Having Reservations

As "architect of the Scottish Parliament", Donald Dewar argued that everything that could be devolved should be devolved¹. A corollary of that would be to say we should seek to devolve powers unless there is a compelling reason not to.

With my These Islands hat on, I've recently been looking at devolution from a Welsh perspective.  In doing so I discovered that Wales offers a perfect case-study of why devolving spending powers is not necessarily a good thing for the devolved nation concerned. Those arguing for further devolution of spending powers to Scotland would do well to take note.

If the United Kingdom stands for anything, it stands for the pooling and sharing of resources. Without such pooling and sharing, Scotland, Wales and Northern Ireland wouldn't each be currently receiving many billions annually in fiscal transfers from England. Without those fiscal transfers, public spending in the devolved nations would need to be dramatically reduced (or, less realistically, tax revenues would somehow need to be dramatically increased).

Using ONS data² we can see how significant these fiscal transfers currently are on a per person basis, not just nationally but also across England's regions.

 [To understand this chart: if you multiply each regional per person amount by the regional population you would get the cash amount transferred in or out - add these figures together and they net out to zero (I've checked, it works) - We're just shuffling money around within the UK here.]

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To head off the standard Scottish Nationalist response: no this data doesn't show that Scotland is somehow being damaged by being in the UK. In fact it reflects the fact that Scotland is able to spend more on public services than it would be able to if it wasn't part of the UK. It's worth noting that transfers "in" for Scotland are caused almost entirely by relatively high spending, for Wales mainly by relatively low revenue and for NI by a mix of both relatively low revenue and high spend. I'll publish more complete analysis by nation/region soon.

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The current mechanism for adjusting the budget available for devolved nations is the Barnett Formula. There are detailed briefings on the These Islands Website which explain both the history and mechanics of the Barnett Formula (How does the Barnett Formula actually work? and What is the Barnett Squeeze?), but all you really need to know is this: the Barnett Formula is not needs based, so changes in devolved budgets do not reflect changes in need.

The Barnett Formula in practice is highly sensitive to rates of change in population, resulting in it serving Scotland (with its declining population) relatively well compared to Wales and Northern Ireland. This is not in any way "fair" or "needs based". The chart below shows the impact over time of applying the Barnett Formula for Scotland, Wales and Northern Ireland, using realistic assumptions and where the only difference between the three nations' formula driven per capita budgets is their actual relative rates of population growth/decline.

This in-built unfairness is why whenever anybody sensible takes a look at the Barnett Formula, the conclusion is the same: it needs to be replaced by a needs based formula.

That the Barnett Formula remains in place today is testament to the combined forces of political inertia and the strength of the Scottish parliament. Scotland is most likely to suffer (relatively) if a "fairer" mechanism for allocating spending among the devolved nations is put in place.

This is of course why, when "The Vow" was being delivered, the SNP insisted that the Smith Commission recommendations included the line "the block grant from the UK government to Scotland will continue to be determined by the Barnett Formula". It's also why the SNP dropped their brief flirtation with the idea of "Full Fiscal Autonomy" for Scotland, because that would mean scrapping the fiscal transfers that enable Scotland's higher public spending.

What struck me when looking at the relative per capita spending data for Wales (see table below) was that the only comparable area of spending where Wales receives a higher per capita spend than Scotland is Social Protection. Social protection is of course not devolved, it's fully reserved. Being fully reserved it is effectively guaranteed to be allocated on a needs basis, because the entitlement to (for example) a State Pension is standard UK³ wide - if there are proportionately more pensioners⁴ in Wales, they'll get proportionately more funding.

Now look at all those other areas where Wales has less per capita spending than Scotland

• Health and Education are fully devolved  - so we know that Wales' capacity to spend in these areas has suffered relative to Scotland due to the way the Barnett Formula works
• Transport is c.80% devolved, so tells a similar story
• The mix of devolved vs reserved is less clear for other areas - but we can observe significantly lower spend for Wales relative to Scotland in "Economic Affairs", "Housing & Community Amenities", "Enterprise & Economic Development", ...

At this point the analysis only really takes me far enough to ask a pointed question: are these lower spend levels for Wales justified by lower need, or has the Barnett Formula left Wales unfairly starved of funds?

This is a blog, so you'll perhaps forgive a rambling conclusion (Chokkablog's motto is "thinking allowed" after all):

• From a "UK-wide" perspective, devolving further spending powers without replacing the Barnett Formula with a needs based formula would be both imprudent and reckless - because the Barnett Formula is not "fair"
• Devolving revenue raising powers carries similar risks. Even if you allow some base level fiscal transfer to remain (i.e. so that if 100% of revenue raising powers were devolved, Scotland would still receive some of England's tax revenues) you would still be exposed to the problem of how that figure was adjusted over time. It's also hard to see how such a situation would be tenable from an English perspective - the more revenue powers are devolved, the closer we edge to Full Fiscal Autonomy. Regular readers of this blog know that would be a terrible idea for Scotland
• Devolving Social Protection powers (for Scotland or Wales) would take away the assurance of  "needs based" funding that reservation of those powers gives
• There's a democratic trade-off involved in accepting that the UK-wide priorities may not be the same as those Scotland or Wales alone would choose - but being in a union is all about compromising how much influence you have in return for enjoying the benefits that accrue from being part of a greater whole. The data suggests Scotland does pretty well out of "the greater whole". At least as far as the Barnett formula is concerned, that's more by accident than design.

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NOTES

1. Profile: Donald Dewar the architect of the Scottish Parliament

2. Country and regional public sector finances: Financial year ending March 2016

These figures are used to allow consistent comparisons between regions and nations. The "geographic" (favourable to Scotland) N Sea revenue allocation methodology figures are used, but in the year in question N Sea revenues were only c.£60m or about £11/capita for Scotland (so frnaly irrlevant).

The deficit for Scotland using these figures is slightly higher than that shown by the 2016/17 Scottish Government GERS Report (£15.2bn vs £14.5bn in GERS for 2015/16 - a £130/capita difference).

The figures are very close also to the GERW data produced by Cardiff University for Wales (£14.8bn vs £14.7bn).

3. Except NI

4. As indeed there are: ONS data

Barnett Formula: Keeping it Simple

My last (long and complicated) blog attempted to explain how the Barnett Formula affects the devolved nation's Block Grant funding over time. In particular it looked at the impact of different relative population growth rates and how the Barnett Formula has been applied in practice as opposed to how it was expected to work. So if you're interested in the how and the why of these dynamics, please read Calling Time on the Barnett Formula.

Free from the burden of explaining quite why all of these things happen, I wanted to take the opportunity to now write a simpler blog which simply demonstrates what happens under various circumstances in a way which I hope will be easier for the casual reader to digest.

My medium of choice will, of course, be the graph.

Simply put: annual application of the Barnett Formula increases each devolved nation's Block Grant by an amount calculated to give the same per capita increase to the devolved budget as that applied to England's comparable spend¹.

To achieve this the formula therefore depends fundamentally on the relative population sizes and how they change over time - so to understand the Barnett dynamics we need to understand how these population proportions (devolved nation vs England) have changed over time.

This graph shows us that since Barnett was implemented in 1978 Scotland's population proportion has been consistently falling (because Scotland's population has been growing more slowly than England's) . Wales' proportion was stable through the 80s and early 90s and has only recently started to decline. Northern Ireland's actually grew slightly through the 80s and 90s and has stabilised more recently. These relative population growth differences entirely explain the differences we're about to see between the devolved nations when we model the impact of the Barnett formula over this period.

The next factor we need to consider is the actual nominal growth in spending in England in those areas where comparable spend is devolved. This is a hard number to get precisely right over such a long time period² but for illustration purposes we'll use the actual annual growth rates for all public spending in "rUK" (where rUK = UK - Scotland)³. This matters because higher nominal growth accelerates convergence (and there were some high inflation years in this time-frame and nominal growth has clearly slowed dramatically in recent years).

The only other assumption we need is how much higher the (illustrative) devolved category spend per capita was for the devolved nation in 1978 when this all started. For illustration purposes I've chosen to use a fairly representative figure of 20%⁴.

So based on actual population changes and assuming the above nominal spend increases, we can now see how application of Barnett would affect that 20% premium in spend per capita over time for each of the devolved nations. Here's the graph:

The blue dashed line shows how "true" application of Barnett would have caused Scotland's spend per capita premium to have converged towards England's. Note that the uptick in recent years shows the premium is actually growing: this happens when absolute nominal spend/capita increases in England are small (as they have been) and Scotland's population proportion continues to fall⁵.

The solid blue line shows the benefit that Scotland achieved because "until 1992, the 1976 population estimates were used for the Barnett Formula"⁶, so "as applied" the Barnett Squeeze (which causes convergence in Spend per Capita between nations) was partially alleviated. As I said in my last blog on this topic: imagine the howls of grievance we'd hear if failure to apply the Barnett Formula as agreed had resulted in a 2.2% detriment to the Block Grant instead of a 2.2% benefit⁷.

The red lines show Wales. Because the population proportion didn't materially change between 1978 and 1992 the "true" vs "applied" Barnett Formula issue makes no material difference. What is clear is that simply because of the different trend in population proportion, Wales has seen a far more marked squeeze in Spending than Scotland.

The green lines show Northern Ireland. Because NI's population share was actually growing between 1978 and 1992 the impact of Barnett as applies (vs "true" Barnett) was to exacerbate the Barnett Squeeze. The Barnett Squeeze for NI is worse overall purely because of the different trend in NI population proportion vs Scotland or Wales.

So there we have it. The Barnett Formula was never intended as a long-term solution⁸ and - as I explored in my previous blog - there are strong arguments for changing to a system which is a) fairer between the devolved nations and b) fairer to the devolved nations insofar as there is a sound needs-based argument for maintaining per capita spend premia in some departments.

As I also argued last time: the easiest way to ensure spend is distributed based on need is not to devolve that spend so that e.g. social protection spend is allocated to individuals based on their need, not where they live.

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1. This is a simplification; if you care for the more complicated detail see > Calling Time on the Barnett Formula

2. As the House of Commons briefing paper succinctly puts it: "it is hard to verify the extent to which the Barnett Squeeze is happening, largely due to a lack of comparable data". My previous blog Calling Time on the Barnett Formula provides a more detailed explanation of the complexities

3. This is mainly because I have these figures to hand and they're suitable for a realistic illustration. If one was so inclined one could dig out the England only figures, but that still wouldn't be giving us the spend just on departments which are devolved (which changes over time anyway) - this assumption is fine for illustrative purposes as it captures macro trends of inflation and general public spending policies. My rUK data series only goes back to 1981 (SNAP data), so for 1979 and 1980 only I simply assume inflation growth (inflation was high then: 13.4% and 18.0%).

4. In 1998/99 (the earliest year that GERS breaks spend out to this level) Scottish spend per capita on (the predominantly devolved areas) of [health + education + transport] was 20.1% higher than rUK.

5. Imagine the increase is zero: in this case neither England nor Scotland's absolute spend would increase, but because Scotland's poulation grows less quickly than England's, our spend per capita relatively increases

6. As per the House of Commons Briefing Paper, page 11 [and discussed in more detail in Calling Time on the Barnett Formula]

7. That being the impact of not updating the population proportions up to 1992

8. Because of my last blog and some happy happenstance, I have recently spoken with some people who were there and involved when the Barnett Formula was put in place. I think it's a fair sumary to say it was only ever intended as a short-term fix to avoid what were perceived as tedious department by department negotiations between the Scotland Office and the Treasury; the assumption was always that something better would be put in place within a handful of years.

For those who care about the spreadsheet mechanics, here's a snapshot of the "true" Barnett model

Calling Time on the Barnett Formula

The "fiscal framework" which governs how funds are allocated across the four nations of the UK (often simply referred to as the Barnett Formula, which underpins it) has never quite worked as intended and is frankly well past its sell-by date.

If we're to have a sensible discussion about how the fiscal framework could be improved, we first have to understand what happens currently and why.

It's hard to explain this in a way that doesn't quickly become mind-achingly complicated or simply too dull to hold the attention of all but the most obsessively curious. With that in mind, I'll try to separate the core arguments from the explanations, use illustrative examples with realistic figures and put stuff the analytically minded might want to understand into separate, smaller notes.

Note: this is a bit of a beast of a blog post: if you want the simple version with clear graphs, try the later post Barnett Formula: Keeping it Simple

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The Barnett Formula & The Fiscal Framework

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1. The Barnett Formula (used to calculate the Block Grant) was designed to cause convergence of per capita spending between the four nations of the UK, an effect known colloquially as the "Barnett Squeeze"


2. The fact that Scottish population growth has been slower than English population growth has to some extent dampened the expected Barnett Squeeze - but it's still happening


3. In the years from 1978 to 1992 the formula was applied "incorrectly" in a way which was materially to Scotland's advantage


4. In pure spend per head terms, Scotland has benefited from the fact that Social Protection has remained predominantly reserved (and therefore continues to be allocated based on need rather than subject to the Barnett Squeeze)


5. Wales has suffered a worse Barnett Squeeze than Scotland due to the fact that its population growth has not lagged as far behind England's


6. The retention of Barnett in the current Fiscal Framework (as recommended by the Smith Commission) means this tendency to converge per capita spending is "baked in" to the current system


7. This is a problem if one believes that spending should be based on need rather than judged to be "fair" simply if  public spending per head converges across the four nations

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1. The Barnett Formula (used to calculate the Block Grant) was designed to cause convergence of per capita spending between the four nations of the UK, an effect known colloquially as the "Barnett Squeeze"

There's an excellent House of Commons Briefing Paper which describes how the Barnett Formula works which explains:

The majority of the devolved administrations’ spending is funded by grants from the UK Government – the block grant being the largest. Since the late 1970s the non-statutory Barnett formula has determined annual changes in the block grant. The formula doesn’t determine the total amount of the block grant, just the yearly change.

When there is a change in funding for comparable services in England, the Barnett formula aims to give each country the same pounds-per-person change in funding. In general, if a service is devolved it is considered to be comparable. 

When a change is made to a UK Government department’s budget (normally at a spending review) the Barnett formula takes the budget change, considers how comparable the services provided by the department are to those provided by the devolved administration, and applies a population proportion, as shown below. This calculation is carried out for all UK departments and the results are added to the devolved administrations’ block grants².

[Change to UK gov department’s budget]

X

[Comparability percentage]³

X

[Appropriate population proportion]

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Note 2: These amounts are generally referred to as "Barnett Consequentials"
Note 3: The “comparability percentage” is a function of how much of those budgets are devolved, as shown by this handy table:

This needn't distract us when it comes to understanding the fundamental dynamics of the Barnett Formula, but is often a source of heated negotiation in practice (e.g. whether spending on the Olympics or HS2 are deemed "comparable" for the purposes of calculating these Barnett Consequentials). As the Briefing Paper explains: “Each programme area, or service, is given a comparability of either 100% or 0%. A service is 0% comparable if: other arrangements are in place to determine each devolved administration’s share of a budget; expenditure is incurred on behalf of the UK as a whole by the UK department; or, the service is deemed unique at a UK level, such as the Channel Tunnel Rail link.”

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Obviously if more spending powers are devolved the comparability percentage goes up, but if we're considering the underlying dynamics of the Barnett Formula it makes sense to consider an area where this doesn't change (if you like, think of a fully devolved area like Education where the comparability percentage is simply 100%).

For most departments (where spend is devolved to all four nations) the "Appropriate population proportion" for Scotland is simply [Scottish population] / [English population]. To understand the Barnett Squeeze let's first consider what happens if this proportion doesn't change (i.e. English and Scottish population growth rates are the same).

We can run the numbers with a simple spreadsheet using actual English population figures and covering the 38 year period since the Barnett Formulas was introduced in 1978. Over that period rUK has seen average annual public spending increasing at about 5.3% pa (a combination of inflation and real growth) so we'll use that assumption for this illustrative department's spending growth in England. Our last assumption is that this is a department where in 1978 Scottish  spend per head was 20% higher than England.

The snapshot of the spreadsheet below shows how the mechanics work: key modelling assumptions are in yellow and the "answer" - the amount by which Spending per head in Scotland exceeds that in England - is in green.

So under these realistic assumptions: if the starting point for the Block Grant in 1978 was a 20.0% higher spend per capita in Scotland than England, after 38 years the application of Barnett would have now reduced that to being only 2.8% higher (if Scotland's population grew at the same rate as England's and there was no "Formula bypass" or other Barnett exceptions⁵")

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Note 4: This makes intuitive sense: 5.3% cumulated over 38 years is more than a 7-fold increase, so by 2015 over 80% of the Block Grant has been determined by the Block Grant Adjustments which are on the same per capita basis, less than 20% is at accounted for by the "base" at the 20% higher rate.
Note 5: as the House of Commons Briefing Paper explains: "The majority of changes in the devolved administrations’ DELs are determined by the Barnett formula. However, there are some items in DEL for which the population based Barnett formula is not appropriate. DEL items outside of Barnett, often known as non-assigned items, are ring-fenced and specific to their particular spending priority. Such items, including depreciation, are determined separately between the devolved administration and UK Government. The population-based approach of the Barnett formula is not appropriate for determining changes in AME grants, because of their demand-led nature, so these are determined periodically between the devolved administration and UK Government." and "Although the Barnett formula represents normal procedure, changes to the block grant can be made outside it - a process often referred to as ‘formula bypass’"

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2. The fact that Scottish population growth has been slower than English population growth has to some extent dampened the expected Barnett Squeeze - but it's still happening

Now we have this simple model, it's easy to see what happens if instead of assuming Scotland's Population grows at the same rate as England's, we use the actual population figures⁶.

The effect of applying the actual (relatively slower) population growth in Scotland is to significantly slow the Barnett Squeeze: instead of the spend/capita premium being reduced from 20.0% to 2.8%, our model now shows it still at 9.3% in 2016⁷.

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Note 6: the proportion actually used is the prior-year population proportion, as this is the only data available when the calculations are made in real life
Note 7: this is less easy to intuit than one might expect. The "base" part of the block grant remains static in absolute terms so becomes significantly higher relative to England on a per capita basis - the same effect applies to prior years' Block Grant Adjustments which will have been calculated on a relatively higher proportion. In addition, the fact that prior-year proportions are necessarily used means there is an addition "built in" squeeze dampening affect as long as the Scottish population proportion is declining.

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3. In the years from 1978 to 1992 the formula was applied "incorrectly" in a way which was materially to Scotland's advantage

There's an extraordinary throw-away line in the House of Commons Briefing Paper (page 11) which reads (highlighting mine):

".. if population proportions are not regularly updated convergence can be affected. For instance until 1992, the 1976 population estimates were used for the Barnett formula. During this time Scotland’s population was falling relative to England’s, which would have worked against the Barnett squeeze." 

We've got the model so it's easy to scale what effect this would have. To improve modelling accuracy I've applied a nominal spending growth rate of 7.6% pa until 1992 and 5.0% subsequently (reflecting actual growth rates in UK spending over those periods) and then looked at what the 20% premium would reduce to if Barnett were "correctly" applied vs. if 1976 proportions were used until 1992 (as actually happened).

"Correctly" applied the Barnett Squeeze would have reduced the 20% premium to 11.1% by 1992 (note the differential growth assumptions now used over the two periods has reduced the 2016 premium to 8.7%)

As actually applied, the premium only reduced to 13.3% by 1992 (and the 8.7% in 2016 has improved to 9.5%)

So this failure to update the population proportions between 1978 and 1992 benefited Scotland's Block Grant amount by about 2.2% - a significant impact and one which is still implicitly reflected in our Block Grant today (albeit now diluted to just a 0.8% impact).

Pause for a moment: I want you to imagine the howls of grievance we'd hear if failure to apply the Barnett Formula as agreed had resulted in a 2.2% detriment to the Block Grant instead of a 2.2% benefit. OK, now carry on.

If you're struggling to get your head around this, you're not alone. That House of Common's Briefing Paper is at best confusing when it states "During this time Scotland’s population was falling relative to England’s, which would have worked against the Barnett squeeze". The implication that updating the population proportions would have accelerated the Barnett squeeze is wrong: the correct Block Grant Adjustment would have required a lower population proportion to be applied than that actually used, reducing the Block Grant adjustment and accelerating the Barnett squeeze⁸.

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Note 8: the error in the briefing paper is perhaps understandable. If the population proportion had remained the same the squeeze would have been greater, but by keeping the population proportion the same in the calculation that doesn't offset the fact that the actual population figure (the denominator in the per capita calculation) does relatively decline

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4. In pure spend per head terms, Scotland has benefited from the fact that Social Protection has remained predominantly reserved (and therefore continues to be allocated based on need rather than subject to the Barnett Squeeze)

Because Social Protection is broken out as a category in Scottish Government GERS figures back to 1998, we can use our model to see what (in purely arithmetic terms) would have happened if in 1999 we'd devolved Social Protection (SP) spend and used the Barnett Formula to calculate Scotland's SP Budget (given what we know actually happened to SP spend in rUK). We can of course compare that to what happened to the actual, predominantly reserved Scottish SP spend per GERS.

What we can see is that on average over this 17 year period Scotland has received £54/capita more Social Protection spending than if it had been simply devolved and subject to the Barnett Formula⁹. Multiply that figure by Scotland's population and you get a £288m average annual benefit.

To put that figure in the context of a standard SNP grievance: their decision to centralise Police Scotland and incur VAT costs us just £25m pa.

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Note 9: of course had this been money from the Block Grant adjusted by Barnett then the Scottish Government would be free to spend the money elsewhere instead

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There's a lot going on behind these figures and I've had to hide some columns for display purposes. The graph below simply charts the "Barnett Effect" (the last row of the spreadsheet above), where the bar below the line means the alternative of using the Barnett formula would have led to less per capita spending in Scotland

In the early 2000s the benefit of retaining Social Protection as a reserved department allocating funds UK-wide based on need (vs. our notional alternative of devolving in 1992) was often greater than £100/capita. The fact that the gap closed in recent years is presumably something to do with Westminster policies that shifted Social Protection spending in a way which negatively impacted Scotland more than rUK ... or it could be to do with the dynamics of decelerating growth in cash spend and the relative population growth figures ... but to be honest I think I've reached the limit of my capacity to try and unravel the figures at this point.

5. Wales has suffered a worse Barnett squeeze than Scotland due to the fact that its population growth has not lagged as far behind England's

Applying the Welsh population figures to our model shows how a 20% per capita spending premium in 1978 would have reduced to a 7.4% premium in 1992 (cf Scotland's 13.3%) and 6.0% by 2016 (cf Scotland's 9.5%).

If we look at the relative population growth trends this finding is not surprising: Wales was exposed to a fairly "pure" Barnett Squeeze until the early 1990s as its population growth  pretty much matched England's

6. The retention of Barnett in the current Fiscal Framework (as recommended by the Smith Commission) means this intention to converge per capita spending is to some extent "baked in" to the system

The current Fiscal Framework is designed to satisfy the Smith Commission recommendations, in particular clause 95 (1) which states that "...the block grant from the UK government to Scotland will continue to be determined by the Barnett Formula". 

Devolved revenue raising powers adds a layer of complexity to this debate because the Block Grant (calculated using Barnett) is reduced by an amount to adjust for revenue devolved. The nature of that Block Grant Adjustment (BGA) was the source of much debate during the Fiscal Framework negotiations, in particular how one indexes the BGA in future years to satisfy (and interpret) the Smith Commission requirement of "no detriment".

As the IFS highlighted at the time: " it is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett Formula remains in place"

7. This is a problem if one believes that spending should be based on need rather than judged to be "fair" simply if spend per head converges across the four nations

I'd hazard a guess that most voters in the UK buy into the principle of pooling & sharing resources: we spend money on public services based on need, we don't just aim to spend the same amount per person.

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Aside: There is an alternative view which is that the constituent nations of the UK should "stand on their own feet" and be fully fiscally autonomous. As this blog has previously explained in detail (> Full Fiscal Autonomy For Dummies) that way madness lies. From a Scottish perspective that could only make sense when oil was generating upwards of £9bn pa of tax revenues - without those oil revenues Scotland would have to find that £9bn pa from some combination of tax rises or spending cuts to be fully fiscally autonomous and satisfy the fiscal constraints that would come with currency sharing. There's a reason we don't hear the SNP calling for Full Fiscal Autonomy anymore.

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As an example: need based allocation would make more sense than equalising spend per capita where population densities differ significantly. It costs more to get basic services to people the more geographically dispersed they are - and the four nations clearly have very different population densities

Scotland's population is 6x more dispersed than England's - is it "fair" to expect the same per capita amount to be spent on Transport or Education?

The demographic challenges differ by nation as well with different proportions of the population economically productive versus those dependent on the state. This is crudely measured by the percentage of the population who are of working age (a measure on which Wales fares particularly badly)

There are of course many other factors to consider when it comes to defining need (healthy life expectancy, unemployment rates, areas of deprivation, etc.) but this blog-post is already too long to start exploring them further.

What we can say is that the arguments for a needs based spending allocation formula seem pretty compelling: as the House of Commons Briefing Paper points out, pretty much everybody who has looked at this question has reached the same conclusion

The change in population is the only consideration of ‘need’ in the Barnett formula. However, the cost of providing public services is influenced by a range of other factors including, but not limited to, characteristics of the population, deprivation and population density.

There have been frequent calls for the Barnett formula to take greater account of need, or to be replaced with a needs-based formula. In 2010 the Holtham Commission, which considered funding for devolved government in Wales, recommended that a need-based formula should determine the block grant. After considering devolution in Scotland, the Calman Commission recommended in 2009 that the block grant should be justified by an assessment of need. Lords Committees in 2009 and 2015 recommended replacing the Barnett formula with a needs-based formula. Similar recommendations were put forward by the House of Commons Justice Committee in 2009 and by other Parliamentary committees in the past.

There's an interesting point to be made here relating to "more powers". 

We've shown above that if (say) Social Protection were devolved and subject to Barnett, it would become subject to the Barnett Squeeze. Unless our population were to decline in absolute terms, the act of devolving spending in an area where we currently experience a higher per capita spend than England would inevitably see a decline in the premium given to spend in Scotland (irrespective of actual need). Were Scotland's population growth to accelerate (or the UK's decline) that squeeze would accelerate. Why would anybody in Scotland think that a good idea?

Of course one could argue that the best way to deliver Social Protection based on need is to apply the same policies nationwide and have the same criteria and needs assessments in place irrespective of which constituent UK nation you happen to live in.

Those continually complaining about spending powers that remain reserved to Westminster should maybe take a moment to consider: fairness may best be delivered by keeping spending areas like Social Protection (or Work & Pensions as defined in the departmental allocation table above) largely reserved.

Personally I'd argue against any further devolution of either spending or revenue raising powers until these fundamental issues related to the Barnett Formula are addressed.

Unreasonable Negotiation

True Story:

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In my early years as a Strategy Consultant I and a colleague were travelling around the Far East whilst gaining an understanding of our client’s International Sourcing operations.  After moving between several countries in just a few days we found ourselves having dinner in down-town Bangkok and decided to get a Tuk Tuk ride back to the hotel.

We were savvy enough to know that we should agree the price for the journey in advance so we hailed our first Tuk Tuk driver and duly started negotiating.  We weren’t going to be taken for mugs and we knew the price in Baht for the journey shouldn’t work out at much more than about £1. We weren't surprised to be offered some outrageous prices but - with a long line of drivers willing to haggle for our business - we merrily dismissed driver after driver as we waited for one to accept a reasonable price.

Eventually we persuaded a driver to accept our £1 and take us to the hotel.  At the end of the journey he pleaded with us for a decent tip, explaining passionately that he had a wife and kids to feed and we really were paying too little for the journey. By this stage, brimming with confidence in our negotiation skills, confident we had paid a healthy full fare and determined not to be taken as a pair of fools at the last hurdle, we airily waved him away and retired to the hotel bar.

Here’s the rub: the following morning we realised that - having been through several currency changes in the preceding days - we had completely messed up our exchange rate calculations. What we had thought was £1 was in fact only 10p.

Apart from the obvious lesson about supply and demand - there was an over-supply of Tuk Tuks which placed us in a very strong negotiating position - this experience taught me something that has served me well in negotiations ever since. We were being unreasonable in our negotiations but because we believed we were being reasonable we stuck by our guns.  If we had known the correct exchange rate - if we'd been reasonable negotiators - we'd have struck a far worse deal.

Note: It's been pointed out that I and my colleague were being dicks in this scenario. I kind of assumed that was obvious but if it needs stating then yes, we were being dicks. Bear that in mind as you follow this analogy through.

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I'm reminded of this experience as the increasingly public and fraught fiscal framework negotiations between the UK and Scottish governments drag on. It's clear that agreeing what's reasonable - what satisfies the condition of "taxpayer fairness" while still honouring the Smith Agreement - is the source of the impasse.

The crux of the matter in my view is this: the Scottish Government are not being reasonable, which is a completely appropriate negotiating position to take to get the best deal for Scotland.

If you're not familiar with the background on the Smith Agreement and the dynamics of the Barnett Formula now might be a good time to read my last blog post (Barnett Fair?); from here on I'll take an understanding of these issues as read.

Both parties agree that a Block Grant will remain and it will be reduced by an appropriate amount on day one to ensure that the first "no detriment" principle is met. The Block Grant's year-on-year changes will continue to be calculated according to the Barnett Formula which ensures another key principle of Smith is delivered: the Barnett Formula remains.

The stumbling point in the negotiation appears to be how the amount by which the Block Grant is initially reduced is indexed over time.  This figure is termed the Block Grant Adjustment (BGA) and all Smith said about this was that it should be "indexed appropriately" and that this should be "fair" to both parties.  It's critical to the understanding of what is reasonable here to be aware of two points;

• The "no detriment" principles outlined in Smith related to the initial transfer of powers and the knock-on implications for one country of another using those powers. There is nothing in Smith that suggests there should be no detriment as a result of reducing the scale of the (spend indexed) Block Grant in return for giving Scotland the upside (and downside) of complete control and retention of further revenues


• The issue being negotiated is not how the "revised base" Block Grant is itself adjusted (this continues to be calculated using the Barnett Formula with all of its inherent flaws and weaknesses), the point at issue is the indexing of the Block Grant Adjustment

Quite simply: the Smith Commission left this indexing open to negotiation and the only guidance given was that there should be an "appropriate" index and that it should be "fair" to both parties. 

So, recognising that this is not the same as being wrong in their approach to negotiation, it does appear that the SNP are being unreasonable.  The "no detriment" principle was specified clearly enough for it to be pretty clearly unreasonable to claim that it's fair to apply it to indexing of the Block Grant Adjustment. 

Again: "no detriment" was specifically defined to apply to the impact of "initial transfer" (i.e. day one) and "policy decisions that affect the tax or expenditure of the other". There was nothing to suggest that shifting the mix of revenue from Barnett indexed to retention and control of own taxes should in itself be designed so as to ensure "no detriment". Indeed it could be argued that the whole point of devolving greater control and responsibility is to make us more exposed to and aware of the impacts of our particular demographic challenges.

To sum up where we now stand;

• The SNP's negotiating position is unreasonable - they are attempting to appropriate the "no detriment" clause and apply it in a way it was never intended to apply.


• The SNP's negotiating position is hypocritical - they are arguing to retain some of the benefits of pooling and sharing that they've spent their political lives claiming are non-existent.


• The SNP's negotiating position is nevertheless appropriate - it's a negotiation and their job is to get the best deal for Scotland; being unreasonable (and hypocritical) is probably necessary to achieve that

Of course the SNP can't lose here. If no agreement is reached they can unreasonably (but credibly) accuse the UK Government of reneging on the Smith Agreement; if they succeed in getting an unreasonable deal it will be in Scotland's best interests - so they'll be applauded for negotiating the 10p Tuk Tuk ride.

Nobody said life had to be fair.

Barnett Fair?

During a brief appearance on BBC's Scotland 2016 last night I was asked about Nicola Sturgeon's letter to David Cameron (full version below) in which she highlighted the importance of the interpretation of the Smith Commission's "no detriment" clause in relation to the ongoing Fiscal Framework negotiations.

I had about a minute to try and cover this rather complex subject and - if I'm honest - I think I made a pretty decent fist of it. Judge for yourself: the relevant part starts at 25:30

With the benefit of the breathing space that this blog allows, forgive me while I let my belt out a notch and try to present a slightly more complete answer.

The key question here is: how do we interpret the Smith Commission's "no detriment" clause?

Even if you don't read the Smith Commission Report in full, I strongly recommend you read paragraph 95 from which I extract the following snippets (bold highlighting is mine);

95 (3): No detriment as the result of the decision to devolve further power; the Scottish and UK Governments' budgets should be no larger or smaller simply as a result of the initial transfer of tax and/or spending powers, before considering how these are used.

[...]

95 (4): No detriment as a result of UK Government or Scottish Government policy decisions post-devolution

(a) Where either the UK or the Scottish Governments makes policy decisions that affect the tax or expenditure of the other [...]

(b) Changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved. should only affect public spending in the rest of the UK. Changes to devolved taxes in Scotland should only affect public spending in Scotland. 

So there are in fact two "no detriment" clauses in Smith.

95(3) is very straightforward. If control over a tax that currently generates £1bn of revenue is transferred (and therefore Scotland gets to keep that revenue directly) then the block grant is reduced by £1bn at the same time; there is no detriment on the initial transfer¹.

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It's worth noting that if this "no detriment" principle was followed to allow all tax raising powers to be transferred to Scotland then there would still be a rump of block grant left at the end of about £8bn (because the "no detriment" approach protects the value of Barnett under current tax raising circumstances²). Readers of Chokkablog will be very familiar with this figure; if you're not please read "What's £8bn Between Friends"

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95(4) is conceptually simple but could be hugely complicated in practice.

First of all let's clear up a surprisingly widely held misconception: this does not mean that the block grant would get reduced if Scotland raised more taxes by using one of its powers (increasing income tax for example). This point should be self-evident (there would be no incentive to use powers to raise more taxes if any increase was offset by a block-grant reduction) but Lord Smith himself felt the need to offer the following clarification in the House of Lords in November 2015;

We arrived at a principle whereby, when taxes are raised, the money is kept and is available ...³

The tricky point this clause is trying to to address is the knock-on effect of changing a tax in one country on tax or spend in another. Here are just three illustrative examples (there are many more);

• If different healthcare charges were introduced in one country but not another, that could trigger health tourism, placing an increased cost burden on the "cheaper" country


• If Air Passenger Duty is reduced in Scotland that could cause loss of air traffic to (say) Newcastle Airport thereby reducing the UK's APD take


• If one country created a low income tax regime it could cause high earners to relocate to the other, thereby reducing the tax take in the country they leave

Clearly isolating and robustly quantifying effects like this will be extremely difficult if not impossible. The presence of these types of effects (whether intended or unintended consequences of Scotland using its devolved powers) is one of the main reasons why some of us counselled against the rush to devolve more powers. I covered many of these arguments while the Smith Commission was deliberating in 2014 and - having argued against devolving income, corporation and capital gains taxes or the minimum wage - I concluded

"... whilst "more powers" is a superficially attractive concept, the devil as always is in the detail.  "More powers" could - if not carefully calibrated - lead to the dismantling of the very benefits of Union that the Scottish people voted so overwhelmingly in favour of retaining."

But we are where we are. The Smith Commission agreement has to be honoured and the issues above should be resolvable by pragmatic political negotiation. As we'll come on to see; it's not as if the existing Barnett arrangement is flawless⁴.

But there is another far larger stumbling block to negotiation which has been raised by the SNP. In Nicola Sturgeon's letter to David Cameron (see page 2 below) she states;

"we are not about to accept risks [...] about which Smith made no recommendation"

So she explicitly accepts the points she's about to raise are not covered by Smith's recommendations before going on to say;

"The UK government's proposals for adjusting the block grant would require Scotland to grow receipts from devolved taxes more rapidly than the corresponding receipts in the rest of the UK simply to ensure its budget is not reduced. This does not meet the Smith Commission's no detriment principles.

We'll come back to this, but we've see what the Smith Commission explicitly covered in their "no detriment" principles and - particularly given she has already accepted that Smith "made no recommendation" about this area - the last sentence here is an unfounded assertion. She goes on to elaborate by saying;

In addition* we could not accept the risk that Scottish funding might be reduced below what it would have been under current funding arrangements simply as a result of differential population growth [...] We could not accept that relative demographic trends within the UK [...] should lead to a reduction in the Scottish budget

* I don't think this is actually "in addition", I think she's explaining why the highlighted problem arises

So what's going on here, why would "relative demographic trends" lead to a reduction in the Scottish budget and is it reasonable to "not accept" exposure to this effect?

To understand this we need to understand both the intended and the actual consequences of the Barnett Formula. Bear with me, this isn't as bad as you might be expecting - let's take it in steps and illustrate by example

• Scotland famously gets more spend per capita than the rest of the UK as a result of the Barnett Formula


• The intention of the Barnett Formula was to close that gap over time (what is sometimes referred to as the "Barnett squeeze") by allocating any growth in spend equally per capita between the two countries


• This works if both country's populations grow at similar rates. If you think about it, if all new Barnett money is allocated on a per capita basis then an increasingly large share of Barnett money becomes shared this way. The overall Barnett sum would trend towards being split equally on a per capita basis (the "unfairly" split base becomes less and less significant over time)


• But - and it's a big but that was not foreseen by Barnett - this doesn't necessarily work if Scotland's population grows more slowly than the rest of the UK. This is easily illustrated by example;
• Say Scotland's population is static but the rest of the UK's grows by 10%
• If the rest of the UK maintain spend per capita then their total spend rises by 10%
• Barnett means Scotland gets our population share of that 10% rise so our spend rises ...
• ... which means Scotland's per capita spend must rise (spend has gone up, population hasn't) even though the UK's hasn't. Good old Barnett.

This really matters. Scotland's population growth lags the rest of the UK; at the moment the way Barnett is structured means we actually benefit as a result. The effect is of course symmetrical - for the same reason we currently aren't suffering the same level of per capita spend spend reduction as the rest of the UK

So the problem for Sturgeon - the problem for Scotland - is that by devolving powers we inevitably shift some money away from being indexed to UK spend and towards being directly dependent on our (population's) actual tax revenue generation. Because our population growth is slower that means we lose out compared to the alternative of not devolving the powers and maintaining Barnett.

It seems to me that it was never the intention of the Smith Commission to have "no detriment" applying to "compared to the alternative of not devolving the powers", but by trying to retain this rather perverse Barnett effect that is what the SNP are arguing for.

There are three lines in Smith that seem relevant here

95 (1): ... the block grant from the UK government to Scotland will continue to be determined by the Barnett Formula

95 (3) (c): The future growth in the addition to the block grant should be indexed appropriately

95 (6): ...the arrangements should [...] be seen as fair, transparent & effective

Well that's not a massive help really is it? As the IFS have pointed out

"it is impossible to design a block grant adjustment system that satisfies the spirit of the ‘no detriment from the decision to devolve’ principle at the same time as fully achieving the ‘taxpayer fairness’ principle: at least while the Barnett Formula remains in place." 

For what it's worth I think the IFS reach this "impossible" conclusion because they are applying a broader interpretation of "no detriment" than that  intended by Smith. It seems clear to me that the specific demographic trend benefits of the Barnett Formula can only be retained in proportion to the block grant. A proportion of the currently "locked in" benefit of Barnett must surely be sacrificed in return for transferring funds out of the block grant when devolving control/retention of more taxes.

So what?

The problem here is that the Barnett Formula is - under current demographic trends - objectively unfair to the rest of the UK. It's therefore impossible to find a fair solution that both gives Scotland the upside of replacing Barnett money with direct control/retention of more of our own taxes whilst at the same time keeping the protection from demographic trends that Barnett affords us. The fiscal framework negotiation are simply highlighting the inherent unfairness in the way an unchanged Barnett would work in Scotland's favour if no further powers were devolved.

More broadly, these negotiations highlight the fact that with devolved power comes devolved responsibility. Part of that devolved responsibility means being more directly affected by Scotland's particular demographic challenges.

I fear that in their summit-fever rush for more powers the SNP made the mistake of believing their own grievance-rousing rhetoric about how badly the Union treats Scotland. The next few days of negotiation are critical: we're about to find out how high a price we're going to pay for the SNP's intemperate haste to seize more powers and weaken the bonds of Union.

*****

Full Letter from Nicola Sturgeon to David Cameron (With thanks to Glenn Campbell's Twitter feed)

1. There is a minor point of uncertainty here between what any given tax did raise in the prior year and will raise in the year it's tranferred (before it's potentially changed) - but that is a relatively trivial point of negotiation

2. This would be in addition to our per capita share of debt, so is not the same as saying we would have an £8bn deficit; we would effectively be able to run a deficict £8bn larger than our per capita share of the UK's

3. As is often the way in live debate he completed the sentence with a form of words that can be somewhat confusing: " ...and, when taxes are reduced, the money comes off the block grant".  The only interpretation of this that makes sense to me is that by "comes off the block grant" he means you'd just have to use the block grant as it exists (take the money off it) rather than that the block grant would be reduced (which would clearly be ridiculous)

4. As the IFS have pointed out, in addition to the relative population growth effect discussed here there issues around the treatment of business rates as well