Revised transcript of evidence taken before
The Select Committee on Economic Affairs
the devolution of public finances
in the United Kingdom
Evidence Session No. 1 Heard in Public Questions 1 - 13
Witnesses: Professor David Heald, Professor Alan Trench, Professor Jim Gallagher
and Dr Angus Armstrong
Members present
Baroness Blackstone
Lord Forsyth of Drumlean
Lord Lamont of Lerwick
Lord Layard
Lord Sharkey
Lord Teverson
Lord Turnbull
________________________
Professor David Heald, Professor of Accountancy, University of Aberdeen Business School, Professor Alan Trench, Professor of Politics, University of Ulster, Professor Jim Gallagher, Visiting Professor of Government, University of Glasgow, and Dr Angus Armstrong, Director of Macroeconomics, National Institute of Economic and Social Research (NIESR)
Q1 The Chairman: Professor Heald, Professor Trench, Professor Gallagher and Doctor Armstrong, I welcome you to the Economic Affairs Committee. I fear that our afternoon may be a little interrupted, because a Motion before the House from Lord Butler is currently being debated. It has some bearing on our inquiry. There is likely to be a Division at around 4 pm, so we will disappear and return as fast as possible.
Thank you very much for coming, and thank you to those of you who have already submitted some helpful written evidence. Perhaps I might start by asking about the Barnett formula to get your views. To help this session along, ideally if you agree with what the previous speaker has said you do not need to repeat it. The Barnett formula is proposed to remain at the centre of the funding formula for Scotland in the new devolved settlement. Do you think that that is a robust, workable and sensible approach?
Professor Jim Gallagher: I will start by saying that the joke I make on these occasions is that there is a small society, of which I am the president, called the Friends of the Barnett Formula. It has one other member, who is the Chancellor of the Exchequer of the day, because the Barnett formula works. It has been remarkably robust. It obviously has a political dimension in the Scottish debate, in that during the referendum campaign all the three main UK political parties undertook that Barnett would remain. Therefore, the probability is that it will for a substantial period, at the very least.
It has advantages that people do not recognise; no doubt my colleagues will point to its disadvantages, but it is easy to disregard the advantages. The first is that it fits with the UK system of public expenditure planning, which is based on an increment, so it is driven by increments. The second is that it puts the UK Government in the position of making the decision that only the UK Government could make, which is the division across the UK between expenditure and what you might loosely call federal spending, reserved spending and devolved spending. The UK Government have the right set of incentives in making that choice, because they are responsible for devolved spending for England and federal spending for the whole UK. In that respect, the Barnett formula works. It requires to be adjusted in reasonably complicated ways to take account of tax devolution. I confidently predict that my society will still have a member in 10 years’ time.
The Chairman: So you do not see a case for fundamental reform of the Barnett formula?
Professor Jim Gallagher: I think that is politically not sensible, given the promises that were made. Nor do I see a replacement approach that would have the advantages of Barnett and get rid of all the problems.
Professor Alan Trench: I thoroughly disagree with Jim Gallagher. Notwithstanding the advantages of Barnett that he notes, and there are other advantages that he does not note, it is now fundamentally inappropriate for the situation that we have. It does not work in the constitutional conditions that we have created, because it assumes that devolved Governments will continue to want broadly the same package of public services that the UK Government will deliver for England. I specifically disagree with Professor Gallagher that the UK Government is the Government with the right incentive about the split between devolved and non-devolved spending. It does not seem that the UK Government have any meaningful incentives other than political happenstance. That drives a sequence of fairly arbitrary decisions.
Scotland notices these difficulties much less than the other parts of the UK because it is generously treated by the Barnett formula. We have now created two further difficulties, each of which is serious and, which compounded, are fatal. The first is that we have introduced this opaque and rather confusing no-detriment principle into how the block grant will be adjusted for new devolved spending functions and devolved tax functions. We continue to the leave the Treasury in sole control of all decisions relating to these matters. That means in effect that the Treasury will make up some numbers and apply them. The numbers that it makes up might happen to be the right numbers, but no one will believe that. Unless there is a much more robust administrative machinery surrounding the block grant, I do not see how it can work. By the time you have made all those changes, you get to the point where you have to accord the late Lord Barnett his wish and take his name off the formula.
Professor David Heald: I am much closer to Jim Gallagher’s view than to Alan Trench’s, but there are some fundamental questions. I do not understand the vow to keep the Barnett formula. If it remains the Barnett formula in its old form, I do not know whether that means it is a block grant plus adjustment mechanism rather than a needs assessment. I always expected that the Barnett formula would become politically toxic, that the name “Barnett formula” would go but the substance might stay the same. It is equally possible now that the name will stay but the substance will change.
The United Kingdom is in a very difficult situation, which I do not think is fully appreciated. The only way that one can make any kind of system work from where we are politically now is on three things. First, we need to have some high-level principles, not mechanical rules. Secondly, we need a referee. It is intolerable that the Treasury should dominate everything, as it has done in the past. Thirdly, we need data transparency. For example, for the past 20 years the Treasury has pretended not to understand my attempts to get the information for what the relative indexes are for comparable, rather than identifiable, expenditure. It has pretended not to understand both in response to freedom of information requests and to questions from Members of the other House. The situation is critical.
One more point about the Barnett formula that Jim did not emphasise is that it preserves the block grant nature of the funding. Once one goes down the route of a detailed needs assessment, the block discretion, which is one of the significant, positive features of the UK devolution system, will come under much greater challenge.
Dr Angus Armstrong: My position is that rarely has something become so totemic when it is due to become less important with the powers that will be devolved. When a formula gets changed it is usually not the same formula, but this one seems to be. Given what is going to happen in Scotland, the time is right for a much broader discussion about transfers across the whole of the UK, including in England. That would open up the whole discussion on Barnett. It does need to be opened up. It is much more a legacy issue to do with the balance of power, rather than asking the economics question of which risks you are trying to share here. That would give very different answers in relation to how it is currently set up, which is comparable services. I do not think that is the economic answer to the question of why you would do transfers across the various devolved Administrations in the UK.
The Chairman: It does not sound as though there are many recruits for your club, Professor Gallagher.
Professor Jim Gallagher: There never have been, Lord Chairman, but it is still going.
The Chairman: I recall that the late Lord Barnett was not a member of your club either. He felt that it was long past its sell-by date. You raised many issues, and perhaps we can now deal with those in the subsequent questions.
Lord Lamont of Lerwick: Before I ask my question about the needs-based assessment, I want to ask Professor Trench a question. Did I understand from what you said that you think that the no-detriment principle should not apply, that there should be no no-detriment principle?
Professor Alan Trench: You could not get away without some form of no-detriment principle, but far too much weight is put on far too nebulous a concept, frankly as an excuse for the Treasury thinking about a problem. Instead of solving a problem, it has used as a convenient phrase that was first dreamt up for these purposes in 2010, at which time too much weight was being put on it for a much more limited form of tax devolution. One needs a much more effective mechanism with much more robust machinery around it. The no-detriment principle has to lurk somewhere in the framework that one would put in place, but as a failsafe to be applied primarily at the political level, not as a concept to be operationalised day to day and to underpin the amount of funding that devolved Governments get.
Lord Lamont of Lerwick: But is not fiscal devolution partly about assuming responsibility? Should that not therefore carry a risk?
Professor Alan Trench: Absolutely. I would say that that is the entire point. The problem with no detriment, in the way that it is being framed and applied, is that it creates scope to wash that out of the system and instead simply to have political recriminations and blame shifting. For example, someone says that because this was to their detriment, they are owed some money and so are going to take some from the block grant, or, if someone makes enough of a row, some money will be added to the block grant. None of that will be in the slightest bit transparent and no one will be able to tell whether or not it is justified.
Q2 Lord Lamont of Lerwick: I go back to the idea of replacing Barnett with a needs-based assessment. Is that so complicated? How should these needs be assessed, and in your opinion what principles underlie a needs adjustment? Have we not been through this often enough? I know that it is always argued about with the local authorities, but is this such difficult territory?
Professor Alan Trench: I was adviser to the Select Committee of this House on the Barnett formula about six years ago, along with, among other colleagues of yours, Lord Forsyth. We outlined a relatively simple and straightforward means by which to do this. I noted that Professor Heald said a while ago that a comprehensive needs assessment would be a very complex affair. The Committee did not consider that it would be so. Partly building on the work that that Committee did, the Holtham commission—the Independent Commission on Funding and Finance for Wales, to give it its full title—subsequently came up with a methodology, which has not been meaningfully challenged or questioned, as a straightforward and largely accurate way of accomplishing that aim.
Professor David Heald: It is no coincidence that that formula was rather favourable to Wales. There are several ways in which you can do this: there are the quick and dirty Holtham commission proposals or the more comprehensive Australian grants commission-type proposals. I make two quick points. The first is that the political climate around these matters is toxic and the future of the United Kingdom remains at risk. Therefore, we are not doing it in a low key political context. The second point is that to run a needs assessment you need a degree of agreement across the territories and the political spectrum about what the state actually does. There are significant disagreements. One example that affects the operation of the Barnett numbers is the question of higher-education fees. If there is significant disagreement about what is done, there will be enormous conflict surrounding that. No doubt technically you could do it, but the people who feel that they are not doing as well as they should be from a particular proposal will complain extremely vociferously. Unless it is a reasonably comprehensive assessment, I think that we will end up with a lot of ad hoc adjustments being made to whatever is proposed.
Lord Sharkey: Who would be the arbiter of these different assessments of need?
Professor Jim Gallagher: That is the difficult question in all this. It is very easy for one institution, such as the Holtham commission or indeed the Treasury, to have a view as to what it thinks need is, but need is essentially a contested concept and people disagree about what needs are, how they should be measured and how much they should be paid for. It is easy to do it in the abstract; it is very, very difficult to do it in practice. I do not agree with my colleagues, in this or other contexts, who suggest that there can somehow be a referee between the Governments. In both cases, the Governments have an electoral mandate and the process that should resolve disagreement between them is politics, not the teacher coming along, marking the paper and saying which of them has the right answer. I do not think that the idea of a referee, in a needs context or any other, is a good one.
Professor David Heald: I will just come back on the referee point. The Australian grants commission proposes, then government decides. It is a question of control of the apparatus of data collection and where the knowledge in the system lies. The crucial point about the role of the referee is that the biggest immediate role would be on data transparency. The Parliaments would have to decide in the end, but the information would be in the public domain for people within the Parliament with different views to advocate their case based on the evidence as they saw it.
Lord Teverson: I would not necessarily advocate this myself, but could it be argued that under very devolved systems a needs-based formula was a reward for failure? However badly a devolved Government do, they are going to be bailed out by someone else. Is that an issue in any way?
Professor Jim Gallagher: Absolutely not. It is not Governments who would be rewarded but people, who would retain public services that they would not otherwise have. Needs for public expenditure are largely driven by demography. In the UK, needs will be driven by the age structure of the population, and the geographic variation in need is substantially driven by that too. That is not a reward for failure.
Lord Teverson: As I said, I am not necessarily advocating that, but I can see that applying on a static basis in year 1, which a lot of these arguments are based on, but in years 3, 5, 10 or 30, is not that more important?
Professor Alan Trench: If you put any system in place, you have to keep it under review. You cannot simply put a system in place, let it run and then come back in year 30 and say, “Oh dear, this is not working very well”. You have to maintain it and conduct periodic reviews. The Australian system, which Professor Heald mentioned, changes the numbers that are allocated every year and goes through a review of the basic structure of the formula every five years. That is the sort of system that I think you would need if you were going to do that. Secondly, if you do not have some external body to review that, you are going to run into very grave difficulties indeed.
Q3 Lord Lamont of Lerwick: Did you have any criticisms of the way in which this was fed into the rates support grant for local authorities? I know that lots of local authorities felt, inevitably, that X was advantaged and Y was not. Data on this were collected in much smaller, in a sense much more targeted areas. As a student of this, do you feel that that mechanism was defective?
Professor Alan Trench: The problems with standard spending assessment mechanism—the RSG, or whatever the current abbreviation is—were twofold. One was that it was massively politically gamed. Authorities would argue that they were done a disservice in a particular year and would secure attachment to a particular indicator that favoured them. So the formula becomes a Christmas tree, and that is a problem of the political process. The second problem is that you end up with something that in many ways is rather like the Australian mechanism that Professor Heald talked about. While I support the architecture of the Australian system, I do not like what the Commonwealth Grants Commission does. It uses something like 70 different indicators, from memory, and is therefore a very data-intensive process. It is equally prone to being gamed by finding bits of data that advantage you and pushing the case for the inclusion of these in the formula. When I went there about 10 years ago, I was amused to discover that in one large state that has done very well out of the formula for quite a long time, the same official was responsible for running the state’s division in the finance department which was responsible for fiscal relations with the federal Government, and the state’s Bureau of Statistics.
Professor Jim Gallagher: I used to run the local government finance system north of the border. You find a great industry that makes very little difference to distribution in the end, because the advantage that one area gains from one measure is offset by the advantage another area gains from another measure, and they all make sure that their measure is in there. The fundamental difference between local government finance and the Australian system, which is virtually indistinguishable conceptually from our rate support grant system, is the asymmetry in this. The Australian Government are not handing out money to themselves but to different sub-national subsidy institutions. The UK Government, in the Department for Communities and Local Government, are handing out money to local authorities and not themselves. The system inside the UK is one in which the UK Government are a recipient of the money as well as the distributor. That asymmetry means that an Australian-type system would not automatically work in our case.
Professor David Heald: Could I come back to Lord Teverson’s question about whether it is a reward for failure? Yes, of course, it could be a reward for failure, but it depends on what you think the dynamics of the United Kingdom are. I will give you two examples. In my view, the United Kingdom is hugely geographically imbalanced, with the effect of what happens in London and the south-east. The rest of the United Kingdom was writing implicit guarantees to the south-east, London and the financial sector during the boom period. For the second example, I will take two local authorities in Scotland. One is Aberdeenshire, which has benefited enormously from the oil development, and the other is Inverclyde, on the west coast, which has suffered from the rundown of heavy industry. You could probably argue that Aberdeenshire is a better-run council than Inverclyde, but clearly there are massive economic dynamics behind that. So yes, you have to be aware of the possibility that you might reward failure, but – unlike in countries such as Canada, the United States and Germany – where one city dominates everything and has an economic area that stretches up the east coast main line, there is a very serious issue with distribution. One of the reasons why Barnett has become politically toxic is because it has been blamed for what is perceived as the bad treatment of the north-east of England. It is absolutely nothing to do with the distribution of money within England, but it is perceived to be. One of the standard arguments against Barnett that one hears is that it treats the north-east of England badly, but that is nothing to do with it; that is an internal English distribution question that is driven by the local authority funding system and by the health funding system.
Lord Turnbull: I start from a fundamentally different position from Professor Gallagher’s. You are saying that the Barnett formula works. I do not think that it does. It has failed two very, very important tests. One is equity. I do not think that you can look at how it has worked and say that the outcome now between the different geographies is fair. Secondly, it does not work because it has no correction convergence mechanism. It seems to me to be a bit like a tax coding that is too generous to you. At the end of the period, the taxman says, “I’ll readjust it so that your tax in the next period is correct”, but he does nothing about the fact that you benefited in the past. With a relative population decline in Scotland and a population adjustment but working with a lag, you are then dealing with the increment. As some of our papers show, this whole thing started being very generous to Scotland and has become more and more so. There are more technical things about the way it interacts with the business rate and the way it has acted in the last five years; the pattern of spending of spending has also been very favourable to Scotland. You may say that you want a Barnett formula, but I do not think we should be saying that we want the Barnett formula. What is missing is any idea of the equilibrium level of grant and then finding some way in which the system over time—that could be five or 10 years—gradually converges. But that mechanism does not exist.
I agree with those who commented that the RSG having 70 measures was ridiculous, because five of them explain 90% of the variation and the rest are all part of the argy-bargy: “I am running a fire service, but there is no fire station out on the coast, so I am disadvantaged”. I think you could have something that is simpler, but the fundamental thing is that it is not fair. We have already recognised that by having to do a special deal for Wales, this underpinning, and simply starting a whole new era of constitutional position on something that is so broken is a fundamental mistake.
The Chairman: Can we move on?
Lord Turnbull: We are going to pick up a lot of those points in subsequent questions.
Q4 Lord Sharkey: I will pick up Lord Turnbull’s question. The Smith commission recommended that the future growth in the block grant should, after the first year, be indexed appropriately. It did not say, or even hinted, what “appropriately” might actually mean. How do you think that such an index might operate, and what might it be?
Professor Jim Gallagher: This is the indexation of the reduction from the block grant, however that block grant is calculated, whether it is calculated by Barnett or otherwise, to reflect the fact that the Scottish Administration now has the flow of tax revenues. The principles—going back to David Heald’s suggestion, let us not talk formulae but principles— are which risks should be allocated to which level of government. Let us take income tax as the simple example. The UK Government will continue to control the tax base in the form of the definition of income and the minimum level. Therefore any changes in the revenue stream that result from changes to those should be a risk borne by the UK Government. The Scottish Government should take the risk from their own tax decisions on the bands and on the rates, and they should also take the risk from differential growth in the tax base between Scotland and the rest of the UK. That way it is taking on some economic risk. That rather encapsulates the no-detriment principle, which should be confined essentially to the first of those points.
The technical way of doing that may be by indexation to the relative growth in English tax revenue, but the important thing is to sort out what the right principle is before we worry about the index.
Professor Alan Trench: I largely agree with that but I will amplify it a little. A very good analysis of this was done by the Holtham commission for Wales, which located precisely these concepts of who bears what risks for what. That remains the lode star. The key point that the Holtham commission made was that these risks are different for different taxes, so it is appropriate to consider different mechanisms for different taxes because the risk profile that goes with a land tax is different from the risk profile that goes with income tax and is different again from the risk profile that goes with corporation tax, for example. So one needs to think about these things quite hard. That is one problem, because I understand that Treasury is looking to use simply one mechanism in this context rather than actually going through the hard process of thinking about this problem and how you match these mechanisms.
The second problem, which I understand is under way in Treasury, is that Treasury is looking at a single fundable pool of reductions from the block grant in relation to all devolved taxation, rather than saying, “This relates to this tax. That relates to another tax”. There may be a sense in which this simplifies the matter and means that you smooth out various problems by letting losses in one area being picked up by gains in another. I suspect that the Scottish government would not let this go forward if they were not fairly sure that this was not going to be a reasonable bet in the longer term, but this is a fraught and distinctly rough and ready way of proceeding, and I strongly urge your Committee to ask some hard questions of Treasury about this when the time comes.
Professor Jim Gallagher: We cannot argue that it is a bit rough and ready in relation to the distribution of grant and very complicated in relation to the reduction of grant.
Professor Alan Trench: Indeed. It is a very peculiar approach.
Dr Angus Armstrong: I do not share the same views as Jim. I think that what the Smith commission has got itself into with its no detriment is in practice almost impossible to put into place. So the idea that you can say that actually the UK controls the tax base but the tax rates are for Scotland and you are going to work out how much the tax revenue is due to one and not to the other—well, good luck. Any sensible economist will tell you how hard that is, let alone when you have people on different political sides with a stake in the game. I think you are putting far too much on the powers of econometrics ever to disentangle these effects.
“No detriment” as a whole is just a legal phrase; it is just dreadful. The idea in the Smith commission is that there is no detriment in the initial devolution of the taxes and then going forward. In the initial devolution of the taxes, because more of the revenues will stay in the devolved Assemblies there is going to be less risk-sharing. Risk-sharing is like the gains from trade; it benefits everybody. How are you going to compensate everybody when all sides lose? Somebody has to pay. The benefits of these things seem to be completely devoid of any notion of risk-sharing.
Going forward, what should you be basing any transfers on? Presumably you are interested in risk-sharing things such as pension risk between the devolved Assemblies and not simply deciding whether you can try to work out what are duty or policies or not duty or policies.
You do have to index the Barnett formula so that it moves forward in time. Some people argue that it should be on a GVA basis. Some people argue that it should be on a tax revenue basis. I think you can get into the problem of rewarding failure when you go down that route. My preference would be an aggregate tax revenue basis so that it depends on the UK’s tax base overall, because I happen not to believe that you will ever be able to completely separate what effect one policy and one part of such a porous border has had on the others. So I would just take it on total revenue and make it as simple as possible.
Professor David Heald: I would draw the Committee’s attention to a paper in the Fraser of Allander Institute quarterly review by Jim Cuthbert, who talks about the effect on Holtham indexation of differential population growth and proposes a modification to Holtham indexation. That is just an example of starting with quite a simple idea that becomes much more complicated, and it is why we need data transparency.
Lord Turnbull referred to the treatment of non-domestic rates. The Treasury decided how that was going to work. The enormous reductions in the context of local government in England had a beneficial effect for Scotland and Northern Ireland, but that was not the intention. One needs the data in the public domain so there can be an intelligent debate at the time about how the system works.
Q5 Lord Teverson: I will pursue the no-detriment principle. It seemed to me when I first read about this concept that I would love to enter into agreements that in no circumstances were detrimental to me. I thought, “That’s a really good invention”. I was interested in your views, Dr Armstrong, because it seemed to me that no detriment was a zero-sum game in that if you had no detriment on one side, the other took the risk. But you were saying that by balancing risk you can have gain on both sides. Could you go through that in a little more detail and persuade me that it is not a zero-sum game?
This has already been mentioned, but do the other witnesses think that this is a completely unfulfillable condition, that it is practically impossible, and perhaps whether any other devolved nation state has tried to implement this in any way?
Dr Angus Armstrong: As regards why it is not a zero-sum game, one of the benefits of risk sharing is that it is like an insurance contract. For example, with the collapse in the oil price and the fall of oil revenues, Scotland shared that risk with the rest of the UK, so the impact on Scotland was much less than if it had controlled all the North Sea oil-related revenue. Other shocks affect the rest of the UK that to a much lesser extent get shared throughout the UK, including Scotland. This insurance contract, which works for all the nations of the UK, leads to a higher level of welfare, because you do not have to make the very difficult adjustments at the difficult time. Scotland did not have to cut back its spending in line with declining revenue. Just as with insurance—your home insurance and so on—not everybody’s house burns down at the same time. That is why you can pool it all and it works to insure each other. That leads to an overall net benefit for the whole of the UK. You can all gain and, for once, there is a free lunch. I know that people always think that that sounds a bit odd, but actually there are such things as free lunches—in insurance contracts for example. It benefits people to go into these contracts. The no detriment principle, if you start untying all that, makes everybody at the margins slightly worse off. How will you compensate everybody? Somebody has to pay. So they obviously did not really think about the function of some of the UK tax system, which is about risk sharing across geographical space.
Professor Jim Gallagher: It seems to me that people have got into a terrible state of excitement about a couple of carelessly drafted words in a political agreement. The Smith commission did its work in a great hurry. It sought to set out some principles on which the system should be based. No detriment is, at best, a piece of loose drafting to reflect the point I made earlier about the allocation of risks. It was introduced, as Alan Trench said, in the context of what became the Scotland Act 2012, where the income tax base was shared, and the proposition was that each Government should take responsibility for the effects of their own policy decisions. If, under that system, the United Kingdom Government had substantially increased the threshold for the payment of income tax or substantially decreased the boundary between the higher and other rates, they would take the financial consequences of that decision for good or ill. There would therefore be no detriment from that decision to the devolved Administration. People are carrying that across conceptually into areas where it is not at all suited.
Dr Angus Armstrong: I accept that you can take it too much from a purist’s point of view. It covers so many sins, but it is actually really important. Suppose that Scotland is allowed to issue its own debt. We know from just about every devolved or federal state in the world that sub-central debt can have feedback effects on federal government debt. How will you measure that? Presumably you will have to measure it at some point, and that is an extremely difficult task. I would like to see how people think they can provide a strong evidence base in what is already a very partisan debate and say, “This is how much you should transfer for your change in tax policy that affected the other side of the border”. Bear in mind that Scotland’s trade with the rest of the UK is equivalent to 80% of its GDP, so just about anything that the rest of the UK does will have an impact on Scotland. You will be doing this all the time. It is a great industry for economists.
The Chairman: Have any Government made the principle of no detriment work?
Professor Alan Trench: Can I just say something comparatively that may answer that question? The answer is no, but I am not aware that anyone has ever tried it either. As a student of these things, I am comparatively completely bemused by the way the UK has both picked up this principle and then elevated it to such remarkable standing. If one looks at significantly fiscally decentalised countries such as Canada, Switzerland or the United States, not only do they not have such a principle but they would positively laugh if anyone were to propose that they should. It is a very peculiar idea that comes out partly from the politics and partly from having a tradition of a relatively centralised Government responsible for resource allocation that is at least notionally meant to relate to need and therefore a desire to see that no one loses out as a result of fiscal devolution. However, we also get ourselves into a further difficulty in that we are trying to decentralise. Very few decentralised systems started by a process of decentralising. The club is a very small and select one: arguably Spain, Belgium, the UK and, if you want to throw it into the mix, Italy. I think Italy is a decentralised state. That is about it. Many of these other systems such as the United States, Canada, Germany, Australia and so on built their fiscal structures around constitutionally federal structures as well. The two grew up alongside each other. We are trying to move things out—to spin them out. I am sorry to say that it looks as if we are making almost as much of a mess of it as Spain has.
Lord Teverson: I just want to clarify something. Is one reason why none of this has been tried elsewhere perhaps because it is not so much of a problem, because Scotland’s economy is so much smaller that there is an imbalance? Anything that goes slightly wrong in England would have a magnified, multiplier effect in Scotland. Does that come into that anywhere, or is it a complete fallacy?
Professor Jim Gallagher: In most cases, a state inside a federal country will be small compared to the rest of the federal country.
Lord Teverson: But in somewhere like Spain there are a number of those places, so I would have thought there was more of a balance that worked. I may have got that completely wrong.
Professor Alan Trench: It is certainly the case that decisions made for England have a profound impact on Scotland in a way that decisions made in Scotland can seldom have a profound impact in England. I remember that problem once described as “being in bed with an elephant”. It is a long-standing problem that Scots are only too familiar with. In a sense, all these debates going back hundreds of years are an attempt to deal with that.
Dr Angus Armstrong: If you look at the big five federal OECD countries, the biggest state relative to GDP of the entire country is about 35%. Now, with the UK you are dealing with 85%. There is a fundamental difference. You are creating what looks to be a federal sub-national Government called Scotland in a completely centralist system. The UK cannot become federal until you do something with England. That is why every time England does something it has a multiplier effect: because of the asymmetric size. That asymmetry goes all the way through these problems.
Q6 Lord Turnbull: You described a case where the UK Government reduces basic rate tax or raises the threshold, and that reduces the income tax yield in Scotland, which you describe as a detriment. That is not a detriment at all. It may be a detriment to the Scottish Government but it is not detrimental to Scotland. The citizens of Scotland keep the money. Their personal disposable income is increased.
Professor Alan Trench: There are two potential detriments there. The first is in relation to the decision about how the UK Government deliver their reduction in income tax for taxpayers. Under the Smith proposals, the impact of an increase in personal allowance is different from a reduction in the standard of tax rate. If you increase the personal allowance, that will take money out of Scottish tax receipts, because Scotland gets all the tax receipts from personal income.
Lord Turnbull: The money is still in Scotland. It is available to the Scottish Government to recover it.
Professor Alan Trench: The solution to accomplish that would have to be that they reduce the rate of income tax for Scottish taxpayers. The problem is that there is an asymmetry between those two decisions. I do not think it necessarily a huge asymmetry, but there is one. There is a second aspect to no detriment where the An Enduring Settlement White Paper gets into a very great tangle to my mind. It says, “Let’s assume that the UK Government have not reduced their tax receipts but increased them”. It then applies those tax receipts to pay for services that trigger further Barnett consequentials as well. It says that Scotland, on that rationale, wins twice. No detriment is meant to come into effect to stop Scotland winning twice, once by way of extra tax receipts, then by increased block grant. I am not sure that that is so—I think they have over-read the problem and overanalysed what in reality would be quite a small amount of money. Even if that is so, there have to be better ways of solving that problem. Those involve making other, quite significant consequential changes to the machinery and structure of the block grant, both in terms of the laws that support it and the way it is applied.
Lord Turnbull: But is the way in which no detriment is being interpreted in Scotland that a cut in the basic rate of income tax—
Professor Jim Gallagher: A cut in the basic rate of income tax is irrelevant to this question. The only thing that would be relevant would be a change in the threshold at which income tax is paid.
Lord Turnbull: Okay. Well, that is probably the way in which it would happen. So let us assume that that takes place, the threshold is pushed up quite a lot and a lot of people advocate that. I cannot see why that creates detriment.
Professor Jim Gallagher: You have to look at the expenditure as well as the revenue side. Let us imagine that the Government decided to increase the basic rate threshold and take the money, for the sake of argument, out of the welfare budget. That would be a proportionate reduction in welfare expenditure in Scotland at the same time. That is what has happened over the last little while. So in answer to the question, “Is the welfare money still in Scotland?” the answer is that the loss to the welfare budget is equal to the gain from the tax budget, but the effect would be to cut the revenue of the devolved system as well. You have to look at the spend aspect.
Lord Turnbull: But the detriment is coming about not through the raising of the threshold but through the change in the proportion of devolved and non-devolved expenditure.
Lord Layard: Would there not be a case for making these calculations in relation to the previous year—the base year—rather than the one where the collected taxes have been affected by changes in the rates made after devolution?
Professor Jim Gallagher: I think not, because you would then be importing differential economic growth into that calculation, and that is a risk that needs to be borne by the Scottish Government.
Lord Layard: But in terms of this problem?
Professor Jim Gallagher: You might create a worse one. I will have to think about that.
Professor David Heald: There are two points that I would like to make. First, the distribution of income is different between England in aggregate and Scotland in aggregate. Scotland, Wales and Northern Ireland—if Wales and Northern Ireland had income tax powers as well—will be differentially affected by an increase in the threshold. Secondly, we are talking about a devolved Administration with significant expenditure powers but very limited tax powers. What happened with the abolition in Scotland of stamp duty land tax was that, quite remarkably, the Cabinet Secretary for Finance got 129 MSPs to vote for a change in the Scottish law—to the land and buildings transaction tax—on a revenue-neutral basis. The United Kingdom Government, having shown very little interest in changing the “slab” nature of stamp duty land tax, just happened to do it on a non-revenue neutral basis. Given that the UK Government have lots of other taxes that they could use to compensate for the loss of revenue, basically, in my view, that was actually targeting the tax base of the devolved Administrations. Equally, the UK Government could target the tax bases of the devolved Administrations by putting the threshold up.
Another issue that I am very concerned about is that the Scottish Government have to tell HMRC by 30 November what the Scottish income tax will be, but the UK Chancellor could change the tax in the March Budget. You can think of the political games that might be played. Let us say that in November 2015 the Cabinet Secretary for Finance tells HMRC—it does not have to be public, but it would obviously leak if he did so—that Scotland will keep the same rate structure in the first year of implementation of the Smith commission proposals. Then along comes the Chancellor in March, who gets rid of the additional rate, which puts huge pressure on the Scottish Government to do the same. You will have a very significant political problem, given the asymmetry in population size and a lack of respect within the United Kingdom between Governments regarding making the system work.
As I said at the beginning of my evidence session, it is not fully appreciated how much the union still remains at risk. The chances of seeing opportunistic behaviour will put the union at even bigger risk.
Q7 Lord Layard: What is the rationale for the choice of taxes to be devolved?
Dr Angus Armstrong: As you know, there is a whole literature on which taxes you should be devolving, and the usual place to start is with the ones with the less mobile factors of production. The example of the SDLT—the property tax—is quite a good one, because you cannot attract resources because they are stuck on the ground: they are properties. That was one that I thought involved healthy competition in the sense that it did not attract resources on the basis of the tax change. In my view, there was a political need to raise a certain amount of money in tax revenue to reduce the so-called fiscal imbalance: the difference between the amount of spending that is devolved and the amount of tax power that is devolved. Income tax, being the most buoyant and the largest-yielding tax that we have, became the easiest way to do it without changing corporation tax, which is really problematic. I do not think there was any rationale. In fact, it is quite bizarre that you devolve this tax, which is highly visible and really important to people—everybody pays income tax and is closely aware of it. It was bound to trigger a reaction in the rest of the UK, but Scotland probably cannot even use it. This is the irony of the whole thing. You have devolved basically all income tax—you can put the threshold at zero, and the definition is still UK-wide—and yet Scotland cannot go two or three percentage points away from the rest of the UK but you have given them the whole powers. I do not know whether it is good or bad. Part of me thinks that it is quite clever that, given this high-level, huge amount of tax, because you cannot use it—
Professor Jim Gallagher: I am not sure that I wholly agree with that. Income tax is the obvious tax to devolve. If you look worldwide, sub-national or sub-state entities have control over income tax in some places—even local governments have control over income tax—and they find over time that they do manage to have different rates. Switzerland has widely different rates of income tax, even in neighbouring cantons, and the market equalises to deal with that. Income tax produces a lot of revenue. It is highly visible and certainly makes the Government highly accountable, and it ties the fortunes of the Scottish economy and the budget of the Scottish Parliament more closely together than they have been in the past, so it is an obvious one to do.
Professor Alan Trench: I am responsible for designing this tax model, which we set out in a paper called Funding Devo More, published by the Institute for Public Policy Research in January 2013. It was based on a number of considerations, including best practice, as far as one could divine it, from federal and centralised systems around the world, and the practicalities of how the UK tax system work and the various constraints on it. That is why, for example, we proposed the idea, which Smith adopted, of assigning half of VAT receipts—10 points of VAT receipts—because under EU rules that cannot be devolved fully. There would be some very strong arguments for devolving sales taxes if one could do so, but it is not possible, so we used the closest equivalent we could find.
One of the problems that we have is that we are going down this path of trying to decentralise. This is not a good place to start from if you are trying to devise an effectively working, decentralised tax system. However, that is where we are, so we have tried to make the best of it. In that paper, we have set out the way you might do it and the arguments for doing so.
Dr Angus Armstrong: To clarify, I do not think there is any federal state that pays all its income tax to a sub-central state. They all pay some federal income tax.
Professor Alan Trench: But the UK has not done that either. The UK still has two income taxes. One we call income tax, and it is a properly designed income tax; the other is a not very well-designed income tax, and we call it employees’ national insurance contributions. Those, by the same argument, expressly remain, under this model, in UK government hands.
Lord Lamont of Lerwick: Do you think it was sensible to separate taxation and savings? Was that done purely for the sort of industrial strategy reason of financial services?
Professor Alan Trench: No, it was done for practical reasons.
Professor Jim Gallagher: It was done for practical reasons, essentially because the biggest number of taxpayers involved here are bank customers. It would require the banks to identify the tax that was held for all those customers, which would just be practicably impossible. This is a recommendation of the Calman commission going back the best part of seven years now.
Professor Alan Trench: That said, it has a significant disadvantage, because as far as one can tell about half the money paid out through savings and dividends income relates to small business. It therefore invites people who are owner-managers of small businesses to wash out their money, to take their money through dividends and be subject to UK tax rather than through income and be subject to Scottish tax, on the assumption that Scottish tax might be higher. They would equally be able to make the converse choice if the UK rate were higher. That is a design problem that one would want in the medium term to get around.
Q8 Baroness Blackstone: What do you expect the arguments would be if there were differential rates of tax between England and Scotland, or England and Wales? How will people react to that? What will they do and how will they behave?
Professor Jim Gallagher: It depends how big the gap is, does it not? They will grumble furiously where they are on the wrong side of whatever border it is. Some of them might move. The fear has always been that they would move in Wales because it is a much more porous border. The fear is that people who commute from London to Edinburgh, particularly those with large incomes, might relocate to the most favourable domicile. The evidence elsewhere is that you can sustain different tax rates—Switzerland is a good example of that—essentially because the market compensates. Income tax rates in Zug are very low and house prices in Zug are very high. People learn to live with this.
Professor Alan Trench: You might think of it as part of the Zurich commuter belt.
Baroness Blackstone: Is it not going to encourage tax avoidance?
Dr Angus Armstrong: Yes. That is the usual thing whenever you get differentials in two taxes with a mobile factor: you get tax avoidance. Your question alludes to how much that is. My concern would be with the higher rate taxpayers who are probably the most mobile and many of whom work on both sides of the border already. I imagine that it would be quite straightforward to arrange their affairs so that they can avoid taxes. Then we have changes in how your income is counted: whether it is between dividends and company earnings or in fact in some of your pension payments, and whether you can start taking those as income. I am quite sure it is very porous, particularly for the high earners who, of course, tend to be disproportionate payers of income tax.
Baroness Blackstone: Does this not damage the political system in that those who are not able to avoid tax will feel pretty fed up that there are others with more resources of one kind or another who are able to? Does that not destabilise the tax system?
Professor Jim Gallagher: Do you not think they feel that today?
Baroness Blackstone: This will just enhance that, will it not?
The Chairman: I am afraid we have a Division. You can give us some tax planning answers when we get back. The meeting is suspended and we will be back within 10 minutes, I think.
The Committee suspended for a Division in the House.
Q9 The Chairman: Are we quorate? I exercise the Chairman’s prerogative. We are quorate but we are running out of time so I will resume, notwithstanding the fact that not everybody is here. I think I was going to take a question and then pass it on.
We come to the institutional arrangements. A number of you have made comments about the fragility of the current or proposed arrangements. As far as I can see, that leaves the power entirely with the Treasury in London. What institutional arrangements do you think are required that could make this funding arrangement robust and fair?
Professor Alan Trench: Institutional arrangements will not in themselves make funding arrangements robust and fair. Institutional arrangements will make a system more workable and may help it to be seen as fair. I think it is in that spirit that one has to approach them. We have done quite a lot of work, particularly in the Bingham Centre’s recent report, A Constitutional Crossroads, on institutional design. I draw the Committee’s attention to that. Specifically, you need to do three things. First is the point that Professor Heald already made about data availability and transparency. We need much better information than we have about what tax revenue is raised by what sources across the UK, what is spent across the UK and how the block grant system works to change the amounts allocated through that. Secondly, we need an independent expert body to take on a variety of roles but in particular the calculation of the amount of block grant. That might well also be the appropriate body to be responsible for collating and publishing the data that must be disclosed, for example. Thirdly, we need an independent mechanism to deal with disagreements and disputes. At the moment under the memorandum of understanding we have a dispute resolution format of the Joint Ministerial Committee, which is chaired by a UK government Minister—just one who was not involved in the original decision being disagreed with. This means that not only is the adjudicator in any dispute part of one of the Governments involved but that the default option in the event that that adjudicator is not able to reach some sort of settlement will be one that favours the UK Government as well. This system is so structurally skewed that it is very hard to have much confidence in it. It is notable that after one trial ran out of the consequentials for the 2012 London Olympics it has not been invoked by any devolved Government. There is simply no point in a devolved Government using it, because they know it will not do them any good.
Professor Jim Gallagher: I do not wholly agree with that because it neglects the reality of the asymmetry between the UK Government and the devolved Administrations. It is not plausible to have a referee, teacher or important person over the top who can tell a Government what to do, because that person would have no democratic mandate. In the end, Governments have mandates. Most of the decisions are made by the Treasury, which people grumble about. The devolved Administrations—I speak as someone who worked for them—sometimes have a bit of a victim or grievance mentality. Sometimes I think they just need to grow up a bit and get on with it. In fact, by and large the Treasury has made decisions that seem entirely defensible. The place that they can defend them is in public and in politics. The way to make that effective—this is where I agree with Alan and David—is to publish more of the underlying data.
The Chairman: So you do not feel that there is need for another body to, as it were, act as referee?
Professor Jim Gallagher: I do not mind another body producing the information. Data collection and publication would be a good thing. It may that the OBR rather than a fresh body could do it. I do not see why, for example, all the details of the Barnett calculation could not be published immediately or why the relative levels of expenditure across the devolved and non-devolved services in England and the UK could not be published. Transparency would be the best medicine, not the creation of a new adjudicator.
Dr Angus Armstrong: The only thing that is missing here is this no detriment principle. So far, I agree that it could be reasonably formulaic if people published the data and you had a reasonably clear and formulaic way of approaching this. However, the no-detriment bit will be art not science.
Lord Lamont of Lerwick: On the link between devolution of tax powers and economic growth, I cannot believe that anyone believes per se that it stimulates growth. Specific changes that somebody might favour might stimulate growth, but devolution per se surely has no connection with growth.
Professor Jim Gallagher: Agreed.
Professor Alan Trench: Agreed. There is comprehensive evidence to this effect internationally.
Professor David Heald: There is some literature about corporation tax. Ronald MacDonald at Glasgow gave evidence to committees on the basis of the use of corporation tax for stimulating growth, but on that point one thing that has not been mentioned this afternoon is the devolution of corporation tax in Northern Ireland. Leaving aside future changes to UK corporation tax, Northern Ireland is talking about having a devolved corporation tax of 12.5%. The Act enables it to have a zero rate of corporation tax. I am waiting for somebody to explain to me why that would not be counted as state aid. The other point is that if and when that is implemented, that will create political problems between the United Kingdom and Scotland.
Dr Angus Armstrong: On tax and growth, you can get an indirect effect. Let us suppose you had tax competition where the factories could not move so that it did not lead to inefficiencies. That sort of competition can lead to better tax policy. We are a long way from an optimal tax policy, certainly in this country. With the example earlier of the stamp duty changes, I think the Treasury was trying to go to a smooth system rather than a slab system for all the time I was there. Only after Scotland did it, and you got a bit of competition, did the rest of the UK do it. If that leads to a margin of improvement in mobility of labour because it makes it a little more sensible, you could just about eke out some sort of notion that it might lead to higher output. Strictly speaking, it is not quite productivity. The growth effect is a level effect. I think you could argue that there are some slight indirect effects, but this is scraping a bit.
Lord Lamont of Lerwick: Yes, and competition gets other people to change their behaviour in turn, as well.
Professor Jim Gallagher: The point is not who makes the tax decision but what tax decision is made.
Lord Lamont of Lerwick: Yes, exactly.
Q10 Lord Sharkey: If the proposals in the Scotland Bill go ahead, how will the Scottish Government compare in terms of fiscal autonomy to devolved sub-central Governments in other countries? Does that matter?
Professor David Heald: There is a very important point here. I gave evidence at the end of last year with Professor John Kay to the Scottish Parliament Finance Committee. One of the points he made was that when you want more powers, you should decide what you will use them for. I think we have got into an environment where people are asking for more powers without any idea of what they will use them for. That is a fundamental difficulty. What worries me is that people are talking about Scotland having more control of taxes than other devolved Administrations, but it depends on whether you have policy discretion. If you are in a situation where technically or politically you cannot actually use that tax discretion, you will find that we get the same outcomes as we did with the tartan tax. It will then turn out that HMRC does not have the machinery to operate it. Baroness Blackstone raised the question of the avoidance industry just before the break. There is a real responsibility on HMRC to make the system work. If the system does not successfully identify Scottish taxpayers, and if obvious arbitrage between corporation tax and capital gains tax is allowed, that will discredit the system. So the first few years will be fundamentally important. The UK has such a centralist mentality that any discussion about taxes being different produces complete horror. Yet other countries have differential tax and the United Kingdom used to have differential domestic rates between areas. That is a whole different argument: one of the other things that has happened in the UK has been the loss of local accountability because of the loss of local discretion about property tax. Property taxes are ideal for holding local authorities accountable but the accountability mechanism has been destroyed by central control. Clearly, the way back will be very difficult.
Professor Jim Gallagher: There is a political point here. Arithmetically, we will see that the Scottish Parliament has very wide spending discretion already and will now have a very wide taxing discretion by international standards. What people often fail to understand is that the spending discretion has been around since 1999 and people in Scotland did not realise the enormity of the devolution that happened. Now it is a political story to explain to people in Scotland that they have an unusually decentralised system by international standards.
Dr Angus Armstrong: It is not particularly constructive to compare other countries. People often point to one or two small places, saying that they have an even greater degree of autonomy. That is true. You could argue that with the Basque Country, for example. However, most of these places are net contributors to central government finances. They are in a wholly different place. If you were to ask, “How will you divide up this existing debt?”, bear in mind that these places—whether it is in Spain with Catalonia and the Basque Country, or parts of Italy or Flanders—on the whole have been net contributors over the past 20 or 30 years. They would not have to take part of the debt, but Scotland would be in a very different position. That is the first point.
The second point is that in many of these countries, where you look at one state, it will be one of many states there. This is where the asymmetry comes back in again. When you are one of many, it is very hard for the others to agree to bail you out. When you are 85%, you can always bail out the smaller country, and that will always invite moral hazard. The structure of the UK matters very much to these discussions.
Q11 Lord Teverson: Perhaps one of the phrases used about Scotland is “full fiscal autonomy”, although it seemed to go in and rapidly out of fashion on occasions. I wonder, first, how practical that is within a unitary nation state. Secondly, is that feasible for Scotland in terms of running a budget and being able to have a sustainable fiscal situation within the country? Can that ever be achieved?
Professor David Heald: I have never understood the supposed attractions of full fiscal autonomy. I understand the intellectual argument for Scottish independence, although I disagree with it. I cannot think of any reason why you should assume that one part of a state will be fiscally balanced. That certainly does not happen in federal countries. The United States has very little intergovernmental grant but an enormous dependence on social security, Medicare and the defence budget. By definition, because of the way the pattern of economic activity and demography works across the territory, there will be implicit or explicit fiscal transfers. On the idea that one bit should balance and that that should hold, if you do that you take on enormous fiscal risks: upward risks if oil prices go up and negative risks if they go down. Scotland is obviously vulnerable in having a big financial sector and very significant dependency upon oil. So I have never understood the argument. There is a possible reason why this argument appeals: because people see it as a way to independence. I can understand the argument; I can see that if I was a Scottish National Member of the other House or of the Scottish Parliament, getting to full fiscal autonomy and showing that it does not work might be a good way to break up the union. Otherwise, I have never understood this position. To give a slightly trivial example, my own parliamentary constituency of Aberdeen South is one of the richest constituencies in the United Kingdom, let alone Scotland. Nobody argues that Aberdeen South or, even more so, AB15, where I live, should balance its budget. The fact is that there are enormous fiscal transfers between different geographical locations. I have never understood the argument that, except as a staging post, we want the powers because we want the powers or because we see that leading to a totally different constitutional settlement.
Lord Teverson: So it is totally a political milestone, in your view.
Professor Jim Gallagher: Yes, absolutely. It is like independence, only worse. The arithmetic in the short run, by which one means the next five or 10 years, would be fiscally catastrophic for Scotland. Its deficit would be structurally somewhere between £7 billion and £9 billion a year larger than the UK’s deficit. It is on all measures a completely crazy idea.
Professor Alan Trench: I think this is always the wrong question to talk about for fiscal autonomy, on the basis that it is a meaningful option that is compatible with the union. I find it very hard to understand how one can call for full fiscal autonomy, which is effectively a Scottish withdrawal from all the systems of taxation, interregional and interpersonal transfers, and of the welfare state that the UK as a whole has, but still claim to remain part of the United Kingdom. It follows that once Scots have decided, as they did last September, that they want to be in the United Kingdom, this is no longer a discussion that can really be had. If it can be had, it is not a discussion for Scotland alone. The discussion necessarily must engage the whole of the United Kingdom because its effects are so profound.
Professor David Heald: One of the things connected to full fiscal autonomy is the argument that Scotland sets all its taxes, gets all its tax revenues and then pays a contribution, very much like the imperial contribution of the Government of Ireland Act. Now, that disintegrated very quickly in the case of Northern Ireland. What it would do here is shift the argument from questions of devolved policy to, “Does Scotland want to pay for Trident?”, and, “Does Scotland want to pay for wars in Syria or Iraq?” Basically, the idea that you get full fiscal autonomy and then you pay would actually shift the nature of the constitutional conflicts from one set of issues to another.
Dr Angus Armstrong: There are other places that have a higher degree of autonomy, so is it possible? The answer is yes. Would it work here? That is a different answer. First, there are a number of risks that are completely forgotten about, very conveniently, in the debate. Deposit insurance: who pays for that? Financial-sector risk: I presume we want the UK Government to be paying for that. Catastrophe risk: who is going to pay for that? Collecting these payments after the event, which is kind of the argument—“Well, if it happens, we will pay you back”—means asking a country in a very difficult situation for a lot of money: “By the way, you owe us this many billion”. That is why you pay your insurance beforehand. You do not go around afterwards and say, “Do you mind coughing up now?” There are many parts to what makes the United Kingdom totally left out of the debate, remarkably.
Lord Teverson: Should we be reinventing the eurozone, monetary union, without fiscal union?
Dr Angus Armstrong: You do not have fiscal union, but it is even worse, because at least in the eurozone they have managed to work out that you need to have a banking union if you are to share some of the financial-sector risks. Here, we have not had the discussion, but I presume that the rest of the UK might feel a little aggrieved if it is paying deposit insurance for everybody else but they are not contributing to it. On that basis, Scotland would presumably issue debt, which it will have to do anyway in my view. If Scotland is issuing debt, got itself into trouble in 30 years’ time and then turned round to the UK and said, “We would like you to bail us out”, the UK could only credibly say no if there was no ongoing exposure of the rest of the UK to Scotland. That is called the existing debt stock. If Scotland paid off its fair share, whatever that might be, of the existing debt stock, then yes, it would be like the Basque Country and these net contributors, but it is not, and as long as we have this joint exposure of 80% of our GDP, of which Scotland is responsible for a share, then just receiving a cheque in the post to pay for the interest certainly is not reasonable and fair to the rest of the UK. So it is only net contributors that can do this.
Lord Teverson: May I pursue one thing? Professor Heald mentioned the Northern Ireland corporation tax, which I wanted to raise as well. I do not know whether Professor Trench, being from Ulster or based there, has an opinion on this, but that changes the state of play and affects legal bodies that are movable. They are not individuals, but they are corporations. Has there been a reaction to that change in terms of mobility? Is something being seen to be happening there? Is that an example that we can take?
Professor David Heald: That remains in the future. There was a degree of political planning in the timing of the passing of the corporation tax Act for Northern Ireland. There was a celebration in west Belfast, led by the First Minister of Northern Ireland, who comes from east Belfast. Clearly there is a belief in Northern Ireland that they will get a huge benefit from corporation tax devolution. The fact that UK corporation tax has been systematically coming down means that the actual potential benefit is less than it might have been in the past. There are two catches. One is at what point you will end up with a state aid issue. The second point—and this is something that might actually stop or delay implementation for quite a long time—is that the Treasury has calculated that every percentage point that brings Northern Ireland corporation tax below UK corporation tax leads to a reduction in Northern Ireland’s block grant. They are presently talking about 7.5 percentage points, and 7.5 percentage points at £40 million per percentage point leads to a deduction from the Northern Ireland block grant of £300 million. What is concerning Northern Ireland Assembly Members now is that they take the hit for £300 million and get this lower corporation tax rate, but if this miraculous cure turns out to be a miraculous cure, the higher tax revenue will go to the UK Treasury. It will not come back. If it turns out to be a miraculous cure, it will come back in the form of higher VAT revenues and higher income-tax revenues. That is basically one of the stumbling blocks that might delay implementation.
The Chairman: Are you saying that all this autonomy is a political slogan rather than a viable financial arrangement?
Professor David Heald: If you gave me a choice to vote between full fiscal autonomy and Scottish independence, I would vote for Scottish independence every day.
Q12 Lord Turnbull: Again on the question of borrowing, leaving aside cash balances, so to speak—you can set limits to that; that is not a difficult technical problem—in the arrangement that we have at the moment, how far can you take the principle of separate borrowing and separate credit rating, and how do you deal with the difference between the old stock and the new stock?
Dr Angus Armstrong: This is the most important question in the whole debate. We spent too much time on the Barnett formula, quite honestly. This is it, because Scotland will have to have borrowing powers. If you are the equivalent of a powerful federal state without borrowing powers, you will be the only one in the world. You would have to have a balanced budget all the time. That is very unlikely to be acceptable. I do not think it is what the people in Scotland think they are going in for. Something that is going to be tough for them is Osborne’s rules. It will come; there are enough references in the Smith commission to it coming. The question is whether you then insist on putting restrictions on it. Can the rest of the UK allow Scotland to issue debt and find mechanisms for market discipline where this thing gets priced as Scottish debt? Then you have responsibility, because now the Scottish Government will be able to say, “But this is costing us a lot. Ah, so you have to pay for your spending now. You cannot just have lower tax and higher spending; you now have some responsibility. I can work out the price for this responsibility, and you can fail”. You have changed the debate.
Lord Turnbull: It is rather good that there is a credit rating and a risk for that geography that relates to that credit rating. The question then is whether the threat of failure is credible. Scotland is not very big, but for the rest of the UK and for England is it too big for England to let fail, in which case the whole thing that it is supposed to become is pointless?
Dr Angus Armstrong: There is a contract that cannot be credibly committed to here. Even if the rest of the UK says, “We will write into our legislation that we will never bail out Scottish debt. We will not let it have the same rating in the UK banking system as UK debt, which currently it would have”, and takes every stop possible to say that this is separate, you can never guarantee that, come the crisis, the UK Government do not turn around and say, “You know what, we make the rules. Forget all about it. We’re changing it again”. You can never get round it, I agree.
Lord Turnbull: So there are two inconsistent things: one is that it is going to happen, and the second that it cannot be made to work.
Dr Angus Armstrong: On the question of whether it can be made to work, can you guarantee that you will never bail it out? The short answer is no, particularly when you can afford to bail it out, and Scotland can be bailed out because it is only 8.5% of the UK and you can afford to do it. The very fact that people know that you can afford to do it starts to play into that. That is where you get this behaviour.
Could you take enough steps to distance yourself to a reasonable degree to bring in some market discipline, so that at least people could say, “Actually, either we are paying the same borrowing costs because we are being very disciplined, or we are paying much higher borrowing costs and this is the equivalent of, say, two hospitals”? This starts costing Scottish taxpayers real money, and this is what then gets the discipline.
I would just point out that every decently sized federal state borrows in its own name. There have always been problems. Even a canton went to court successfully, and there are Länder in Germany where this becomes an issue. But overall there is enough evidence that market discipline can be a useful constraint on the decision-making
Lord Turnbull: The point is that the creditors can stop lending, but there is no equivalent to equity or bailable capital. How does anyone enforce this debt if Scotland does not pay?
Professor Jim Gallagher: The legislative way of doing that at the moment in relation to local government is to make the repayment of debt of the first charge on tax income. Local government has had that power since for ever, and that has been the constraint on it.
Lord Turnbull: Right, but does that become a nuclear option that is so powerful that the UK Government would not have the nerve to implement it?
Professor Jim Gallagher: It would be on Scottish tax income, and it would be in the hands of the creditors, not the UK Government.
Dr Angus Armstrong: The UK Government could still decide to come in and bail it out, but there are enough provisions that you can put around this to make it very clear that this is a bailout. That is not a position that I think the Scottish Government would like to be in in the future, but the key thing before that point is whether you can get to the point where the debt starts being priced properly to reflect risk and the behaviour, and therefore you build in this responsibility.
Lord Turnbull: To sum it all up, how far would you go down this path, and what essential safeguards would you need to put in?
Dr Angus Armstrong: I think it is inevitable that Scotland will start borrowing in its own name. On the safeguards that I would put in, I would like to put in legislation that the rest of the UK would in no circumstances bail us out.
Lord Lamont of Lerwick: Have we not been there before?
Lord Turnbull: Yes, it is called Ireland, and—
Lord Sharkey: It is actually called Panama. Is that not why the Scottish joined the United Kingdom in the first place?
Dr Angus Armstrong: At the moment there is no Scottish debt. The Scottish Government could behave very prudently and just issue a modest amount. We are presuming that this will all be a disaster and that they will behave in a certain way. Actually, perhaps the democratic process will force them to behave in a reasonable way. It is wrong to assume that as soon as they have this power they will blow the whole house. On the financial system, one of the mistakes in Europe is to say that all sovereign debt is zero-rated. We would not like to do that. We would treat it as other countries treat sub-central government debt, where they trade on the spread—and quite a significant spread. It is 2% higher for a lot of these large sub-central states, the Ontarios of the world, to borrow from us. That 2% makes a difference and becomes an issue when you go back to your constituents and say, “Yeah, we are building this and, by the way, paying 2% more than if we had been able to borrow from the UK like we used to”.
Professor Jim Gallagher: The place to start on this is with capital expenditure. There is already a proposition on the table that the Scottish Government should be able to borrow additionally to the capital expenditure they get from the Barnett formula. In my view, the next sensible step, which should have been the previous sensible step, would be to say that all Scottish Government capital expenditure is borrowed for rather than paid out of Barnett revenue. Some of it may be borrowed from the UK and some of it from the market. There is already a need for cashflow borrowing because the flow of tax revenues is not the same pattern as the flow of expenditure. The difficult one, and Angus may disagree on this because I do not know what I think on it, is the extent to which the Scottish Government should be able to borrow for macro-economic management purposes. Should they be able to say, “We are not really in favour of this austerity? We would like to borrow and spend some more, if you do not mind?” I am slightly hesitant about that. I know that the Treasury would have kittens at the very suggestion. Yet those are the three areas to which one might move. I would start with capital and move cautiously.
Professor David Heald: I will add a different point. While the United Kingdom remains a member of the European Union, Scottish borrowing would count as part of UK borrowing.
Q13 Lord Forsyth of Drumlean: I apologise for arriving here at the last moment. I think I generally explained that I had to speak on EVEL in the Chamber, but I will read the transcript with great interest. One of the points I made in the debate this afternoon is that, according to the pollsters, if you ask people in Scotland about the Smith commission, they almost without exception have no understanding of what is proposed. You get a large number who do not know what has been proposed, yet you also get an equally large number saying that the proposals do not go far enough. Do you think that there is enough awareness of what is involved with devolution and what the issues are? Has there been enough transparency? How can we get this on to a level of debate that is informed rather than aspirational?
Professor David Heald: I have been arguing throughout this meeting in favour of greater transparency. It might lead to more debate. What has been happening in Scotland is not to do with the fine detail of these proposals. Something very significant happened during the referendum campaign. Certainly something very significant happened during the UK general election in Scotland. So there is a disconnect between talking about what the mechanics are in putting a system in place and the broader political context. I could have made reference a few minutes ago to the fact that what worries me is the climate in which Scotland wants more powers without any sense of in what circumstances and in what way one would use them. That is very dangerous. At the end of the day people think, for example, that if you get welfare devolution the cuts will be less harsh without telling where the money comes from. You could devise a system whereby you had less harsh welfare cuts but you must find the money from somewhere within the programme that funds health and education. That is not the kind of debate that has been happening.
Dr Angus Armstrong: I do not think it is possible to get anywhere near that level of sophistication. Understanding the taxes that have been devolved, how they will work and things like the Barnett formula are just not what the public are likely to digest. We have seen in survey evidence that across Scotland even people who want more powers devolved are in favour of more welfare and less tax. There is a complete disconnect with reality here because there is no discipline. There is no market discipline or reason to change that. The mindset seems to be to just keep that attitude and keep asking for more powers and more money. We need to get away from what I call “pocket-money devolution”, where the rest of the UK says, “Here is £100. You go and spend it as you like”. That is not responsibility. The only way you get that is when you have borrowing powers and people can see the price they pay now for your decisions.
Professor David Heald: The only way you get responsibility is with tax powers that you can use. We have to be very careful not to get tax powers that are unusable because of technical reasons to do with either HMRC capacity or the political dynamic between Westminster and Holyrood. That would lead to significant disillusionment. In the present climate in Scotland, that would be extremely dangerous.
The Chairman: Is it your view that the Scottish Government have a firm grasp of all these issues?
Professor Jim Gallagher: The Scottish Government have a political grasp of these issues, which is entirely driven by their constitutional objective. At a technical level, I would be surprised if they were yet in a position to make good-quality tax decisions, but they have to start somewhere. They have struggled a bit with the establishment of the tax collection office for the initial two devolved taxes, which are very simple taxes. They will find the making of income tax decisions challenging, particularly as they get a bundle of new responsibilities for tax and welfare, and will not have the political or administrative skill set already to deal with them. However, in the end, to go back to Lord Forsyth’s question, the answer—if there is one—is not power but responsibility. I agree with David that responsibility comes where the Scottish Government will have to make tax decisions. At some point they will make the wrong tax decision and people will notice. That is the kind of explanation that will get through to people.
The Chairman: Thank you very much. Our next session is with the Chancellor in September, who I think you claim is the only other member of the Barnett fan club. We will inquire on that matter. We will also have the opportunity to understand in detail the Treasury’s grasp of these matters. Thank you very much indeed.