Wednesday, 25 February 2015

Yes or No: Makes no Difference

One of the unfortunate legacies of the Independence Referendum is that all subsequent attempts to constructively debate Scottish politics - and the economic choices we face - are rapidly hijacked by those who believe the only question that counts is: should we be independent: Yes or No?

That's unfortunate because one of the major positives of the Referendum should be that as well as being more politically engaged, many of us are also far more economically informed.

Why don't we capitalise on this improved understanding of our economic challenges and move the debate forward beyond simplistic Yes/No questions?

Why can't we make ourselves better voters by actually thinking about the difficult choices our elected representatives face without getting bogged down with worrying about whether they sit in Westminster or Holyrood?

Context

Hopefully we can frame the discussion with some uncontroversial statements that most rational observers agree with.

Firstly two observations that are as true for Scotland as they are for the whole UK
  • The level of deficit we currently run is unsustainable
  • There are social inequalities that need to be addressed

Secondly some observations taken directly from GERS (detailed analysis here) about challenges Scotland would face if we were a fiscally autonomous region within the UK
  • Consistently higher levels of government expenditure in Scotland are offset by higher tax revenues only because of oil - at least from a deficit per capita  perspective we can't consider oil to be "only a bonus"
  • With oil revenues as they were in 2012-13, the deficit per capita was worse in Scotland than the the rest of the UK by £500/capita or about £2.7bn
  • The subsequently decline in oil prices means that by 2014-15 Scotland is likely to be facing a deficit gap to the rest of the UK of about £1,100/cap or nearer £6.0bn
  • It is quite possible that oil revenue will rebound
    • The worst case is that we are experiencing the beginning of a long-term decline in oil revenues 
    • The best case for Scotland is that we are currently just witnessing the impact oil price volatility has on our economy

Thirdly: there will be those who seize on any positive arguments made for the future of the Scottish economy with "well then we should have voted Yes" - so let's remind ourselves that as result of the No vote (whether you agree with it or not) there are additional questions which we don't need to concern ourselves with now
  • Currency
    • What currency would we have used and with what fiscal strings attached?  
    • Would we have needed our own currency and if so what would it have costed us to establish it?
       
  • Trade and employment
    • To what extent would our hugely important trading relationship with the rest of the UK have been damaged by independence and what would the implications for employment in Scotland have been?
    • Would our relationship with the EU have been jeopardised/weakened or actually saved/strengthened by independence?

Finally
let me suggest we park to the side some of the other arguments which might distract us from positively looking at the challenges we face
  • The Oil Fund
    • If we're only interested in looking forwards, arguing what we should have done in the 1980's is pointless
    • We'd need to be running a surplus to contribute to an oil fund; so let's focus on working out how we might actually achieve a surplus (whether independently, with Full Fiscal Autonomy or as an integral part of the UK)
  • Competence
    • "Westminster has fucked it all up; surely we can do a better job ourselves" is - I hope we can agree - at best an incomplete thesis
    • Surely a more positive approach is to focus on what we think competent leaders could or should actually do and use that to inform who we vote for (and/or - if you insist - what level of devolution we might choose to fight for)

The Significance of Oil

Whether your objective is to make a better economic case for independence (or maybe full fiscal autonomy) or simply to strengthen Scotland's contribution to the UK, our reliance on oil revenue has to be addressed.

It's obvious that we should maximise the value our economy generates from this natural resource so we need to strike a careful balance between the tax burden we place on North Sea operators and the relief we offer them when the global oil price slumps.  In this regard the UK and Scottish objectives are of course completely aligned - it should "simply" be about finding the right balance between taxing and supporting the industry.

It is equally obvious that the Scottish economy would be more robust if we were less reliant on this source of tax revenue.  For some this statement is considered heretical as if it in some way implies oil is not an asset; of course that's a nonsensical response to what is an economically rational observation. It would be naive in the extreme not to at least consider the possibility that the OBR oil revenue forecasts could be correct and may represent a long-term structural trend. The graph below shows actual figures in grey, 2012-13 (most recent GERS) in dark grey, OBR forecast in light grey and Scottish Government White Paper scenarios in red


In essence the challenge is simple: the only way we can reduce our reliance on oil is to generate more tax revenues from elsewhere or to spend less public money.  The alternative is to hope that oil "does it for us" which - to me at least - doesn't sound like a particularly robust economic strategy.


Revenue Side

Let me reintroduce my 2012-13 GERS revenue & cost flow chart (detailed workings here > Scotland's Economy); hopefully this can help us at least get our heads around the main dynamics we have to consider, the economic levers we have to play with.  Revenues generated in Scotland  are shown in Green, Scottish public expenditure made in red.




The net effect is that in 2012-13 we generated a £12.1bn deficit (i.e. £12.1bn more was spent* in Scotland than generated* in Scotland).  If you doubt this figure comes directly from Scottish Government GERS or if you have concerns about the nature of the GERS methodology I refer you to the footnotes at the bottom of this post.

* I'm aware that some of these costs and some of these taxes are allocated or estimated - we will come to that when we consider how they might be varied

We know things will have got >£3bn worse since these figures were produced due to the oil price crash - so in 2014-15 we are likely looking at a deficit of  >£15bn (or >£2,800 per capita).

In the spirit of this post I would argue that whether you believe we should be independent or not you should have a view as to how that deficit can be eliminated (or at least materially reduced).  Let's not distract ourselves at this stage with who holds the levers - let's think about what (from a Scottish perspective) we might want done with them.

So how can we raise more tax revenue or where should we reduce expenditure to find the £15bn pa. or so we need for Scotland (either independently or contributing as part of the UK) to be running a surplus (i.e. for us to be able to start reducing our debt burden)?  We need to grow the green bubbles and/or shrink the red ones - let's consider how.

The intention of the rest of this blog is to stimulate thought and debate, to share some thinking out loud; it is not intended to be in any way "the answer" but rather to help us understand the orders of magnitude we are dealing with here


Employment Tax Revenues

By far and away the biggest source of government revenues are employment taxes at £19.4bn: this in turn is obviously a function of how many people are employed, how much they are paid and the tax regime in place.

  • The electorate is highly attuned to tax rates: they affect us directly and we can easily work out whether a tax rate or threshold change would impact us personally.  Years of campaigning and polling have taught political parties to be wary of explicitly suggesting personal tax increases. It's worth noting the ICAS Report which observed that for Scotland "even if there are no behavioural changes [...] another 10% on the top rate of tax might raise maybe £240m". The implication is clear: to have a material impact on the deficit though income taxation requires addressing tax rates of those on middle incomes.  As a scaling factor here: if we all paid 5% more tax (and NI) this would generate about £1bn.
  • It's kind of obvious that reducing unemployment not only reduces the welfare burden on the state but also increases the tax revenues generated through employment taxes.  Without getting bogged down in definitions of employment and unemployment (e.g impacts of part-time work and those not actively seeking work) we can observe the headline unemployment rate in Scotland is 5.7% (very similar to rUK).  A halving of the unemployment rate would therefore add roughly 2.35% to the current employment rate of 73.2% = 2.35/73.2 = a 3.2% increase in working population.  If we take the highly (ludicrously?) optimistic assumption that these jobs would be at average wage levels this would increase employment tax generation by £0.6bn (3.2% of £19.4bn).  Of course this should remove some people from welfare which we need to consider when we look at the cost side of the equation.
  • If companies simply pay people more this of course directly generates more employment tax revenues (with a smaller negative off-set of corporation tax assuming all cost increase aren't passed on through price inflation).  These increases are of course at higher marginal tax rates. You can see why Osborne & Cameron are so keen to suggest companies give pay rises - from a government perspective it generates money for no political pain
  • Of course the National Minimum Wage is the only way the government can currently force companies to pay (some) people more.  In Scotland there are 100k people on the NMW (4.3% of the workforce) which allows us to work out a very simple scaling figure here: increasing the NMW from £6.50 to £7.00 for a full-time employee increases their annual income by about £1,000 and their employment tax contribution (tax at 20%,employees NI at 12%, employers NI at 13.8% = 45.8%) by  about £460.  So for these 100k people in Scotland this translates into only £46m (a 0.2% overall impact on employment tax revenues).  This is of course the minimum number of people who would be affected by an increase in the NMW as people just above the NMW are likely to swept up by any increase and there is the domino effect through businesses as other pay levels need to increase to maintain a sensible salary architecture.  That said I find it hard to imagine how even a 10% increase in the NMW could have a ripple effect of more than 1% on overall wages - so we can probably safely scale this as at best <£0.2bn impact on Scottish employment tax revenues.  This is a topic worthy of a blog post all on it's own (I'll get to it) because there are complex dynamics at play: e.g. reduction of welfare burden where households of those currently on minimum wage receive benefits; possible impacts on employment rates, pricing of goods, regional and global competitiveness etc.  If you're keen to know more now right now I suggest having a scan of the latest Report of the Low Wage Commission

So what do we conclude on Employment Taxes?   As context: over the last 5 years the nominal increase in Scottish employment tax revenues has been 4.6% - over that same period the Consumer Price Index increased by over 14%. I'd suggest that you'd have to be pretty optimistic about employment rates and wage inflation (even fuelled by a NMW increase) to generate more than £0.5bn of extra revenue (in real terms) before you have to simply start taxing middle earners more.  Of course economic growth (such that tax revenues increase faster than public spending) is the other way out of this trap - hold that thought.

Consumption Tax Revenues: VAT & Duties

If you look at the size of the consumption taxes (VAT £9.3bn and Duties at £5.9bn) it's obvious why these are to "go to" place for politicians seeking a quick fix.  Assuming (simplistically of course) that consumption patterns wouldn't change a drop of VAT from 20% to 15% would lose us £2.3bn or of course an increase of the basic VAT rate to 25% would gain us £2.3bn. Of course as with any tax increase the fear is that it leads to a reduction in consumption and potentially slows or stalls economic growth.  You can't get something for nothing.  Similar arguments of course apply to duties with Fuel, Tobacco and Alcohol being the biggies.

Other Taxes

If you look at the chart you can see that after Oil & Gas, Employment, VAT and Duties we're down into smaller numbers so it becomes even harder to have a material impact on the deficit by tweaking these.  Let's take them in turn

  • Business Taxes of £5.1bn are made up of corporation tax £2.9bn and Non-Domestic rates of £2.0bn.  It's worth noting that corporation tax is one of the most uncertain GERS figures because nobody knows how much profit companies would report in Scotland as opposed to rUK - in fact HMRC estimate this number as nearer £2.5bn in 12-13.  There has been much talk about tax avoidance (about which more below) but I haven't heard many arguing for a higher corporation tax burden.  It's worth highlighting that retained (post tax) corporation tax profits are what pay dividends; dividends (in the long run) drive share prices; dividends and share appreciation is how investors make returns; pension funds are the largest investors ... so controlling corporation tax is not just about incentivising business investment, employment and economic growth it's also about protecting the value of pensions.
  • Tax Avoidance is a hot topic right now but to scale the issue it's worth noting the Scottish Government Independence White Paper "targeted" a revenue gain of £250m through (unspecified) reductions in tax avoidance - so for the sake of this exercise let's give ourselves £0.2bn through reduced tax avoidance
  • Gross Operating Surplus (GOS) is largely the state owned Scottish Water
  • Council Tax of £2.0bn has of course been frozen in Scotland; a 10% increase would bring in £0.2bn
  • Wealth Taxes of £1.4bn are mainly taxes on interest & dividends (£0.6bn), the balance being capital gains, inheritance tax and other.  Clearly as interest rates increase and if corporate profits (hence dividend payments) grow we will see some up-tick in this figure but in terms of policy changes even (as an illustration) a doubling in inheritance tax take would only give you £0.2bn


Economic Growth

So before factoring in real economic growth, on the revenue side (the green bubbles) you really struggle to anything close to £1bn of improvement without some fairly radical employment or consumption tax (e.g. VAT) increases

Which is of course why economic growth is the key - so let's scale this.

Non-Oil revenues for Scotland were £47.5bn in 2012-13 so to close our £15bn (post oil crash) deficit we need 15/47.5 = 31% real revenue growth (that is growth in tax income above growth in public expenditure).

If we look at historic UK real annual GDP growth rates (using e.g World Bank data) we can see that the best average annual rate we've achieved over a 5 period in the last 20 years was 1.9% pa in the period 1990-1995.  14 years of that would get us there.

This is of course why amid all the talk of austerity there is a clear understanding from all parties that economic growth is the golden key here - austerity that damages long-run growth is counter-productive .


Cost Side

Of course all of the above has looked only at the revenue side.  What choices do we face on the cost side (the red bubbles)?  Our total expenditure was £65.2bn in 2012-13 so to get our £15bn through cost-cutting we need to reduce all expenditure by 23%.  Tricky.

It's a big topic so forgive me if I skate through the main issues rather quickly;

Defence

Scotland's defence "bill" in 2012-13 was £3.0bn.  The NATO member state target spend level on defence is 2% of GDP.  In Scotland's case in 2012-13 that would imply a spend of £2.9bn.

Some of the numbers that are loosely thrown around as savings from dumping Trident are extremely misleading (e.g. lifetime investment costs as opposed to Scotland's share of the annual cost).  There's an interesting debate to be had about spending on Trident or alternatives (as the Centre Forum cover here) - but people who think scrapping Trident is an economic fix are - assuming we are serious about remaining in NATO - wide of the mark.

Having said that it appears many NATO members spend nearer 1% of GDP (including Germany - see here) so I guess you could realistically argue for halving our defence expenditure and saving £1.5bn. That would clearly be a pretty controversial position to adopt - it's perhaps more realistic to note the Scottish Government Independence White Paper suggested a defence spend of £2.5bn or a £0.5bn saving


Health

Let me declare an interest: the NHS saved my life when I had cancer and my wife works for the NHS. Perhaps its not surprising then that for me - as for so many - our health service is somewhat of a sacred cow when it comes to cost-cutting conversations.

Of course in Scotland we have free prescriptions for all and we are a relatively unhealthy lot (we generate £95 more tobacco and alcohol duty per capita than the rest of the UK) - this may in part explain why we spend £190/capita more on health than the rest of the UK.  If we closed that health spend gap with the rest of the UK it would save us 10% of our health budget or £1bn. Good luck to the political party who propose that.

Welfare & Unemployment

At £22.5bn this is clearly the dominant contributor to public spend.

From inspecting the UK accounts (p.71 here) more than half of this figure comes from old age (pensions) sickness & disability expenditure.  Unemployment benefits are only about 2.5% of this figure - the other main areas are housing, social services, benefits and income support

Unemployment is clearly a factor here but not the main driver. The chart below (from Prof Brian Ashcroft's Economy Watch) shows that unemployment rates are not high by historical standards and are falling (with Scotland very closely mirroring the UK as a whole).




The issue of in-work-poverty would appear to be a bigger concern - the Joseph Rowntree Foundation estimate that 21% of UK households live in poverty   There are clearly a significant number of people in low paid employment whose households are recipients of benefits. This is a huge and complex topic I won't attempt to cover here - but suffice to say the topic of National Minimum Wage must be one of the factors to consider in this debate.

Others

Frankly when you look at the other cost areas and you consider how we might find £bn's of cost savings it gets pretty tricky.  I'm running out of steam for now so I'll leave it for you to look at the remaining red bubbles and think about it!

So What?

I guess the overall conclusion once you've ploughed through all of this is not surprising - we can find maybe a billion or two by tweaking our tax and spend policies but the deficit will not be closed without either eye-wateringly severe austerity measures (hammering the masses with taxes and or slashing health & welfare expenditure) or a return to sustained long-term real economic growth.

But whilst it's easy to say austerity measures that threaten growth are to be avoided, I'd suggest it's equally important to observe that simply loosening our belts in the hope that economic growth will naturally follow is not a good enough strategy.

So what are the specific actions we can take to stimulate sustainable economic growth? Feels to me like a subject for a future blog post.


******************

Footnotes

For those who sometimes doubt the figures I use are the same as GERS

  • The data tables I uses are all downloaded from the Scottish Government GERS website here
  • The GERS methodology statement can be found here
  • The GER report itself is here
  • The table below shows the deficit of £12.1bn in 2013-14 that my figures reconcile back to


A common complaint raised when discussing GERS figure comes from those who followed some of the less reliable commentators during the referendum debate. These commentators sowed doubt and confusion by failing to understand how the GERS figures are compiled.  Take this statement from Wings Over Scotland (sourced here)
Or this from Business for Scotland (sourced here)




If they bothered to read the GERS Method Statement they would know that VAT and Duty are (correctly) estimated based on consumption and that corporation tax is estimated based on location of economic activity (not head office)





9 comments:

Anonymous said...

I like your analysis which suggests that we're in the shit regardless of where we go from here and would also like to make some points.

Have you discussed your conclusions with any professional economists for them to verify your conclusions?

An Intersting fact that came out of the referendum was the differences between the numbers of scots in the rest of the UK and rUK citizens residing in scotland. the numbers were 700k and 400k respectively, indicating a population deficit of 300k Assuming that each earns median wage then this is about £7.5Bn missing from the Scottish economy annually. In my experience the average age of those outside Scotland is lower and more are of working age and generally in higher earning jobs while the converse is true of the rUK population in Scotland,ntheyd come to retire or downsize for example.

So add in another 200k targeted immigrants and Scotland's deficit would be much more manageable.

This actually points to a fundamental problem with the UK in that the lack of a balanced Regional policy means that it is difficult to determine whether UK growth at a national level is being distributed evenly across the population, or whether there are vast differences (as I expect there is in favour of London). my hunch is that Wales, Cumbria and Northern Ireland lose badly out if this.

Terry Summers said...

Kevin,
Once again a 'tour de force'. Simply and clearly stated to expose the economic climate we find ourselves in and the options we have to extricate ourselves from this predicament.
I look forward to more of the same.
Cheers
Terry

Kevin Hague said...

Anonymous:
a/ my conclusion is not that we are without hope but that we should be realistic about the challenge and avoid leaping to simplistic and un-thought-through conclusions
b/ I make no conclusions that need "verifying" - I make factual observations in an open and discursive manner
c/ you've lost me with your expat point - are you assuming forced repatriation of expat Scots?

Anonymous said...

Sorry for the confusion. my point on expats was that we're there enough opportunities in scotland then fewer would have left and more would return too. the other point I was trying to make was that the deficit could be reduced if there was an influx of young immigrants to Scotland as it would reduce our average age and increase the numbers paying into tax. However the economy needs to be creating many more jobs.

This in turn suggests that a regional policy is required in the UK to spread out the benefits of growth far more evenly through investment in infrastructure rather than starting from London & SE. Wales and many regions of England get a seriously bad deal.

Jason Hoffman said...

Has anyone done a similar analysis on the uk as a whole? If we take it that an independent scotland would have struggled to pay its way, how does the same analysis work for the Uk Economy.

Are we Better Together? Is the uk deficit unsustainable? Are we relying on London to disproportionately drive our economy in the way North Sea oil is considered for scotland?

I've read a lot of interpretations and analyses of Scotland's economy - some optimistic and some pessimistic, but none for the uk as a whole.

Wicked Eric said...

Good read Kevin, extremely easy to follow and well researched.

Two aspects of this that I would like to bring up are:

i) How the UK's current level of borrowing compares when taken in a historical context.
ii) What level of borrowing is considered too high?

Looking at the figures since '66, I count only 7 years during which Britain ran a budget surplus.

In addition to that, taken as a proportion of GDP we see that we ran a larger deficit from 92-94 than we do presently.

So is it even desirable for us to completely eliminate the deficit (or 'close' it, to use the same terminology that you do)? The data tells us that running a budget deficit has been a matter of course for around 4 decades now and that we have been through periods of comparably high borrowing before.

You state that the current deficit is too high (or unsustainable), but by what exact criteria is that true? From my reading on the subject, public borrowing levels are generally regarded as acceptable if they result in a stable debt to GDP ratio (which is the measure of a country's ability to service its debt).

Looking at this figure we see that public debt increased at a unsustainable rate post-financial-crisis, but as of this year debt to GDP appears to have stabilised around the 90% mark.

So if the data is telling us that we are in no danger of being unable to make future payments on out debt, why should deficit reduction be elevated to such a high priority? And why should we assume that eliminating the deficit entirely would be a necessary strategy?

Apologies for the slightly rambling nature of this comment, it's a bit of a brain dump while I try and get my head around the meaning of all this.

Edward Witney said...

Another great analysis. The level of fiscal incompetence in Scotland regarding Government figures is like that of the third world. The SNP have tried not to talk about economics because their assertions are not backed up by the data.

Anonymous said...

NO ONE IS OFFERING FFA. NO ONE WILL OFFER FFA.

Are you not bored telling people who think differently that they are stupid? Certainly most are bored hearing it and it will sway no one. Despite what you claim, your 'economics' are far more politically motivated than you admit.

Try some number crunching on Osborne or Ball's fantasy economics and then come back and say that we could not do better.

I will not be reading any more of this ideologically driven 'analysis'

Anonymous said...

Whatever you claim,you are most definitely not politically neutral. You have spent how many years now(?) trying to disprove the economic case for Independence and now FFA which is not even on the cards.

You have not put the unionist case under anything like the same scrutiny yet you claim to have the best of intentions. Your only interest is maintaining the status quo because it serves you and your ilk well. Stop the hypocrisy.