Instead sub-state governments are reliant on grants and shared revenues from central government. In practice creditors develop bailout expectations and therefore lend more freely to sub-state governments on the assumption that central government will ultimately prevent any debt default.
Rodden has described what he calls a bailout game where sub-state governments are reluctant to adjust their fiscal policies and instead hold out for the bailout. One state that has faced difficulties of this kind is the Federal Republic of Germany. While the reputation of the German government for fiscal rectitude is very strong in the international markets, this rigour has not always been present among the Lander. The problem is aggravated, of course, by the German government’s horror of debt default and this has inadvertently provided a guarantee to investors lending to impecunious Lander. The problem is clearly not cultural in Germany’s case, rather it stems from a poorly designed form of fiscal federalism where the federal government has no effective control on borrowing by Lander.
This danger could be even more lethal in Britain where the devolved governments and legislatures are buttressed by national sentiment. The UK government might find it difficult to resist calls for a bailout because such rigour could undermine the strength of the Union. In Germany, Lander that got into difficulty with excessive borrowing blamed the inadequacy of the central government block grant. It does not take a great leap of the imagination to envisage similar scenarios in the UK, only they would be amplified by national grievances.
A better approach would be to allow borrowing through a UK regulated fund such as the Public Works Loan Board. Silk acknowledges this in part, “We believe that borrowing sourced from the direct issue of Welsh bonds is likely to be more expensive than borrowing from the UK Government” (para 6.3.17) and adds that all borrowing should be subject to a limit (Recommendation 19). Unfortunately, Silk then slides into a far looser arrangement by calling for commercial and bond markets to be open to the Welsh Government (Recommendation 19). Here lies the road to the mischievous bailout game!
Perhaps I am being over anxious. I certainly hope so. I can take comfort from what Silk says on the need for a devolved dimension to the work of the Office of Budgetary Responsibility (OBR). Here Silk is robust and realistic. The quality of fiscal data is key to effective tax raising powers and the accountability that they should promote. The Assembly would be greatly assisted by a devolved dimension to the work of the OBR. And here Silk is also helpful in calling for the OBR to audit the devolved funding system where appropriate, which would subject the UK government to rigour in its negotiations with the devolved administrations.
It is then two cheers for Silk. Conservatives in particular should welcome what the Commission recommends on tax raising powers and the need for a devolved dimension to the work of the OBR. It could be a game-changer for Welsh Conservatism. At last the Party could offer an enticing combination of tax cuts to generate economic growth and fiscal rectitude – aided by sound analysis from the OBR – which could prove increasingly appealing to the Welsh electorate. No wonder Labour hum and haw!