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.

---

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"

---

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