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Speech to SOLACE Scotland conference

(Society of Local Authority Chief Executives – Scotland)

Delivered by Professor Graeme Roy, chair of the Scottish Fiscal Commission, on 15 September 2022

Introduction

Thank you Monica for the introduction. It’s a pleasure to speak with you this afternoon. I’ve been fortunate to interact with SOLACE colleagues in different forums over the years, including at your excellent SOLACE Scotland Spring Springboard events.

This is my first opportunity to speak with you as the new Chair of the Scottish Fiscal Commission. I wanted therefore, to take that opportunity to set out what I see as the different elements of the strategic picture that are shaping the outlook in which local budgets – and indeed budgets across the public sector – now sit. And provide, where possible, some thoughts on the outlook.

I’ve remarked to several people on how when I started studying economics, we were living through the period of ‘great moderation’. Throughout the late 1990s and early 2000s, there was a belief amongst many policymakers that we had abolished ‘boom and bust’.

Growth was strong, globalisation was opening up new markets, and living standards were improving year on year. Inflation was low and stable. Interest rates were at historic long-term lows. And, importantly for what we’ll talk about today, public spending was growing rapidly.

In the early years of devolution, spending grew more than five per cent in real terms per annum[i].

Indeed, such was the pace of growth the first couple of Scottish administrations were accruing underspends that accumulated to around £1.5 billion by the time the SNP minority administration took office in 2007. The ‘golden years’ of public policy had arrived. 

 Of course, all of that was turned on its head by the 2008/09 financial crisis.  And since 2008, we’ve had two referendums, real-terms cuts in key budgets, a global pandemic and – now – a war in Europe and cost-of-living crisis. So, we live in uncertain times.

And the immediate outlook for the next few months looks particularly challenging. The cost-of-living crisis will have significant implications not just for public sector budgets but, most importantly, for the people – including the most vulnerable in our society – who depend upon the services that local government provides.

Understandably, there is uncertainty too around the policy response. As we’ll discuss later, we’re due an Emergency Budget Review in the next couple of weeks with a response from the Scottish Government soon after. Following that the start of the Budget process for local government 2023/24 and beyond.

It’s therefore helpful to reflect upon the strategic context for our public finances at the current time. To do that, I’ll take a look at what I’d characterise as the different elements shaping both the supply of public funds but also the demand on those funds.  

Scottish Fiscal Commission and the Scottish Budget

To start however, it’s useful to remind ourselves how the Scottish Budget is determined. As you know, things are now considerably more complex since tax and social security powers have been devolved. The new fiscal arrangements mean that in addition to the UK Government Block Grant, funding comes from devolved tax revenues and, of course, local taxes[ii].

For the block grant and devolved taxes, both elements are not only themselves important, but it is their interaction that is critical too. The net Block Grant – largely determined by the Barnett Formula – still makes up the core base of funding for the Scottish Budget each year. The rest mainly comes from tax revenues.

Chief amongst these is income tax. Now, crucially what matters for the Scottish Budget isn’t just the performance of Scottish income tax revenues but their relative performance compared to the UK. This is because underpinning the Scottish Budget framework are a system of complex adjustments to the block grant to account for the revenue the UK Exchequer is now forgoing from devolving taxation.  

Depending on the tax policy decisions of the Scottish Government, and crucially the performance of our economy, Scottish devolved tax revenues may or may not fully offset the block grant reduction. In short, all else remaining equal if Scottish income tax revenues grow more quickly than in the rest of the UK – either through quicker growth in the tax base, tax policies, or both – the Scottish Budget will be better off than it would have been without tax devolution.

Of course, the opposite also holds true. Importantly, tax policies are set in advance for the year ahead, and can’t be changed within year. The Scottish Government can also fund spending through borrowing and drawing down from a savings mechanism called the Scotland Reserve. But there are constraints on how much flexibility they have with these tools.

They are primarily designed to support budget management rather than operate as large-scale mechanisms to shift resources from year-to-year or to bring forward large-scale discretionary spending plans over and above the block grant or tax revenues.

Resource borrowing for example, is permitted to smooth forecast errors with strict limits on how much and for what purposes it can be used for. At the same time, the Scotland Reserve annual drawdown is usually limited to £250 million for resource funding, and again, is largely for budget management.  Scotland’s Fiscal Framework very much envisages macroeconomic management of the economy – including via trends in public spending – as being ‘reserved’.

As a result, the Scottish Government is constrained by the requirement that it must broadly match its spending to available funding each year.  So, if events change through the year – for example, pressure for increased spending – it is largely limited to seeking two sources of support.

First, to await any additional spending allocations from the UK Government – as happened during the COVID-pandemic; or second, to reprioritise spending from one area of the Budget to another. Now it’s within this context that the Scottish Fiscal Commission plays its role.

We’re Scotland’s independent fiscal and economic forecaster. We produce forecasts for the Scottish economy, devolved tax revenues and social security benefits. We also assess the reasonableness of the government’s borrowing plans and provide commentary on the funding available to the Scottish Government. We operate independently from the government and are accountable to the Scottish Parliament. We produce two sets of forecasts each year. One which informs the Budget and the other the Government’s Medium Term Financial Strategy – which this year, also helped to feed into the Government’s four-year Resource Spending Review. And we have a key role to help explain – impartially and transparently – the Scottish Budget process and the pressures shaping its outcome.

Emerging Supply and Demand Pressures in the Scottish Budget

So, given that context, what do we know about the outlook for the Scottish Budget, and by implication, local government budgets? As I mentioned at the beginning, I think it is useful to think about the different pressures on the supply of public funds and the demand on those funds in the months ahead.  Each of them is having their own distinct and significant impact upon the outlook for the Scottish Budget.

Supply

Public finances

Starting with supply factors, the first key strategic element is the outlook for the block grant. Remember as I outlined earlier, this is still crucial – even with tax devolution – for determining the overall size of the Scottish Budget. 

When the UK Government set out their medium-term resource spending plans in the autumn of last year, plans were for the Block Grant settlement to grow this year but then to remain broadly flat over the rest of the Spending Review period[iii].  

These changes help mean a higher core Scottish resource budget than ever – outside of the emergency funding brought forward during the pandemic. But pressures across portfolios, some from increased demand others the result of policy choices, as well as inflation, have meant that for many in the public sector it certainly hasn’t felt like a time of plentiful resource.

How has that outlook on UK Government funding changed since that Spending Review? Firstly, around £400 million of additional funds have been allocated via the Barnet Formula for 2022-23 since the Scottish Budget was set[iv].

Secondly, and most importantly, there is the expectation that these spending envelopes are likely to change further in the months to come. As mentioned, the new Prime Minister has promised an Emergency Budget. Will we see additional funds or cuts designed to support tax cuts or new alternative spending priorities?

From the perspective of the Scottish Budget, what will matter will be where any additional support (or savings) are targeted. For example, additional spending in Westminster departments where the equivalent Scottish responsibility is devolved will result in increased funding through Barnett consequentials.

Of course, the Scottish Government isn’t forced to follow the UK Government’s lead. It can choose to spend any additional funds – or implement any savings if consequentials are negative – in the way it sees fit.

We know, already, of one major policy initiative: the Energy Price Guarantee. This won’t impact the Scottish Budget directly, but will see households across Scotland benefitting from the cap on price increases. In total, the proposal to see households pay an average £2,500 per annum. The cost of the policy is yet unknown although the Institute for Fiscal Studies suggest it may amount to “over £100 billion over the next year alone” – that’s more than the £70 billion furlough scheme …itself one of the largest spending interventions in peacetime[v].

How this is to be paid for over the medium term has also yet to be set out. But it is entirely possible that changing spending plans may form part of any approach.

Tax policy changes have also been trailed. To the extent that these are concentrated on taxes such as national insurance and corporation tax, they will impact directly on individuals and businesses in Scotland, but they will not impact on the Scottish Budget.

If the new Chancellor announces revised plans for income tax, such as bringing forward the last Chancellor’s – Rishi Sunak’s – planned cut in the basic rate to 19 pence, this will impact the Scottish Budget.

As I outlined above, what matters in the Scottish context is the interaction between devolved taxes and their corresponding block grant adjustments. If the UK Government was to announce a cut to income tax for next year this would reduce the Block Grant Adjustment, resulting – all else remaining equal – in increased funding to the Scottish Budget.

Of course, the Scottish Government would have to decide whether to follow-suit and cut tax – and therefore spending – or retain the revenue but with a wider tax differential between Scotland and the rest of the UK.

Economy

The second strategic element is the outlook for tax revenues and the economy more generally. Until recently, Scotland’s economy had been in a period of recovery since the pandemic. By the end of June, Scottish GDP was 0.4 per cent above its pre-pandemic level in February 2020[vi].

Unemployment has been close to its lowest figure on record[vii]. But the outlook has weakened in recent months. Back in May – when we were setting out our last formal assessment as part of the Scottish Government’s Resource Spending Review – we did highlight this risks from inflation, but since then, these pressures have increased beyond expectations.

The IMF has spoken of a ‘gloomy and more uncertain’ outlook, with global growth this year likely to be just half that it was last year[viii]. In May, we expected inflation to peak at 8.7 per cent in the fourth quarter of this year, before falling back below 3 per cent for 2023-24 onwards[ix].

But in August the Bank of England expected inflation to peak closer to 13 per cent[x].

The Energy Price Guarantee will help mitigate some of that pressure on headline inflation, but prices are still on track to increase at the fastest rate in a generation over the next few months. Crucially, the Bank of England’s latest report also now forecasts the UK economy to enter a recession in 2023.

There are two important implications of this outlook for the Scottish Budget. First, the performance of the economy has a clear read across to the UK tax base of which Scotland is a key part. All else equal, the quicker we grow our tax base, the more resources there are available for spending across the board, including for the block grant and local tax revenues.  

With tax devolution, what also matters for the Scottish Budget is how our devolved taxes perform relative to the equivalent taxes in the rest of the UK. So far, since tax devolution in 2016, the Scottish economy has tended to grow more slowly than the UK as a whole, with weaker growth in earnings and employment.

As a result, despite seeking to raise over £500 million in additional income tax revenues from its tax policies, because of the mechanics of the fiscal framework and that slower growth in Scotland, in 2020/21 we see that the Scottish Government is only ‘better-off’ to the tune of £96 million[xi].

In our latest forecasts, we took the view that this trend of relatively weaker growth – particularly in earnings and employment – is likely to continue in the near term.

The second implication of the current economic outlook is how the sharp – and unexpected – rise in inflation is eroding the spending power of public sector budgets. A government is no different from households or businesses in that if inflation is on the rise, the real-terms value of its budget declines.

When the UK Government set out its spending review in the autumn of 2021, inflation was around 4%. In July, it was closer to 10%[xii]. Energy costs for heating schools, community centres and libraries are all on the rise. The cost of materials for construction projects are on the up, and most importantly pressures for increased wage demands have risen.

Even if inflation returns to its target of 2% within the next couple of years or so, there will have been a ‘level-shift’ in the cost of delivering public services that won’t – unfortunately – disappear overnight.

Responding to that, not just over the next 12 months, but in the medium term is going to be a constant feature of budget planning across the public sector.  

Demand

Public finances

So that sets out the context for the likely ‘supply’ of funds over the next few years. What about the strategic elements that will shape the ‘demand’ for these funds? The first element to unpick are the demand pressures within spending priorities.

In May, the Scottish Government set out their Medium-Term Spending Plans in the Resource Spending Review. This was the first review in a decade. This included priorities for its new Social Security powers and Health and Social care.

The Government outlined plans for continued growth in health spending. A key reason for increased spending on health is the changing structure of our population. Between 1997 and 2022, the share of Scotland’s population aged 65 and over has been estimated to have increased from 16 per cent to 20 per cent. Such trends are expected to continue.

At the end of August, we published 50-year projections for Scotland’s population. Given trends in births, deaths and migration Scotland’s overall population is projected to fall by nearly 900,000, a drop of 16 per cent, between 2022 and 2072. This more than reverses the 400,000 increase over the last 20 years[xiii].

On top of a smaller population, the number of 16- to 64-year-olds will fall so there are likely to be fewer people working. Indeed, for every 10 people between 16 and 64 there are 3 older people now, but by 2072 this increases to 6 older people. So, pressures on demand for health and social care are only likely to increase just to maintain the same standard of service because the nature of demand.  

At the same time, as a result of the Scottish Government rolling out new payments to replace those previously delivered by DWP, we expect devolved social security spending to increase from just over £4 billion this year to nearly £7 billion by 2027-28. This means social security’s share of resource spending is rising from 10 per cent this year to around 14 per cent in 2026-27[xiv].

Crucially, spending is forecast to run ahead of the transfers that the UK Government is making to support the devolution of these powers, implying that the money will need to be found from tax increases or reprioritisation from other portfolios.

This, in part, reflects the Scottish Government allocating resources to target one of its key priorities, reducing child poverty. But this comes with an opportunity cost. Taken together, in May the IFS estimated that because of a relatively flat overall funding envelope, coupled with growth in health and social care and social security funding, the resources available for many other spending areas – including local government – could amount to 8 per cent below this year’s levels in real terms by 2026-27[xv].

Of course arguing for less of a cut (or more of an increase) in other areas, comes with an opportunity cost (or benefit) elsewhere in the Budget. Not only that, but, these calculations were based on inflation figures from March 2022 that were lower than they are now.

Given the outlook on inflation, without additional funding, the real terms pressures will likely be that much greater. Last week, we saw the first set of announcements from the Deputy First Minister as he responded to such pressures. With £500 million of funds re-diverted to ‘cost-of-living’ priorities.

The Scottish Government has announced plans to present a statement within two weeks of this month’s UK Emergency Budget. Whilst this will focus upon this financial year – 2022/23 – it is not unreasonable to expect announcements from both governments in the coming weeks to contain commitments that will spill-over into next year and perhaps beyond.

Public finances

The second and final strategic element to unpick are the demand pressures arising from the ‘cost-of-living crisis’ and the impact it is having, and will have, on households across the country. Back in May, we were already projecting real incomes to fall in 2022-23, with the income squeeze likely to disproportionately affect lower-income households.

Research for the David Hume Institute last month showed that eight out of ten Scots are already cutting back on spending and one in three are losing sleep worrying about their finances[xvi].

The Resolution Foundation have forecast that absolute poverty in the UK could rise sharply, with child poverty is on track to reach its highest rate since the 1990s[xvii].  

With people enduing such hardship, there will inevitably be greater demand for public services and financial support. This is likely to be a feature for all levels of government, including local government. The Scottish Welfare Fund has for example, seen the number of applications remain high relative to pre-pandemic levels.

There is also the continued well-documented pressure on social care services delivered by local authorities. It is understandable too with high inflation for there to be pressure on employers to increase pay. With around £22 billion per year spent on the total devolved public sector pay each year, decisions here will have significant implications for the prioritisation of delivery within portfolios right across the public sector[xviii].  

With higher costs generally, any higher than budgeted pay awards this year will need to be accommodated within existing spending plans.

Conclusion

The outlook for the economy and the budget is one of uncertainty.

The Scottish Government has to manage uncertainty with its finances and has limited set of tools to manage that uncertainty. Local government cannot insulate itself from that uncertainty. Unpicking the different components, both in terms of the supply of funds and the demand for funds can be a useful way of making sense of the competing priorities and pressures that you face.

I don’t envy your roles as leaders during this time, but I hope that knowing what the uncertainties are can help you to manage and plan for the future. In the Scottish Fiscal Commission our aim is to help set out transparently how the Scottish Government’s funding changes, and how the outlook for the economy and taxes is affecting that funding. I very much look forward to working with you. I wish you luck!

And with that I’ll hand back to Monica to chat through any questions.

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[xviii] Investing in Scotland’s Future: Resource Spending Review, Scottish Government