Every state with devolved institutions of government, redistributes revenues among subsidiary jurisdictions. These allocations promote equalisation of resources — taking money from places with a large tax base and giving to those with less taxable capacity. Or they recognise differences in needs: grants compensate poor or scattered regions for the extra costs of achieving levels of welfare or public service provision available elsewhere.
The financial arrangements between Scotland and the UK as a whole are not determined by either needs nor resources but by historic accident, based on a formula named for Joel Barnett, a Treasury minister in 1978.
The Barnett formula takes the level of public expenditure in Scotland in 1977 and adds annually a share, pro rata to population, of the additional expenditure in that year in England on functions devolved to Scotland. The base year was generous and Scotland’s population has since declined relative to England’s. The outcome has been a level of per capita public expenditure in Scotland between 10 and 15 per cent above English levels. This is not justified by reference to Scottish needs. Average incomes in Scotland are much the same as the rest of the UK and Scotland’s remote areas would justify only a more modest subsidy.
Yet retention of the Barnett formula was part of the “vow” made by UK party leaders in the panic preceding last September’s independence referendum. However, the devolution of income tax rates and bands to Scotland requires adjustments to the Barnett formula. The white paper published by the UK government on January 22, optimistically entitled “An Enduring Settlement”, begins to describe these adjustments.
The complex principle is this. First, you estimate what income tax would have raised in Scotland under the old rules. Then, since Holyrood now receives income tax receipts directly, you deduct this amount from the grant paid to Scotland by the UK government under the Barnett formula. In subsequent years, you make a similar deduction, indexed in line with the evolution of the tax base in the UK as a whole. Scotland therefore retains any extra revenue its tax policy generates.
But what if the rest of the UK changes its income tax structure? The paper recognises that this would require further adjustments to the Barnett formula but does not describe what they would be. This vagueness is probably deliberate. The requirement is that any increase or reduction in revenues from income tax outside Scotland will result in a proportionate reduction or increase in the grant to Scotland.
Suppose the rest of the UK cuts income tax and abolishes the National Health Service (health is a devolved function). The Barnett formula cuts the grant to Scotland in line with reduced expenditure in England. Unless compensated, Scotland cannot either maintain its health service or reduce its own income tax. If the UK increases expenditure on a reserved function — it declares war on the EU, say, and raises income tax outside Scotland to pay for it — then a corresponding amount must be deducted from the block grant. This cut forces Scotland either to implement a similar increase in its income tax or to make a compensating reduction in its non-military expenditure.
So even with income tax devolved, the Scottish government will be under fiscal pressure to match changes in tax elsewhere in the UK. Any action by the UK government that has tax or expenditure implications anywhere in the UK, whether related to reserved or devolved functions, will have consequences for tax and expenditure decisions in Scotland through the Barnett formula.
Lord Barnett, who died recently, hoped his funding mechanism would not be his legacy. But it is, and it taints any concept of “English votes for English laws”.
This article was first published in the Financial Times on February 11th, 2015.
