SCOTLAND S FISCAL DEFICIT

SCOTLAND S FISCAL DEFICIT or THE ELEPHANT IN THE ROOM SUMMARY REPORT 11th April 2016 1

Chart 1 25 SUMMARY Scotland's deficit billions 20 15 20 13 19 19 14 17 13 17 15 15 15 10 10 9 7 5 5 4 2 0 0 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16* *Author s Forecast On shore de3icit Oil income Net de3icit Scotland has two measured economies offshore (taxes on North Sea Oil profits) and onshore (everything else). Both are in serious trouble with oil taxes approaching zero and the onshore economy in chronic, unsustainable deficit. When devolved matters are dealt with by Scotland s Parliament and Government, huge attention is paid to the smallest detail of income and expense and to tight budgetary control and rightly so. But the onshore deficit, where many billions of pounds are involved, is ignored. It is as though the deficit is unreal that, if we close our eyes tight shut and wish very hard, it will go away all by itself. There is a great deal of debate amongst Scotland s politicians about how increased taxes could provide better public services. There appears to be no debate at all about how the deficit could be brought under control. But the deficit won t go away by itself and it is a very real problem. Scotland does not raise nearly enough in tax to pay for its public services. This is not sustainable without external funding. This is the elephant in the room. Lots of countries have deficits but they don t have elephants. Scotland does. And no matter how it arose only the Scottish Government can develop a strategy to deal with it. No matter who forms the next Scottish administration this needs to be an urgent and central priority. The purpose of this paper is to contribute to a debate on the deficit by analysing the performance of the Scottish economy using data from official Government sources and providing an audit trail back to source. It is intended to make regular updates as further data becomes available. This is a summary version. If more information is needed the detailed version or supporting spreadsheets may help. 2

CONTENTS Page 1 MAIN CONCLUSIONS 2 DEFINITIONS 3 NORTH SEA OIL AND SCOTLAND S ECONOMY 4 SCOTLAND S DEFICIT AND EUROPE 5 SCOTLAND S DEFICIT AND THE UK 6 SCOTLAND v THE ROUK THE ONSHORE DEFICIT GAP 7 THE 10 BILLION DEFICIT GAP WITH THE ROUK: PART ONE 8 THE 10 BILLION DEFICIT GAP WITH THE ROUK: PART TWO 9 EXPLAINING THE REST OF THE DEFICIT 10 THE FUTURE 11 THE NEED FOR BETTER PLANNING, INFORMATION AND SCRUTINY 4 5 5 6 7 8 11 10 12 13 14 3

1 MAIN CONCLUSIONS On the basis of current forecasts, for the foreseeable future North Sea Oil will make no material contribution to Scotland s economy. Scotland s total fiscal deficit was 15 billion in 2014-15. This is likely to be repeated in 2015-16. This is equivalent to around 10% of GDP. On the latest available information this would be by some margin the worst in Europe. Scotland s total economy is significantly weaker than the UK as a whole. Scotland makes up just over 8% of the UK population but accounted for over 16% of the UK deficit in 2014-15. In 2015-16 it is likely to account for over 20%. Scotland s onshore deficit in 2014-15 was 17 billion. It is likely to improve to around 15 billion in 2015-16. Of the 17 billon onshore deficit around 7 billion is due to Scotland being tied closely to the economic cycle of the UK. As the UK economy improves so this element will shrink. The other 10 billion is due to Scotland s onshore economy being much weaker than the rest of the UK (ROUK). This is long term and mainly structural. Of this 10 billion around 2 billion is due to lower per capita income and 8 billion to higher per capita expenditure compared with the ROUK. The 2 billion income gap is mainly due to weakness in income tax. This is caused by Scotland having proportionally fewer top rate income taxpayers than the ROUK with lower average incomes. If Scotland matched the ROUK profile for top rate taxpayers it would grow total income by over 2 billion. Increasing taxes on this group of people is not an obvious way to encourage it to grow and is unlikely to make a material impact on the deficit. Moving the top rate to 60% for example is estimated to yield less than 300 million a year. This is 3% of the deficit gap with the ROUK. If the increase in tax rate caused taxpayer flight it could be very much less. The 8 billion expenditure gap is a direct result of the long term application of the Barnett Formula. This has supported public services in Scotland for many years but as a consequence it is the biggest single element in Scotland s deficit and the biggest single obstacle in the way of resolving it. This is the fundamental dilemma facing the Scottish economy. Scotland needs better, more frequent and independent information on its overall economic performance and in particular on its deficit. There is a clear need for a Scottish equivalent of the UK OBR with a much broader remit than that of the Scottish Fiscal Commission, even as now envisaged. Even more, Scotland needs a government strategy which acknowledges the problem and sets out to deal with it. The numbers are very big and no easy solutions will present themselves. It is a problem which has been long in building and it will take many years to resolve. 4

2 DEFINITIONS NFB is Net Fiscal Balance and is the difference between total government revenues and expenditure including capital expenditure. A deficit is when expenditure is greater than income over a year. Debt is an accumulation of deficits. GDP is Gross Domestic Product and is the monetary value of all finished goods and services. 3 NORTH SEA OIL AND SCOTLAND S ECONOMY Because of the fall in oil prices Scotland s geographic share of North Sea oil revenues has collapsed. Chart 2 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0-2.0 1998-99 1999-00 2000-01 2001-02 Scotland geographic share of oil revenues billion 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2021-21 No income from North Sea oil taxes is expected over at least the next 5 years. We need to understand Scotland s onshore economy and to regard oil as an add-on to the onshore economy rather than an essential cornerstone. 5

4 SCOTLAND S DEFICT AND EUROPE How Scotland s deficit has evolved over the last 17 years including and excluding oil. The graphs show the value of Scotland s deficit in billions and what it represents as a % of GDP. Chart 3 0 Scotland's NFB deficit billion - 5-10 - 15-20 Including oil Excluding oil - 25 Chart 4 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 0.0% - 2.0% - 4.0% - 6.0% - 8.0% - 10.0% - 12.0% - 14.0% - 16.0% Scotland NFB deficit as % of GDP 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 Including oil Excluding oil Total Economy (including Oil) It can be seen that the deficits go back well before the recession began in 2008-09. In 1999 the total deficit including oil was around 2 billion (3% of GDP). In the most recent year it was nearly 15 billion (10% of GDP) a growth of 13 billion or 7 percentage points over the last 16 years. This would be by some margin the worst in Europe. The deficit is sustainable only due to funding from the rest of the UK. Onshore economy (excluding oil) The excluding oil lines in charts 3 and 4 show the deficit in the onshore economy has grown from 4 billion in 1999 (5% of GDP) to 17 billion (11% of GDP) in 2015 - a growth of 13 billion or 6 percentage points. Given the lack of oil income anticipated in coming years, understanding how the onshore deficit has arisen is essential in planning how to deal with it. 6

5 SCOTLAND S DEFICIT AND THE UK Scotland s onshore economy has a major deficit problem. It is also substantially weaker than the UK as a whole. Scotland V UK Scotland's share of UK NFB and UK population over 1 year 5 years 10 years 17 years 2014-15 2011-2015 2006-2015 1999-2015 Table 3 % % % % NFB share total economy 16.8% 11.6% 10.3% 11.8% NFB share onshore economy 18.3% 15.7% 16.3% 19.2% Scotland's share of UK population 8.3% 8.3% 8.4% 8.4% This shows that over the last 1, 5,10 and 17 years, Scotland s share of the UK total deficit was higher than its population share and in 2014-15 was over double the UK s share. It could exceed 20% in the current year. Scotland s share of the UK onshore deficit has been consistently around twice that of its share of the UK population. Another way of looking at it is to compare Scotland s NFB deficit % of GDP with the UK s. Chart 5 6.0% 4.0% 2.0% 0.0% Scotland v UK NFB deficit gap as % of GDP - 2.0% - 4.0% Including oil Excluding oil - 6.0% - 8.0% The blue line shows that in its total economy (including oil) Scotland outperformed the UK in only 3 years out of the last 17. The red line shows the onshore economy (excluding oil) Scotland was consistently between 6 and 8 percentage points worse than the UK. Since the recession would have impacted roughly equally on Scotland and the rest of the UK (ROUK) it is unlikely to have had any material effect on the relative performances of the onshore economies (the red line). This line reflects real sustained structural weakness in Scotland s onshore economy relative to the UK. 7

Scotland s weaker numbers dilute the overall UK results of which Scotland is a part. To fully understand Scotland s relative onshore weakness we need to look at how Scotland compares with the ROUK. The rest of this paper will focus on the onshore economies of Scotland and the ROUK. 6 SCOTLAND v THE ROUK THE ONSHORE DEFICIT GAP How Scotland s onshore NFB deficit has evolved in comparison with the ROUK. Chart 6 5.0% Scotland and ROUK onshore NFB as % of GDP 0.0% - 5.0% - 10.0% - 15.0% ROUK Scotland - 20.0% The chart confirms that Scotland s onshore economy has been significantly further in deficit that the ROUK since at least 1999. It also shows that Scotland and the ROUK share very similar trends in depression and recovery. This is perhaps not surprising since the two economies are closely integrated in trade and government. It is probably true to say that irrespective of government this linkage would continue and, to adapt the old adage, if the ROUK catches cold Scotland sneezes. Chart 7 0.0% Scotland v ROUK onshore deficit gap in % points - 2.0% - 4.0% - 6.0% - 8.0% - 10.0% The gap has stayed between 6 and 8 percentage points over a 17 year period. 8

If we take this deficit percentage gap between Scotland and the ROUK and apply it to Scotland s onshore GDP it gives a cash value of the difference the amount in billions by which Scotland s onshore economy is weaker each year than the ROUK and by which it would have to improve through lower expenditure and / or higher income to achieve ROUK deficit levels. The next chart takes the last chart and adds a line for this cash value gap (red values on the billions scale are minus numbers) Chart 8 Scotland v ROUK deficit gap in % points and billions 0.0% - 1.0% - 2.0% - 3.0% - 4.0% - 5.0% - 6.0% - 7.0% - 8.0% - 9.0% 12 10 8 6 4 2 0 billions The value gap has doubled since 1999 from around 5 billion to 10 billion a year. What caused the gap with the ROUK to grow to 10 billion and what caused the other 7 billion of the 17 billion onshore deficit in 2014-15? To answer these questions we need to look in more detail at how the gap with the ROUK is made up. 7 THE 10 BILLION DEFICIT GAP WITH THE ROUK: PART ONE How Scotland s onshore deficit gap with the ROUK evolved over the last 17 years. Scotland can be compared with the ROUK by looking at per capita amounts for income and expenditure. Here is the comparison for 2014-15 set out this way. 2014-15 Onshore comparison Scotland v ROUK Table 4 Scotland ROUK Scotland v UK Per capita % Revenue (ex oil) 9667 10016 349 97% Expenditure 12800 11274 1526 114% NFB -3133-1258 1875 249% Scotland s per capita income levels are 349 less than the ROUK or 97% of UK levels 3% lower. Expenditure is 1,526 higher - 14% higher The net onshore deficit is 3133 per person in Scotland compared with the ROUK s 1,258 two and a half times higher. 9

The evolution of this over the last 17 years can be seen in the following graph. Chart 9 0-200 - 400-600 - 800-1000 - 1200-1400 - 1600-1800 - 2000 1998-99 1999-00 2000-01 2001-02 2002-03 Onshore comparison Scotland v ROUK per capita 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 Lower Income Higher expenditure NFB de3icit It can be seen that the difference in deficit per capita has grown due to the income gap staying relatively steady while the expenditure gap grew. The gap in income is largely due to Scotland being weak relative to the ROUK in income tax. This is because Scotland lacks high rate taxpayers and those it has have lower incomes than the ROUK. If Scotland matched the ROUK for these elements it would add around 2.5 billion a year to Scotland s income. Increasing taxes on this group of people is unlikely to make a material impact on the deficit. Moving the top rate to 60% for example is estimated to yield less than 300 million a year. This is 3% of the deficit gap with the ROUK. If the increase in tax rate caused taxpayer flight it could be very much less. There is a much more significant driver of the expenditure gap the Barnett Formula. This is a mechanism used by the UK Treasury to automatically adjust the amounts of public expenditure allocated to Northern Ireland, Scotland and Wales. This is largely what was responsible for the expenditure gap between Scotland and the ROUK in 1999 and it has driven its growth since then. What are these worth in total each year? 10

8 THE 10 BILLION DEFICIT GAP WITH THE ROUK PART TWO If the per capita differences between Scotland and the ROUK are multiplied by the Scottish population, total cash values of these differences are produced. These are the amounts by which Scotland s total income, expenditure and NFB deficit would change if Scotland achieved the same levels of income and expenditure per capita as the ROUK. For example 2014-15 2014-15 Scotland v ROUK Cash Values of Differences Difference Scottish A x B Per capita population Table 5 Millions bn Revenue (ex oil) 349 5.3 1.9 Expenditure 1526 5.3 8.2 NFB 1875 5.3 10.0 A In total the NFB difference of 1,875 per capita is equivalent to a gap of 10 billion. This is pretty much the number we were looking for. Of this total, just under 2 billion or 20% is due to Scotland s lower revenue and just over 8 billion or 80% to its higher expenditure. B This is how it grew. Chart 10 0-2 - 4-6 - 8-10 - 12 1998-99 1999-00 2000-01 2001-02 2002-03 Onshore Comparison Scotland v ROUK billions 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 income expenditure NFB de3icit Over the last 16 years growing differences in income and expenditure between Scotland and the UK have added about 5.5 billion to Scotland s NFB deficit. Around 0.5 billion or 10% of this is from income underperformance but the bulk of it just under 5 billion or 90% - is due to expenditure. We can directly link the growth in the deficit gap with the ROUK to per capita 11

differences in income and expenditure and the Barnett Formula. This chart picks up the comparison between the deficit gap and value gap evolution shown earlier (Chart 7) and adds on the value line produced from the per capita calculations Chart 11 Scotland v ROUK gap in % points and billions 0% - 1% - 2% - 3% - 4% - 5% - 6% - 7% - 8% - 9% 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 12 10 8 6 4 2 0 billions % Gap GDP values Per capita values There is a very good match between the two value lines. This seems to be good evidence that both the % deficit gap and the growth in the value of this gap between Scotland and the ROUK are largely caused by the Barnet formula. Scotland needs to find ways to fill this deficit gap. This does not mean that it needs exactly to match ROUK for income and expenditure per capita values. But it does need to find the money from some combination of income growth and / or expenditure reduction. It is the key task of a Scottish government economic recovery strategy to determine how. 9 EXPLAINING THE REST OF THE DEFICIT What caused the other 7 billion of the Scottish onshore deficit in 2014-15? The answer to the second question seems to be that it is an unavoidable consequence of Scotland s economy being closely integrated with its much larger neighbour the ROUK. As the ROUK moves into and out of recession Scotland is pulled along with it. Just as the UK is subject to world economic cycles, Scotland is subject to the ROUK s. At least in the short term and probably also in the long term Scotland probably can t do very much about this as the ROUK economy is too large for Scotland to influence and its economic cycles will dominate and drive Scotland s. The next chart shows how much each of these factors impacted on the history of the onshore deficit. 12

Chart 12 5.0 Scotland's onshore deficit history billions 0.0-5.0-10.0-15.0-20.0 Barnett gap Income gap UK driven - 25.0 In 1999 if Scotland had parity with the ROUK in per capita income and expenditure there would have been a modest surplus. Scotland was pulled into deficit by the existing effects of Barnett and relatively weak income. UK effects began to push the deficit from around 2003 and then more dramatically with the crash of 2008-09. The reason the onshore deficit is now improving is because Scotland is participating in the overall UK recovery. 10 THE FUTURE This is the author s forecast of how the pattern of the deficit will evolve over the next 6 years. It is based on the latest OBR forecast for the UK. Chart 13 5.0 0.0 Scotland's onshore deficit history and projection billions - 5.0-10.0-15.0-20.0 Barnett gap Income gap UK driven - 25.0 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 13

The push down effect of the UK economy will have gone by 2020-21 but Scotland will still be left with the effects of its own weakness relative to the ROUK and a probably onshore deficit of around 11 billion. It should also be borne in mind that although the UK economy is forecast to achieve a modest surplus its long term record in maintaining surpluses is very poor as this next chart shows. (from ONS November 2011 sheet 14 UK Long Term Deficit) Chart 14 4.0% UK NFB as % of GDP 2.0% 0.0% - 2.0% - 4.0% - 6.0% - 8.0% - 10.0% - 12.0% 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 As can be seen, years of surplus have been the exception rather than the rule. Without reduction of the gap with the ROUK any UK deficit will add to Scotland s deficit in the future as it has in the past. And unless there is a fundamental change in the UK economy history suggests that UK deficits will be the rule rather than the exception. It looks like the elephant is not going away anytime soon. 11 THE NEED FOR BETTER PLANNING, INFORMATION AND SCRUTINY The need for better planning and more independent information on and independent monitoring of Scotland s economy. Scotland lacks information on key financial data and a general lack of independent scrutiny of what it does publish. More importantly Scotland lacks regular, comprehensive and official reports on its overall economic and fiscal performance and in particular on forecast performance. If the deficit is to be tackled fixing this must be a key priority. The obvious remedy is to set up the Scottish Fiscal Commission as an OBR direct equivalent and give it powers and duties to produce regular and independent economic and fiscal independent updates on all key aspects of Scotland s economy. It is hoped that this paper provides evidence that such changes are urgently required. ENDS 14