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

Who's Really Against Austerity?

It's increasingly clear that the key to political popularity these days is to tell anybody who'll listen that you're "anti-austerity" and that your opponents are "pro-austerity". It's quite simple really: we're being subjected to unnecessary hardship because [insert nemesis] is ideologically committed to austerity and causing unnecessary economic pain. The names of Paul Krugman and Joseph Stiglitz are normally mentioned; cue rapturous applause and soaring poll ratings.

Now the two Nobel Laureats cited above are undoubtedly hugely influential economic thinkers and staggeringly smart men - but I would suggest they are only peerless in their field when it comes to self-promotion. You don't need to believe you're smarter than them to observe that it's easy to build a popular following by telling people that they needn't be enduring the austerity being foisted on them by nasty politicians. That those nasty politicians have to prioritise actually running national economies ahead of selling popular books on economics and building their media profiles is by the by.

I'm not saying that Krugman and Stiglitz are wrong - I'm simply suggesting that they could well be wrong, that having a Nobel Prize does not confer infallibility.

If we were able to sit and discuss the question of austerity with either of these two eminent men, I'd like to think that they'd make nuanced arguments. Maybe they'd suggest that austerity isn't really a binary choice - it's not something that you either do or don't do - but that's its all about timing and degree. Maybe they'd sheepishly explain that part of their role is to gain headlines, fill column inches, boost their universities' profiles - to be box office.  Maybe we'd discover some of their more simplistic (some say strident, some say patronising) pronouncements are simply a result of them playing to the gallery;

"I don’t know how many Britons realise the extent to which their economic debate has diverged from the rest of the western world – the extent to which the UK seems stuck on obsessions that have been mainly laughed out of the discourse elsewhere" - Paul Krugman

"Austerity has failed. But its defenders are willing to claim victory on the basis of the weakest possible evidence: the economy is no longer collapsing, so austerity must be working!" - Joseph Stiglitz

When it comes to the public debate they are in the enviable position of arguing against strategies currently being pursued - it's pretty easy for them to simply assert that whatever the current outcomes, it would have all been so much better if only more politicians had listened to them.

Unfortunately for Krugman he squandered some of this advantage by making doom-laden forecasts of continued economic decline and spiraling unemployment. As many commentators have pointed out, events have proved him wrong: "Paul Krugman is wrong about the UK and borrowing" (Andrew Lilico), "Where Krugman Goes Wrong About Expansionary Austerity" (Tim Worstall), "Paul Krugman has got it wrong on austerity" (Jeffrey Sach).

Fair enough. There's nothing wrong with lauded experts' forecasts occasionally being seen to be wrong (unless you're one of those who believe Nobel Prize winning economists are somehow meant to be infallible).

How does Krugman explain why economies pursuing the austerity he dismisses have been recovering? Take this example where he states that after imposing "harsh austerity" in 2010:

"... Prime Minister David Cameron’s government backed off, putting plans for further austerity on hold (but without admitting that it was doing any such thing)" - Krugman

Krugman is so passionately wedded to "austerity bad" (in a way that doesn't allow for any nuance around nature or degree of austerity being pursued) that the only way he can explain how unemployment has continued to fall and modest economic growth has been delivered is to suggest that we've not really been experiencing austerity after all. We went from "harsh austerity" (we'll come on to look at whether that was actually true) to no austerity at all. Who knew?

Of course the reality that Krugman himself is tacitly admitting to here is that austerity isn't as black-and-white a choice as his headline assertions would have us believe.

One of the problems is that it's not always clear what we mean when we talk about austerity. This isn't "just semantics" - it's important that we agree what a word means before we decide if we're for or against it.  Let's take two definitions of "austerity";

• "In economics, austerity is a set of policies with the aim of reducing government budget deficits. Austerity policies may include spending cuts, tax increases, or a mixture of both."
  - Wikipedia
• "A lower standard of living associated with the curtailment of government spending" - Chambers Dictionary: 

Of course the first of these defines austerity policies, the second describes the hardship that is one of the potential outcomes of some austerity policies. This semantic confusion is easily exploited in the world of sound-bite politics. It's as if we used the same word for surgery and pain: we're probably all against pain (other than the occasional masochist among us) but I'd suggest fewer of us are against surgery.

So let's agree that by "anti-austerity" we mean being against directly addressing the deficit through spending reductions and/or increases in taxation rates (the alternative being to increase expenditure and/or lower taxation rates in the hope that resultant economic growth will lead to higher tax revenues sufficient to cause indirect deficit reduction ... or I suppose if you're really blasé there's an option not to worry about deficit reduction at all).

If you accept this definition and think about it for even just a nano-second, it's clear that statements like "Anyone who understands macroeconomics knows that austerity is microeconomic theory that can't work" are nonsensical. The corollary of that argument would be that no spending level can be too high, no taxation level can ever be too low - that no matter what the deficit level you should never reduce spending levels or raise tax rates (because that would be the very definition of austerity and that "can't work").

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As an aside; the quote above comes from a Twitter exchange with Richard Murphy of Tax Research UK. He often makes very useful contributions to taxation debates in particular - but in this instance he actually asserted that austerity was "deliberate sabotage of UK economy". He appears to be currently acting as Jeremy Corbyn's economic advisor. Quite incredible.

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To be clear: I'm not championing "austerity" here, I'm merely suggesting that we have to look at the nature, scale and pace of austerity measures being introduced before we can form a view as to whether they are appropriate or not. I'm also not arguing that the way the austerity we have experienced in the UK has been delivered is "right" - I happen to believe that too much attention has been paid to reducing spend and not enough to raising taxes (as we'll come on to see), and that the spread of pain has fallen far too heavily on the poorest in society. This graph (created by the ever excellent IFS) illustrates the second of these points clearly - the people being squeezed down on are not the middle, they're the poor.

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Twitter exchanges have taught me that people struggle to read this graph  so I'll walk through it (assuming you've at least read the title). 

• From left to right we see the poorest in society across to the richest, broken into deciles (groups of 10%) - so the poorest 10% in our society are the left-most column, the richest 10% the right-most of the continuous sequence. The final column on its own on the right is the overall average.
• The coloured bar elements sum to show the annual cash impact (the white line) of the tax and benefit reforms on individuals in each of these groups - so the poorest 10% loose £800, the next poorest 10% lose £1,300 ... whereas the richest 10% only lose £200 and the second-richest 10% actually gain nearly £200
• The blue line shows the same thing but as a percent of net income (i.e. what proportion of "take-home" money is lost) using the right-hand scale  - so the poorest 10% and next poorest 10% are about 7% worse off ... whereas the richest 10% are only 1% worse off and the second richest 10% are actually slightly better off.

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It strikes me the only way we can move away from the simplistic binary rhetoric of pro- and anti- austerity is to look at some actual data - what levels of austerity are we in the UK experiencing and how do these compare with other economic areas? If we're "anti-austerity" what precisely is it that we're against?

I've downloaded info from the Eurostat Annual Macro-economic Database (May 2015) and stuck to this single source (trusting that the EU's economists are better at compiling cross-country comparable economic data than this weary blogger). The data series they provide includes forecasts for 2015 and 2016 - for some reason they don't provide data prior to 2006 for "Euro area" or Greece. So be it.

The analytical approach I've chosen is to take 2006 as a base year for indexing purposes  (i.e. the year before the current economic crisis kicked-off) and to look 10 years either-side so we can see the net effect of the financial crisis and austerity measures in context. It's an approach that has its pros and cons (choosing an arbitrary starting year is always slightly dodgy) but it gets us going, allows us to at least start asking some sensible questions.  If you think of understanding the figures as peeling the onion, what follows is just the removal of the crusty brown outer layer.

Starting with government expenditure (excluding debt interest) in real terms and comparing the UK with the US and the Euro Area;

The surge in spending through 2007 - 2012 is due in part to government interventions to support the banks¹ (the UK intervened earlier than the Euro Area) ... so presumably part of the subsequent apparent decrease would be due to these interventions not being repeated. The key here is that I think it's reasonable to compare our 100 index point of 2006 (before any interventions) to 2014 (after the main interventions) to get a sense of the underlying real terms increase in spending over that period. On that basis we can see that government spending in the UK and Euro Area is actually about 10% higher than pre-crisis levels and the US is on track to be 20% higher. 

Now let's add to this graph some selected Euro Area countries to provide a little wider context - the scale of the financial intervention in Ireland of course stands out;

It's interesting to note that the only countries spending below pre-crisis levels are (of course) Greece and (just) Italy. The trend in UK spending is towards the bottom end of the range of other countries but is very similar (post 2006) to Germany and the Euro Area countries. Prior to 2006 it's clear the the UK's rate of government spending was increasing at a markedly faster rate than all but Ireland; France and in particular Germany have seen far smoother (but on average lower) spending growth over the period. The forecasts (when Eurostat published these figures in March) are for The UK to be the only country other than Greece to be reducing real spend.

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As an aside: in the context of the Scottish FFA debate I've highlighted before that if you were to close the £8bn deficit gap through spending cuts that would require a 12% reduction in government spending. That would drop us somewhere between Italy and Greece on this graph - proof that it could be done I guess.

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To what extent are these absolute expenditure trends supported by GDP growth? To understand this (and get a sense of the different government spending models) we can look at spending as percent of GDP;

It's no surprise that the US has a lower government spending model and it's clear their forecast spending increase is GDP growth driven (spend/GDP is actually slightly declining). The UK's model is to to spend slightly less of GDP than the Euro Area average - and the current trend is to further widen that gap.

Adding other countries for a wider perspective, France's higher spend model stands out.

So we've seen the spend side of austerity - now let's look at the taxation side. We're going to look here at the Tax Burden as percentage of GDP² so we can see the extent to which tax has been used as austerity measure (again indexed to 2006);

It's striking that (relative to the starting point of 2006), the UK has been been reducing the tax burden overall whereas the Euro Area and the US have been increasing it. Oil revenue declines will be a contributing factor here but certainly doesn't explain this size of shift³; clearly something else is going on. Depending on your perspective you might see this as justified if it drives superior growth in the UK, or you might feel that increasing the overall tax burden is (potentially) a good way to make sure those with broader shoulders can take their share of the pain of austerity (and free economic capacity for spending driven growth).

Adding other countries to the graph simply reinforces this observation - the UK's is the only line heading downwards in recent years, the only country reducing our tax burden;

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Here's a good point to pause and consider Krugman's comment about the "harsh austerity" implemented in the UK in 2010.

I'd suggest you would measure "harshness" by either the steepness of either the increase in tax burden/GDP or the decrease in real expenditure - or possibly by the overall change in these measure from 2006 (pre-crisis) to now. On that basis I reckon Greece, Ireland and Spain have experienced far harsher cost side austerity than us and we've largely avoided tax side austerity (unlike Greece, Italy, France and - to a minor degree - Germany).

Some of the poorest people in the UK have experienced austerity of course (per the earlier IFS "squeezed Poor" analysis) - but at a macro level it's hard to argue that the UK as a whole has experienced "harsh" austerity.

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To complete the picture it makes sense to look at the tax burden as a percentage of GDP. As you would expect this is broadly the same profile as the spend/GDP graphs: the US economy is a low tax / low spend model; the Euro Area is (on average) a higher tax / higher spend model than the UK

You know the drill by now - we'll add other countries and you can pick your favourite;

So now we've got an actual data driven view of the alternative tax/spend and austerity models being pursued, let's see what macro outcomes are being delivered. We'll start with real GDP (again indexed to 2006);

The Euro Area has had it's double dip recession and is limping back towards growth; the UK is back to reasonable levels of growth; the US has been growing steadily now for 5 years. If what we've been experiencing is austerity, by this measure at least it's working. Of course we will never know what might have happened had we just kept spending ...

Let's add the other countries for the wider context;

It's clear that in terms of real GDP growth only the US and Germany (of our selected subset of countries) have done better than the UK since 2006 ... and if you look carefully you'll see that we've grown faster than all of these comparators except the US since 1996*. The scale of Greece, Italy and Spain's woes is clear, as is the extent to which they drag down the Euro Area.

*Addendum: looking again I see Ireland has actually grown significantly faster over the long period

Finally let's look at Deficit/GDP. This is simply an arithmetic function of all the figures we've just covered plus non tax-burden government revenues less debt interest^4,5 (I'm too tired to graph these but trust me it all adds up - I'm careful like that);

On this important measure (below the line means the absolute debt is increasing), the UK and the US started from worse positions in 2006 and fell deeper than the Euro Area - but in all cases the deficit to GDP ratio is improving and (recognising the last two years are forecasts) the UK appears to be reducing its deficit at an accelerating rate. On this measure we are close to getting back to where we were before the crisis - although of course our debt burden now is much greater and the UK's deficit rate is still materially worse than that of the Euro Area.

One last time; let's crowd the graph up;

We weren't in a great place in 2006. The combination of cost-side austerity and GDP growth is slowly coming to our rescue but on latest actual numbers we still have a deficit of concerning magnitude (for reference the EU's "excessive deficit" threshold is 3%). It's possible that reducing the tax burden is at least in part the driver of higher GDP growth - but it's yet to be shown whether that will truly deliver in terms of deficit reduction.

Focusing on the UK: it seems to me there's room to be a bit more aggressive on overall taxation levels and certainly opportunities to spread some of the pain away from the poorest in society; in return it looks like we could let our belt out a notch on expenditure to drive economic growth through investment.  Of course that - at its simplest - was the Labour Party's economic strategy going in to the last General Election.

Funnily enough it's also pretty much what the SNP's published economic strategy was too. Analysis by the IFS showed they basically matched Labour's more relaxed spending plans ...

... but (despite their cries of "social justice") were less willing to use tax increases as an economic lever.

Of course the SNP's rhetoric was that they were the only anti-austerity party⁶.  The IFS showed - and anybody paying attention already knew - the easy sound-bites were not supported by published policies.  So next time somebody tells you they're against austerity, maybe ask them what they actually mean by that.

It strikes me that being against austerity is like being against surgery: it's unpleasant, you only do it if you have to and there are a wide range of different procedures to choose from.  Not all cuts are the same.

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Footnotes

1. As explained at least in part by Eurostat (Impact of support for financial institutions on government deficitsImpact of support for financial institutions on government deficits) bank capital injections were largely treated as "deficit increasing capital transfers (government expenditure)" and had a big impact on Euro Area Expenditure in 2010 and 2012 - these were calculated to increase Euro Area deficit by about 0.5% of GDP in each of those years and given spend/GDP is <50%, the direct  impact of the bailouts would only be about 2 index points on the Euro Area spending line. The impact in Ireland was much larger (20% of GDP in 2010) and was significant in Greece and Spain in (3 - 4%of GDP 2012).

2. This this makes up about 90% of the total government revenue for the UK and Euro Area, about 83% in the US.

3. Oil revenues went from 2.3% of UK revenue in 08-09 to 0.8% in 13-14 (per HMRC/GERS) so that would only explain roughly 1.5 points of index movement

4. It breaks down like this:

  -  Revenue/GDP  = (Tax burden/GDP + other revenues/GDP*) 

  -  Spend/GDP = (Spend.GDP + interest/GDP**)

  -  Deficit/GDP = Revenue/GDP - Spend/GDP

* In the UK these are fairly consistently about 4% or GDP, in the US 6-7% -- I've not dug into detail but I presume they include Gross Operating Surplus of state owned assets and proceeds from asset sales

** In the UK this was 2.0% of GDP in 2006, 2.7% in 2014

5. An annoying definitional idiosyncracy: Public deficit/surplus is defined in the Maastricht Treaty as general government net borrowing/lending according to the European System of Accounts (ESA95) - to all intents and purposes this means that we can treat "net borrowing/lending" as the same thing as "deficit". I've checked and the figures do indeed reconcile closely with the figures you'll find elsewhere n this blog using UK Government and GERS figures.

6. "48 Hours To End Austerity: SNP MPs will vote for an end to austerity and against Labour or Tory cuts"

Let's Talk About Growth

Watching the latest round of SNP politicians' media interviews (and hearing the echoes on social media) it's clear they're working off a crib-sheet that reads something like this;

If Scotland was able to run its own affairs - if we had control over the levers of growth - then we would grow our way out of the £8bn black-hole that we keep being told about. It might be true that Full Fiscal Autonomy now would be "tantamount to economic suicide" (SNP MP George Kerevan) - would be "a disaster" (SNP MP Tommy Sheppard) - but it's still a sensible medium term aim.

Saying we'd have an £8bn deficit as if that's something we'd have to get rid of overnight when all countries (including the UK) run deficits is simply scaremongering. Anyway these figures are all hugely uncertain and based on assumptions that the SNP don't necessarily agree with ... and who would argue that Scots wouldn't be better at running our own affairs than Westminster Tories?

If I could be bothered I could find plenty of direct quotes (from the likes of Stewart Hosie and Pete Wishart) to back me up on this - but I think most will agree this fairly paraphrases the SNP line at the moment.

So let's unpick it.


"We would grow our way out of the £8bn black-hole if we had full powers"

Putting aside the obvious point that the SNP have yet to make any concrete policy proposals that would lead us to believe that they would somehow achieve this superior growth, let's just concentrate on the magnitude of the challenge.

The numbers are easy: Scotland generates £50bn of onshore tax revenue, so to increase that by £8bn means growing it by 16%.  If we're to make this additional tax revenue through economic growth (as opposed to through increasing tax rates) then we'd need to grow GDP by 16%.  [For those who care about such things, Scottish onshore tax generation consistently runs at about 37% of GDP].

It's important to understand that this growth needs to be growth relative to the rest of the UK because that £8bn figure is the deficit gap (on which more later). It's what we need to generate to be paying our way within the UK, for us to be making Full Fiscal Autonomy work. See my post Full Fiscal Autonomy for Dummies if you need convincing.

To get an indication of the scale of this challenge we need look no further than the Scottish Government's own White Paper: Scotland's Future: Your Guide to an Independent Scotland. As you might expect they had a go at scaling how much faster an independent Scotland might grow when no longer shackled to the UK. In fact they were so pleased with their analysis that they quoted it five times (pp 23, 43, 88, 375, 619). Here's the wording from page 23;

"Similar countries to Scotland have seen higher levels of economic growth over the past generation. That is because they have the bonus of being independent and are able to make the right choices for their nation and economy. If Scotland had matched the levels of growth of these other independent nations between 1977 and 2007, GDP per head in Scotland would now be 3.8 per cent higher"

I think we can safely assume that the countries and timescale used were selected to make the strongest possible case - after all, why stop at 2007 when more recent data was available? - and just in case you doubt if that is a cumulative 30 year figure, it's clarified on page 619:

"The average rate among small European countries was 2.61%, a gap of 0.12% each year. Over a 30 year period the compounded effect of this gap totals 3.8% of GDP"

So the Scottish Government's own attempt at scaling the economic growth benefits that "the bonus of being independent" might bring was 3.8% over 30 years. We're looking for 16.0% to grow our way out of the deficit gap. As one of my erstwhile American colleagues used to say: you do the math.

Frankly I could stop here. The assumptions required for the SNP's "levers of growth" argument to work are exposed as ludicrous by their own analysis.  But I'll carry on because this SNP Hydra has many heads ...


"The IFS say we'd have an £8bn deficit"

The £8bn (or £7.6bn) is consistently referred to by the SNP as the IFS forecast of Scotland's deficit. This is simply untrue.

I've blogged about this before and this simple table summarises the key figures

Scotland's deficit in 2013-14 per Scottish Government's own GERS analysis is £12.4bn and is forecast by the IFS to be £14.2bn in 2015-16. This is the net result of (largely know) oil revenue declines offsetting expected deficit reductions (as a result of UK-wide policies).

It shouldn't be beyond the wit of any half-decent politician to understand and remember these figures. If they're going to engage in this debate they really should know what Scotland's deficit is. If they're going to write a press release about it surely it would unforgivable to get this basic fact wrong?

Well here's the SNP's official press release (posted on Thursday 11/06 at 07:44) which includes these words:

"The IFS figures they cite suggest that Scotland would have a deficit of £7.6 billion in 2015-16. But over the five years to 2013-14, the UK’s cumulative deficit has been worth over £600 billion."

I (and many others I'm sure) jumped on this howler within minutes - the BBC picked up on it and contacted the SNP for a statement (see at 22:30 in this broadcast of BBC R4's More or Less) and yet still (13:50 on Saturday as I'm writing) the Press Release sits there uncorrected.

There are only two possible explanations for the SNP and their spokespeople making and repeating this error: either they don’t even know what our deficit is or they know full well but think they can get away with simply lying about it. I don’t know if they’re insulting our intelligence and actively trying to deceive the electorate or they’re just spectacularly incompetent. These are the people negotiating Scotland's economic future - god help us.

To compare this (wrong) annual figure with the cumulative 5 year UK figure really is so obviously ridiculous that I'll treat it as an aside.

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For fun let's work out the scale of this misrepresentation of data

1. Using the £7.6bn increase instead of the £14.2bn total is a 1.9-fold misrepresentation
2. Comparing a single year with a five year total figure is obviously a 5-fold misrepresentation
3. Comparing an absolute number spread across the whole of the UK with an absolute number shared across just 8.3% of the UK’s population is a 12-fold misrepresentation
4. Comparing UK figures from the past (when the deficit was worse) with a Scottish figure for the future (when the onshore deficit is forecast to decrease) is – as it happens -  a 1.6-fold misrepresentation

So that’s 1.9 x 5 x 12 x 1.6 = a 185-fold misrepresentation. Bravo!

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Of course the right comparison to make is that Scotland's deficit is forecast to be 8.6% of GDP compared to 4.0% for the UK: so more than twice as bad.


"Suggesting we'd have to get rid of the deficit overnight when all countries (including the UK) run deficits is simply scaremongering"

Under FFA we would still be sharing a currency and a national debt with the rest of the UK, so to be be paying our way we would simply need to be (over a sensible period of time) running a deficit at a similar rate to the rest of the UK. That's what the £8bn defines - the amount we'd need to find from more taxes or less spending to be holding our own within the UK.  If you like: it's the amount we'd need to find to get back to the position we're in now by pooling and sharing within the UK.

Nobody's saying that under FFA Scotland would have to eliminate its deficit.

As for "all countries run a deficit" - no they don't. To put it simply: those running deficits borrow their money from those running surpluses.   It's been pointed out this is an over-simplification which I'm happy to accept - suffice to say there are plenty of countries who run surpluses from time to time


As for "we'd have a deficit but so do lots of European countries" - it's rather silly to talk about having a deficit as if it's a binary thing (you either have one or you don't). Clearly the scale of the deficit matters, so let's put that forecast deficit of 8.6% in context.

The graph below shows European Commission data on net lending / (borrowing) by country as a percentage of GDP in 2015;

Stop drooling over Norway; it's unseemly.

I confess I'm not sure how Norway's sovereign wealth fund plays in these figures (although it's clear in 2014 Norway was running a considerable surplus) - but for other countries this is basically the same as surplus/(deficit).

Let's repeat the graph without Norway (just so it's easier to read) and add a line at -3% (which the European Commission's Stability & Growth Pact defines as the threshold for "excessive" deficits).

I don't think anybody can seriously argue that Scotland running a deficit of 8.6% of GDP would be "just like other European countries running deficits".  Our deficit would be considerably worse than any other European country, worse than Croatia, Serbia and Montenegro.

This would need to be addressed and it could only be addressed by yet more borrowing (if Scotland's borrowing capacity would allow it), higher taxes or lower spending.  To imagine how this would be playing out had we voted Yes and been renegotiating our position within the EU - while grappling with currency issues, transition costs and business flight - is quite terrifying.


"These figures are all hugely uncertain"

Actually they're not really. All the IFS assumptions do is extend the consistent long-term relative onshore tax and spend generation levels and factor in the known impact of oil revenue declines.

Of course these figures don't reflect what actions a Scottish Government would take if given FFA. That's precisely the point: maintaining the tax and spend status quo would be unsustainable under FFA. What we need to hear is how the SNP propose to close this gap. These analyses present the problem with FFA and - given they're the ones asking for it - it's right that the SNP should be asked to explain what their solution would be.

I think we've shown that just saying "we'll grow the economy" is not a good enough answer - so it becomes a question of which taxes will go up and which costs will be cut?  The SNP are very reluctant to answer this question.


"It's based on assumptions that the SNP don't necessarily agree with"

As we've seen the assumptions are hardly controversial and it is - as ever - really just all about oil. The latest OBR Fiscal Sustainability Report is very thorough on the topic. We can argue about future oil prices but two points are undeniable;

1. The profitability of North Sea production is in long term decline due to rising costs, not just falling oil prices.
2. The decline of North Sea production is not a surprise - it's been forecast for years, the only question has ever been one of timing

Unfortunately during the independence referendum it appears summit fever led the SNP to present hopelessly optimistic forecasts; they've not been too keen on producing forecasts since. But if they don't like the OBR and IFS forecasts, they really need to show us some of their own.


"Who would argue that Scots wouldn't be better at running our own affairs than Westminster Tories?"

This is always the payoff. When all else fails (and it does) accuse those who argue against FFA of talking down Scotland, of suggesting Scot's aren't capable.

It's true that the SNP seem hell-bent on demonstrating that they don't understand Scotland's economy, but let's not make the mistake of conflating the SNP's leaders with the Scots people.

The question is not one of competence or who happens to be in power in Westminster right now. It's about understanding and valuing the benefits of UK wide pooling and sharing. FFA means sacrificing that and for some of us that seems like a wildly reckless and self-destructive act.

The Great Escape

I'm just back from one of my regular business trips to China. These trips always provide a refreshing sense of perspective on the political and economic debates we have in the UK.

Based on my experiences on this trip I'm keen to write about democracy and state control of media.  I have a draft blog written about how even the structure of the Chinese language impacts the way we should think about our business and social interactions with Chinese business partners, colleagues and friends.

But these blog posts will have to wait, because today I feel compelled to focus on one topic: economic growth.

I return home to read of a predicted Scottish landslide for the SNP at next week's General election. If this happens (and it seems clear it will) this will be the greatest escape since ... well most of them didn't escape in The Great Escape but I'm too jet-lagged to think of an alternative analogy.  Let's just say it will be a great escape.

Since the referendum the publication of two sets of Scottish national accounts ("GERS") and the focus on the economic realities of Full Fiscal Autonomy (FFA) should really have nailed the SNP's economic nonsense once and for all.

I make no apologies for repeating this graph of the Scottish Government's own GERS data because it powerfully illustrates this point.

Without oil we consistently run a long-term onshore deficit gap to the rest of the UK of about £9bn. We are currently shielded from that by pooling and sharing with the rest of the UK - Scotland does not "suffer" this deficit gap currently.

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As an aside: some people react to this graph and say it's "just a snapshot". Below I have removed the most recent two years' data and highlighted the "snapshot" 5 years that were used for the Independence White paper. The Yes campaign used this period to justify their "we're independently fiscally as strong as rUK" rhetoric, long after more recent data became available.

Now *that's* what I would call taking a misleading snapshot.  To point out - as many of us did - that the figures actually showed how exposed Scotland's economy was to volatile oil income was dismissed as "talking Scotland down" or "suggesting oil is not an asset". Infuriating.

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So might oil come to our rescue?  This seems highly unlikely - not because the oil price will never recover but because their is an underlying decline in North Sea profitability due to rising extraction costs.  It's profit that get's taxed - so the North Sea tax yield has been deteriorating independently of the oil price decline.  Few people seem to understand this graph but I'll repeat it anyway - the black line shows the actual historic amount of North Sea tax generated for every $ of oil price.  The line declining shows the declining tax yield.  Contrast that with the red line showing the oil price and you should see my point.

It's quite possible therefore that North Sea oil revenues are in terminal decline. At the very least we are seeing a stark illustration of the fact that they cannot be relied upon as the basis for an independent Scottish economy. North Sea oil really does have to be considered as "just a bonus".

Faced with this harsh reality the SNP can no longer hope to deny the scale of the onshore deficit gap between us and the rest of the UK.

So back to this onshore (or "underlying") deficit gap. It's self evident that this gap is caused far more by higher spending on public services than by lower revenue generation.  Closing the gap by cutting public spending is the obvious easy fix (about 14% cuts across the board is all it would take) but hardly a vote winner so certainly not something the SNP would admit to contemplating. Raising tax rates wouldn't be a popular option either so the SNP are left grasping at the remaining straw left to them - they'll deliver "unprecedented" economic growth.

When asked quite how this will be delivered they reel off a series of tax cuts - cutting APD, reducing VAT on tourism and unspecified "targeted tax cuts to SME's".  In the short-term at least this would of course reduce the tax take and exacerbate the deficit problem but this is simply glossed over.  We're told we need to take a longer term view, look at the big picture, show some ambition and believe we'll grow our way out of this.

Let's put aside for a moment that there is little to suggest that the raft of tax cuts proposed would drive enough economic growth to offset their revenue reducing impact. Let's ignore the fact that if this strategy would work it would be as appropriate to the UK as a whole as it is to Scotland.  Let's run with the theory that the main Westminster parties are simply too stupid to realise that this political elixir is available to them.

Instead let's just ask three questions.

• How much economic growth would we need to close this deficit gap?
• How long would it take take to achieve that growth?
• What would we do in the meantime?
  

The "how much" question is easy to answer - we'd need to grow our onshore tax revenues by 16% over and above  the rest of the UK to close the gap. The SNP say they would cut taxes to achieve this growth which means our tax take as a percentage of GDP would decline. This means of course that we would need to see even higher than 16% relative GDP growth.

OK so what about how long?  I decided to search  the Independence White Paper for any indication of the growth levels that the SNP were aspiring to back then. After much trawling (head-shaking and teeth-grinding) all I could find was this gem on page 108:

If Scotland moved from the rates of growth it has experienced in the past to instead match the levels of growth of small European countries, the benefits for people in Scotland in terms of prosperity and employment would be significant. As an illustration, had growth in Scotland matched these other independent nations between 1977 and 2007, GDP per head would now be 3.8 per cent higher

So the illustration they chose to demonstrate the sort of difference we could expect to see from independence was 3.8% higher GDP growth over a 30 year period.

At that rate of relative economic growth it would take us about 120 years to close the gap.

I think it's reasonable to conclude that the SNP's claims that growth alone will address the onshore deficit gap fails this "sanity check" rather spectacularly.

So as we come to the third question: what would we do in the meantime?  There are limits to how far we can go with debt - I think I might have once heard some Nationalists suggesting the amount of debt we have now is too much - so the answer is extremely simple.  We'd have to dramatically reduce public spending.

The SNP campaign to scrap Trident but not to dramatically reduce the defence budget, they talk of "unfair cost allocations" without actually pointing to any material examples - and in fact they talk of increasing public spending (alongside reducing business taxes).

The SNP position is transparently, demonstrably, economically nonsensical - and yet a large proportion of the Scottish electorate appear to accept it.

The SNP know what they are doing of course.  Tell big simple lies and keep repeating them, offer the people a bogey-man to blame, sell the hope and ignore the reality. It is cynical, calculated political deceit.

What makes it worse is that the people who will suffer most if the SNP succeed are those to whom their messages appeal most; the worst off in our society.

It appears the scale of the SNP's deception may only be realised by the Scottish people when it's too late to do anything about it.  Of course by then the SNP aim to have broken up the BBC and to have their own state-controlled media in place.  Having just emerged from a week behind the Great Firewall of China, I have some perspective on the potential for politicians to exert influence over the masses through media control - but that is a topic for another day.

Oil Price and Scottish Tax Generation

It's highly frustrating when the debate on Scotland's economy is reduced to a simplistic "when the oil price recovers we'll be fine".

Take this example from Gordon McIntyre-Kemp of "Business for Scotland" (who have given up any pretence of being anything other than SNP cheerleaders as evidenced in detail here);

Labour are feverishly promoting the £7.6bn black hole scare-story to put people off FFA but it’s a myth; firstly because it assumes oil prices won’t ever recover, and even a moderate increase to $70/80 would wipe out any additional deficit.

This is nonsense.

First of all let's look at recent history.  In 2014 the average oil price was $99 and Scotland generated £2.6bn of North Sea tax revenue.  That's £2bn more than the £0.6bn assumed in the IFS forecast that leads to their £7.6bn "black-hole".  So based on recent history a $99 oil price fills about a only quarter of the back hole, leaves us still with over £5.6bn to find.

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As an aside: if you doubt the existence of the black-hole I suggest you read Full Fiscal Autonomy for Dummies which explains that the black-hole is a long-term structural deficit difference that is simply revealed by falling oil revenues

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Secondly let's consider whether there might be more to our North Sea tax revenue generation than just the oil price.  Of course there is;  it's profit that gets taxed which means tax revenue generation is a function of  [production volume] x [profitability] x [tax rates].

First let's look at (inflation adjusted) North Sea oil tax revenues and oil price on the same chart

Notice how there's a clear relationship but particularly in recent years the revenue line declined even when the oil price held up?

Take a few seconds to think about the following graph because it tells us an awful lot. I've plotted the ratio between the two lines; the ratio of N Sea oil revenue generated (£m) to the average $ oil price in that year. So what we're able to observe here is the real terms relationship over time between $ oil price and actual Scottish tax revenue generated - it's a measure of North Sea oil's tax generation productivity

Is it just me or can you see a trend emerging here?

We shouldn't be surprised by this. As the most economically attractive reserves become depleted production moves to less economically attractive ones - profit per barrel reduces even if the $ oil price doesn't move. Combine that with production volume declines and reductions in tax rates to protect the viability of North Sea activity (and jobs) and you'd expect to see exactly what we can empirically observe; we get less bang for the oil price buck over time.

To quote Oil & Gas UK

After more than a decade of spiralling costs, over-taxation and weak regulation, the UK offshore oil and gas industry is now bottom of the league in terms of the cost of producing a barrel of oil and gas.  The UK’s difficulties have been greatly exacerbated by the sudden drop in oil price but it would be a grave mistake to believe that the price fall is the cause of the problem.  A recovery in the price, even to $100 per barrel, would not resolve matters

This might be forcing the data a little -  but based on the trend line above it would seem reasonable to suggest £40m/$ is an optimistic forward assumption (the last three years have been 44, 26 and 13 respectively).  To get the £8.2bn oil revenue we'd need (the £0.6bn the IFS already forecast + the £7.6bn "black-hole") we'd need an oil price of 8,200/40 = $205.

This is clearly an extremely crude (ahem) analysis but I think my point is made; to suggest all will be well for an FFA Scotland if the oil price just recovers to $70/80 is just ridiculous.

In case you're thinking "what about exchange rates" or "is this maybe a function of absolute oil price" here's that same productivity graph with UK GDP inflation adjusted average oil price on it

As you can see the productivity decline has happened independent of whether the exchange rate adjusted oil price has been rising or falling - absolute oil price and exchange rate are not the tax productivity drivers.


***

I suppose I'd better address the other points that Gordon McIntyre-Kemp raises in that article. This won't take long.

Secondly FFA will give the Scottish Government powers to balance income and expenditure [...] FFA is the key to rapid economic growth and prosperity for Scotland. Here are five key ways Scottish FFA can balance the books, cut the deficit, raise revenues and create jobs

Sounds great doesn't it?  Gordon's found the silver-bullets that will fix our economic woes.

1. "Refocusing the Economy on SMEs"
Sounds reasonable. But don't all government's want a successful SME sector? What's Gordon's innovative idea? "Targeted tax incentives". Fair enough, tax cuts for SMEs might work - it's hardly ground-breaking but we've got another four ideas to go

2. "Targeted Tax Incentives"
Within this idea he goes on to explain that "SMEs hold the key to rapid economic growth".  So this is the same as number one really - tax cuts for SMEs. Maybe he was rushing when he wrote these.

3. "Increasing Research & Development". 
Sounds like a great idea. I mean there are plenty of incentives for this already like R&D tax credits and patent boxing but maybe Gordon's got a new idea. Guess what? It's "targeted tax incentives". This is getting a little silly

4. "Abolishing Air Passenger Duty"
This is a targeted tax incentive - reducing a guaranteed tax take in the hope of a net gain from boosting tourism. It might work - but of course the Smith Commission recommended that this tax be devolved anyway so we'll find out soon enough; no need for FFA.

5. "Reducing VAT on Tourism"
Well this a targeted tax incentive too. We lose a guaranteed tax take through VAT on tourism in the hope that the economy net gains from the boost in tourism that could result.

I'm afraid that's it.  It's basically one idea; reduce taxes in the hope the net effect will be beneficial to the economy.

Now I'm not saying that isn't a chance that some business and consumer tax reductions could result in net economic improvement. They might be beneficial or they might be detrimental, it's a tough call. Not for our Gordon though. He concludes - with the spectacular confidence that comes from knowing you'll never be held to account -

If Scotland had FFA we would have the power to do all of the above and grow our economy at unprecedented rates, thus demonstrating conclusively that Scotland would be better off as an independent partner to the other countries of these isles but worse off by remaining a devo-lite region without fiscal autonomy. 

Gosh.

Would grow our economy at "unprecedented" rates - so by definition at rate that have never been known before.  Just by reducing some taxes.  There will be finance ministers all over Europe kicking themselves that they hadn't thought of this. "Thus demonstrating conclusively" - he's hypothesised an outcome which he admits would be unprecedented and continues as if he's proven something. Extraordinary.

There's more

Just the few policies highlighted above would make 5% growth attainable for Scotland 

Well he plucked that number out of his nether regions didn't he?

You'll forgive me if I don't waste more of my time on this - if you believe that some tax reductions will deliver 5% growth because Gordon says so then I'm afraid you're beyond my reach.

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.


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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)