Why Our Kids Should Hate Us: Debt and Taxes

With a title as enticing as "The sustainability of Scottish public finances: a Generational Accounting approach" you could be forgiven for not having read the latest paper to emerge from the National Institute of Economic and Social Research (NIESR).

It's a rather dry academic text which necessarily spends a lot of time defining the analytical approach taken and assumptions used. The findings of course have to have caveats applied, but there are two unsurprising (and helpfully quantified) headline conclusions

1. "The current path for the [UK] public finances is unsustainable"

• By not paying enough tax (and/or by spending too much on public services) we are passing on an unfair financial burden to future generations
• To address this now through tax increases (such that future generations would face the same fiscal burden as ours) would require an increase of between 3 and 10% to our total tax burden¹.

2. "from a purely fiscal point of view, Scotland is better off without 'full fiscal autonomy'"

• If the SNP achieve their stated aim of Full Fiscal Autonomy (FFA) for Scotland, we would be materially worse off. This is of course before allowing for the positive (or negative) impact of the different economic policies that FFA would enable Scotland to pursue. 
• To address the additional burden that Scotland would face under FFA (over and above that which we face already as part of the UK) would require a further increase of between 19% and 21% to our total tax burden (all other things being equal)

What's quite helpful about this analysis is you don't need to fully accept the first conclusion (or indeed the underlying premise) to be able to appreciate the second. By comparing their baseline projections for the UK and an FFA Scotland, the relatively greater scale of Scotland's economic challenge is revealed.

So on the specific question of "what price FFA?", the NIESR's view can now be added to the list of voices saying "over £8bn pa"²

• In FFA for Dummies and FFA for Dummies: Methodology we saw that the 15 year average onshore (e.g. excluding North Sea revenues) deficit gap  between Scotland and the UK has consistently been in the range of £8bn to £9bn a year. Given the OBR are forecasting only £0.1 - 0.2bn pa of oil revenue, this "without oil" analysis is increasingly apposite. Let's take the £8bn (low end of the range) and state that figure in the same terms as above: we would require a 16% increase in our total tax burden to close that gap.
• In March 2015 the IFS forecast a 2015-16 deficit gap of £7.6bn. The OBR oil revenue forecast they were using at the time was for £0.6bn - so simply adjusting for the latest OBR forecast of £0.1bn gives us a restated IFS deficit gap of £8.1bn. So again: we would require a 16% increase in our total tax burden to close that gap.
• As we've already said, the NIESR analysis of FFA suggests we would require a 19% to 21% increase in our total tax burden to close the gap. In 2013 cash terms that's £9.5 to £10.7bn pa.

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The reason why the NIESR FFA gap is wider is conceptually quite straight forward. Their analysis includes the same starting deficit difference (Scotland's deficit is higher than the UK's) and uses the same OBR assumptions for future oil revenues, but in addition they factor in the net fiscal implications of Scotland's different population age profile over time. At its simplest: Scots are on average older³ and receive higher age-adjusted per capita spending on education and pensions while generating a lower level of per capita income tax revenue.

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So common sense observations of historical trends and realistic assumptions about future oil revenue showed that FFA would (all other things being equal) require a 16% increase in Scotland's overall tax burden¹. The NIESR have simply shown that if you add in Scotland's particular demographic challenges the scale of the fiscal gap will become even greater, equating to a c.20% increase in Scotland's overall tax burden.

It's important to highlight that none of these analyses factor in the possible impact of FFA on Scotland's relative performance versus the UK, the extent to which FFA may allow us to close the fiscal gap through superior economic growth. Of course it's quite possible that FFA could be damaging to Scotland's economic performance, but even if you believe FFA is some sort of magic wand that would deliver extraordinarily superior economic growth, these analyses show quite how extraordinarily superior that economic growth would need to be. 

The SNP's own White Paper showed that cumlative 3.8% superior growth over 30 years was an empirically observed "bonus of being independent" - at that rate it would take over 100 years to close the fiscal gap identified by all these analyses.

The alternative to more debt and/or more taxes is of course to reduce public expenditure. Here's where the absolute figures matter: we're now looking for £8 - 10bn a year of savings versus those costs allocated to us in the Scottish Government's own GERS figures. Without getting distracted here with the usual arguments (Trident, House of Lords, HS2, etc.), suffice to say that nobody has come close to suggesting savings that would add up to anything like £8bn a year; the notoriously optimistic White Paper itself suggested only £0.6bn of net savings.

You'll still come across deficit-gap deniers on social media of course - but the reality is that there is now an overwhelming consensus that Full Fiscal Autonomy would be economically ruinous for Scotland. In the words of SNP MP George Kerevan

For Scotland to accept fiscal autonomy without inbuilt UK-wide fiscal balancing would be tantamount to economic suicide.

Well quite.

If Scotland becomes fully fiscally autonomous future generations will have two things to thank us for: more debt and higher taxes.

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But let's look back at the first of these conclusions: from a UK perspective, to what extent are we failing future generations by not paying enough tax (or spending too much) today?

The first issue to consider is demographics: the ageing population. In our lifetimes we pay taxes to and receive expenditure from the State. At either end of our lives (when we're in education and in retirement) we are typically net beneficiaries and in the middle of our lives we are (hopefully) net contributors.

The longer we spend in our dotage the longer we spend being net beneficiaries (through pensions and healthcare). This is of course why retirement ages are being increased - to make us net tax revenue generative for longer and to have a commensurately shorter period during which we will be a burden on the state. Needless to say, being a burden on the state really means being a burden on the next generation.

This is where the Generational Accounting (GA) approach comes in. It aims to address the question of generational equity: what is the tax burden that we should incur now to avoid future generations having to incur an even greater tax burden?

Based on the above dynamic you would think perhaps that the very act of running a deficit would create generational imbalance - by living longer we're going to be a more expensive generation to support in our dotage than the last one was, so why don't we need to be saving for that now?

The answer of course is the countervailing influences of population growth, real productivity growth and other costs which may not grow as quickly (the benefits of national scale) . So let's get into some of the assumptions the NIESR have used.

• They assume 1.5% real productivity growth in perpetuity (which, as Prince would point out, is a mighty long time) and a 3.0% real government discount rate (which makes future costs smaller in net present value terms)
• They use ONS population projections (which must include highly uncertain net migration assumptions)
• They assume that unallocated expenditure (UE⁴) either remains static in real terms or (even under the worst case scenario) only grows in line with population.

To these arguably optimistic assumptions we have to add one important caveat about the GA approach: it explicitly assumes that all debt must be paid back (or to be more precise: as time tends to infinity debt must tend to zero). This feels pessimistic to me in that it implicitly assumes there isn't such a thing as a sustainable level of national debt.

Feel free to grapple with the equations in the paper yourselves. I don't claim to have fully understood the analysis and may well have missed something.  If  I've understood the dynamics of the equations properly then the starting deficit and debt positions are in fact the dominant variables⁵ (at least when it comes to defining the FFA gap).

But maybe we don't need to get buried too far into the detail. It seems intuitively obvious that if we don't do something about the scale of the UK's debt (by addressing the deficit) then future generations will be repaying our debt and shouldering some of the tax burden that we should surely be facing now.

The NIESR analysis certainly seems to suggest our approach to fiscal policy is akin to our approach to climate change: we are in danger of leaving a generational legacy to be ashamed of.

When our kids get round to working this out - when they realise we bequeathed them the certainty of more debt and higher taxes - they'll have every right to ask us: what the hell were we thinking?

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1. Note on use of "increase in total tax burden"

For simplicity the NIESR state all of their findings in terms of tax as a percentage of GDP. To make the figures easier to relate to, I state them as an increase in total tax burden. To illustrate: the current UK tax burden is 36% of GDP, so a required increase of 3.6% of GDP would be a 10% increase in total tax burden.

It's perhaps worth noting that if we were to translate these figures into "take-home pay impact" (i.e. if the increase tax revenue was to be achieved through income tax and NI alone) we would need to multiply the figure by 2.4 (NI and Income tax makes up 42% of total UK tax revenue; 1/0.42 = 2.38). So an increase in the total tax burden of 10% would mean a 24% increase in the Income tax and NI burden if that were to be achieved solely through payroll taxes.

Of course the alternative to increasing taxes would be to reduce public expenditure; so you can take as read the words "and/or an equivalent reduction in public spending" every time a required tax increase is mentioned. Of course public spending is higher than tax revenue (hence the deficit) so the percentage reduction in public spending required will be slightly lower than the percentage increase in tax. To illustrate: Scotland's 2013-14 deficit of 8.1% of GDP is as a result of spending being 23% higher than revenue, so e.g. a 16% increase in tax is equivalent to a 16/1.23 = 13% decrease in spending.

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2. Note on NIESR analysis of devolution impact

The NIESR also has a go at calculating the Generational Accounts for Scotland under the devolution settlement currently being negotiated. Given there's conceptually no need for Scotland on its own to achieve intertemporal and intergenerational balance under a devolved arrangement (even if we accept the principle that the UK should) and the inevitable uncertainty around the nature of the future block grant, I'm leaving this analysis to one side.

I confess to some confusion as to the presentation of the Devolved scenario figures on page 23 where the paper states;

"One interesting result is that if we add the size of the required tax increase in the UK and the devolved Scotland scenario together, then the resulting tax increase would be about 1 to 2 percentage points of GDP lower (depending on the assumption about the unallocated public expenditures) than in the case of a “fiscally independent” Scotland."

This seems to imply that the Devolved scenario is additive to the UK baseline scenario and not a standalone scenario

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3. Note on Scotland's different age profile

Scots are on average older despite dying younger. The obvious implication is that (differences in birth rates aside) proportionately more young people emigrate and/or less young people immigrate to Scotland. This is one of the reasons why Scotland needs economically productive migrants even more than the UK as a whole.

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4. Unallocated Expenditure

Government costs that "cannot reasonably be allocated to individuals" such as defence or environmental protection

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5. Notes on Generational Accounting Methodolgy

The explicit assumption is that all debt is repaid by future generations (or at least that debt tends towards zero as time tends towards infinity). There is presumably an argument to be made for a sustainable level of debt which would lower the implied tax burden increase required.

There is an assumed real rate of productivity growth of 1.5% compared to a real government discount rate of 3.0%. I think this means that if there were no age profile changes then the discounted contribution of future generations would inevitably be lower than today's.

The observation (page 15) that the tax increase required for intergenerational balance is lower than that required for intertemporal balance suggests that the above difference in real productivity growth and real discount factors is more important than the increased burden created by changing age profile. I think.

The assumption around net government purchases which are not allocated to individuals (UE) is critical. These costs are discounted at 3.0% but assumed to remain either static (in real terms) or to grow only in line with population. I *think* this explains why the highest baseline tax increase required (3.7%) is lower than than the current deficit (5.6%). Basically this is suggesting we don't need to eliminate the deficit today to meet our future financial requirements (even given the unfavourable demographic trends) because the UE burden will relatively decline as long as real productivity growth is achieved