1

SCOTLAND’S FISCAL DEFICIT

or

THE ELEPHANT IN THE ROOM

SUMMARYREPORT

May 2017 Update

2

SUMMARY Chart 1

*Author’s Forecast Scotland has two measured economies – offshore (potential taxes on North Sea Oil profits) and onshore (everything else). Both are in serious trouble with oil taxes having collapsed and the onshore economy in chronic, unsustainable deficit. If you want to know what Scotland’s onshore deficit is for any year it is really simple – just take the UK deficit as a % of GDP and add 6 percentage points – you won’t be far off the mark 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 it is unreal – that, if we close our eyes tight shut and wish very hard, it will go away all by itself. But Scotland does not raise nearly enough in tax to pay for its public services. This is not sustainable without external funding. For this, Scotland relies on subsidies from Westminster. Wishing the problem away will not make it happen. This is the elephant in the room. Lots of countries have deficits but they don’t have elephant sized ones. Scotland does. And no matter how it arose only the Scottish Government (SG) can develop a strategy to deal with it. 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 the first such update and sadly little has changed since the original paper in 2016. The deficit has not gone away and it is still being ignored. This is a summary version. If more information is needed the detailed version or supporting spreadsheets may help.

2018 19

17 1615 14

710

54

20 0

12

9

1413

14 15 14

0

5

10

15

20

25

2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 *

Scotland's deficit £ billions

Onshorede5icitOilincome

3

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

9

10

12

13

14

4

1 MAIN CONCLUSIONS

• Onthebasisofcurrentforecasts,fortheforeseeablefutureNorthSeaOilwillmakenomaterialcontributiontoScotland’seconomy.

• Scotland’stotalfiscaldeficitwas£14.8bnin2015-16.Thisislikelytoreducetoaround£14bnin2016-17butwillstillbeequivalentto9%oftotalGDP.OnthelatestavailableinformationthiswouldagainbetheworstinEurope.

• Scotland’stotaleconomyissignificantlyweakerthantheUKasawhole.Scotland

makesupjustover8%oftheUKpopulationbutaccountedfor20%oftheUKdeficitin2015-16.In2016-17itislikelytoaccountforover25%oftheUKdeficit.

• Scotland’sonshoredeficitin2015-16was£14.9bn.Itislikelytoreducetoaround

£14bnin2016-17.

• Ofthe£14.9bnonshoredeficit,around£5.5bnisduetoexternaleconomiccycles.AstheUK,EuropeanandWorldeconomiesimprovesothiselementwillshrink.Theother£9.4bnisduetoScotland’sonshoreeconomybeingmuchweakerthantherestoftheUK(ROUK).Thisislongtermandstructural.

• Ofthis£9.4bnaround£2.3bnisduetolowerpercapitaincomeand£7.1bnto

higherpercapitaexpenditurecomparedwiththeROUK.

• The£2.3bnincomegapismainlyduetoweaknessinincometax.ThisiscausedbyScotlandhavingproportionallyfewertoprateincometaxpayersthantheROUKwithloweraverageincomes.ItisridiculousthatthelastavailableanalysisofincometaxinScotlandbytaxbandisfortheyear2013-14.ThisshouldbeakeymetricoftheeffectofincometaxpolicyinScotland.

• The£7.1bnexpendituregapisadirectresultofthelongtermapplicationofthe

BarnettFormula.ThishassupportedpublicservicesatahigherlevelinScotlandthantheROUKformanyyears.AsaconsequenceitisthebiggestsingleelementinScotland’sdeficitandthebiggestobstacleinthewayofresolvingit.

• SimplydefendingsubsidiespaidtoScotlandwhilefailingtoevolveastrategyto

growtolivewithoutthemisdrivingthecountrytowardsafiscalcliffedge.

• Scotlandneedsbetter,morefrequentandindependentinformationonitsoveralleconomicperformanceandinparticularonitsdeficit.ThereisaclearneedforaScottishequivalentoftheUKOBRwithamuchbroaderremitthanthatoftheScottishFiscalCommission,evenasnowenvisaged.

• Evenmore,Scotlandneedsagovernmentstrategywhichacknowledgesthe

problemandsetsouttodealwithit.Thenumbersareverybigandnoeasysolutionswillpresentthemselves.Itisaproblemwhichhasbeenlonginbuildinganditwilltakemanyyearstoresolve.

5

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

No material income from North Sea oil taxes is expected over at least the next 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.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1998-9

1999-0

2000-0

2001-0

2002-0

2003-0

2004-0

2005-0

2006-0

2007-0

2008-0

2009-1

2010-1

2011-1

2012-1

2013-1

2014-1

2015-1

2016-1

2017-1

2018-1

2019-2

2020-2

2021-2

Scotland geographic share of oil revenues £ billion

6

4 SCOTLAND’S DEFICT AND EUROPE How Scotland’s deficit has evolved over the last 18 years including and excluding oil. The graphs show the value of Scotland’s deficit in £ billions and what it represents as a % of GDP including and excluding a geographic share of North Sea oil income:

Chart 3

Chart 4

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 £2bn (2% of GDP). In the most recent year it was nearly £15bn (9.5% of GDP) – a growth of £13 billion or 7 percentage points over the last 16 years. If Scotland had been an independent country its deficit would have been 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 £4bn in 1999 (5% of GDP) to £15bn (10% of GDP) in 2016 - a growth of £11bn or 5 percentage points. Given the low oil income anticipated in coming years, understanding how the onshore deficit has arisen is essential in planning how to deal with it.

-25

-20

-15

-10

-5

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

Scotland's NFB deficit £ billion

IncludingoilExcludingoil

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

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

Scotland NFB deficit as % of GDP

Includingoil

Excludingoil

7

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 18 years

2015-16 2012-16 2007-2016 1999-2016

Table 3 % % % %

NFB share total economy 20% 13% 11% 12%

NFB share onshore economy 20% 16% 16% 19%

Scotland's share of UK population 8% 8% 8% 8%

This shows that over the last 1, 5,10 and 18 years, Scotland’s share of the UK total deficit was higher than its population share and in 2015-16 was over double its share of the UK population. Scotland’s share of the UK deficit could exceed 25% in the current year and this proportion is only likely to grow. Another way of looking at it is to compare Scotland’s NFB deficit % of GDP with the UK’s. Chart 5

The blue line shows that in its total economy (including oil) Scotland outperformed the UK in only 5 years out of the last 18. The red line shows the onshore economy (excluding oil) Scotland was consistently around 6 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. 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.

-8.0%-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%

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

Scotland v UK NFB deficit gap as % of GDP

Includingoil

Excludingoil

8

6 SCOTLAND v THE ROUK – THE ONSHORE DEFICIT GAP How Scotland’s onshore NFB deficit has evolved in comparison with the ROUK. Chart 6

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. The next chart confirms the steadiness of the gap between the two economies Chart 7

The gap has stayed around 6 percentage points over an 18 year period. 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.

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%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

Scotland and ROUK onshore NFB as % of GDP

ROUK

Scotland

-8.0%

-6.0%

-4.0%

-2.0%

0.0% Scotland v ROUK onshore deficit gap in % points

9

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

The value gap has doubled since 1999 from around £5 billion to £10 billion a year. Of course if the deficit gap remains steady as a % of GDP and GDP grows then the absolute size of the deficit will grow too. But is it only growth in GDP which caused the gap with the ROUK to grow to £10bn and why should there be a gap in any case? 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 2015-16 set out this way.

2015-16 Onshore comparison Scotland v ROUK

Table 4 Scotland ROUK Scotland v UK

Per capita £ £ £ %

Revenue (ex oil) 9989 10425 436 96%

Expenditure 12759 11436 1323 112%

NFB -2771 -1011 1760 274%

• Scotland’s per capita income levels are £436 less than the ROUK or 96% of UK levels – 4% lower.

• Expenditure is £1,323 higher - 12% higher • The net onshore deficit is £2771 per person in Scotland compared with the

ROUK’s £1,011 – two and a half times higher. The evolution of this over the last 18 years can be seen in the following graph.

0

2

4

6

8

10

12

-8.0%-7.0%-6.0%-5.0%-4.0%-3.0%-2.0%-1.0%0.0%

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

£bn

Scotland v ROUK deficit gap in % points and £ billions

10

Chart 9

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. Increasingtaxesonthisgroupofpeopleisunlikelytomakeamaterialimpactonthedeficit.Movingthetoprateto60%forexampleisestimatedtoyieldlessthan£300millionayear.Thisis3%ofthedeficitgapwiththeROUK.Iftheincreaseintaxratecausedtaxpayerflightitcouldbeverymuchless. 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? 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 2015-16

-2000

-1500

-1000

-500

01998-99

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

Onshore comparison Scotland v ROUK £ per capita

LowerIncome

HigherexpenditureNFBde5icit

11

2015-16 Scotland v ROUK

Cash Values of Differences

Difference Scottish A x B

Per capita population

A B

Table 5 £ Millions £bn

Revenue (ex oil) 436 5.4 2.3

Expenditure 1323 5.4 7.1

NFB 1760 5.4 9.5 In total the NFB difference of £1,760 per capita is equivalent to a gap of £9.5 billion. This is pretty much the number we were looking for. Of this total, £2.3 billion or 25% is due to Scotland’s lower revenue and £7.1 billion or 75% to its higher expenditure. This is how it grew. Chart 10

Over the last 18 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 higher per capita expenditure. We can directly link the growth in the deficit gap with the ROUK to per capita 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

-10.0

-5.0

0.0

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

Onshore Comparison Scotland v ROUK £ per capita difference x Scotland population

£ Billion

income

expenditure

NFBde5icit

12

Chart 11

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 £5 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 – and the ROUK’s and Scotland’s own economies being subject to wider economic cycles in Europe and beyond. 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. The next chart shows how much each of these factors impacted on the history of the onshore deficit.

-8%-7%-6%-5%-4%-3%-2%-1%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

0

2

4

6

8

10

12

£bn

Scotland v ROUK gap in % points and £ billions

GDPvalues

Percapitavalues%Gap

13

Chart 12

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 may evolve over the next 6 years. It is based on the latest OBR forecast for the UK. Chart 13

Assuming Scotland matches UK projected (by the OBR) growth rates per capita in onshore income and in expenditure the evolution of the Scottish onshore economy over the next 6 years can be projected. In the above chart these projections have been added to the previous historical graph.

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0Scotland's onshore deficit history

£ billions

BarnettgapIncomegapResidue

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

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

2021-22

Scotland's onshore deficit history and projection £ billions

Barnettgap

Incomegap

Residue

14

The push down element of the external factors will have gone by 2021-22 but Scotland will still be left with the effects of its own weakness relative to the ROUK and a probably onshore deficit of around £14 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

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. 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

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

UK NFB as % of GDP