Devolution and Fiscal Policy

As I noted in my previous post, devolution can offer fiscal policy options that are just as credible as the policy mix that would be available under independence. And these options could be available without some of the costs of independence.

Let us be clear what I am talking about here when I refer to 'fiscal policy'. By fiscal policy I mean the use of variations in tax rates, tax bases, tax instruments, spending mix and spending levels to achieve economic policy objectives. These objectives can be stabilisation, growth and distribution. I focus on stabilisation here leaving growth and distribution for later posts.

The target of stabilisation is usually a level of GDP, and employment where there is no economically usable spare capacity in the economy. That is, where the output and unemployment gaps are small, or close to zero, and unemployment is almost wholly 'structural'. More technically the economy would be at the Non Accelerating Inflationary Rate of Unemployment (NAIRU), currently estimated in the UK to be around 5% of the workforce. Scotland's NAIRU should be similar.

It is broadly accepted by economists that in 'normal' times - i.e. when interest rates are not at a lower or zero bound - that a sovereign state with its own currency would tend to use monetary policy to meet its stabilisation objectives. However, when nominal interest rates are close to zero then monetary policy is much restricted and the burden of stabilisation as Simon Wren Lewis notes falls onto fiscal policy. Now for sovereign states and regions that are part of a monetary union the position is much the same. Monetary policy is not available at the level of the state or region. Fiscal policy becomes the only tool to realise stabilisation objectives.

Is there evidence that fiscal policy can influence the level of GDP at the individual state and regional level within a monetary union? The answer to this appears to be, yes. See this post and chart from Paul Krugman

The chart shows the relationship between changes in real government consumption and changes in real GDP as share of initial real GDP in eurozone states. Krugman acknowledges that for some states observed here the causation might run from GDP to government spending as a consequence of the credit crunch, but two conclusions would appear to follow.

First, the austerity view that cutting government spending raises GDP does not appear to be supported - note this graph does not show full fiscal changes because tax changes and transfer payments changes are not accommodated. Secondly, within a union and where states have a high degree of fiscal autonomy, the possibility of using fiscal policy to influence GDP change seems real.

What does this say about Scotland?

Well, first, it suggests that an independent Scotland as an accepted part of the UK sterling monetary union should be able to adopt a different fiscal policy stance to stabilise GDP than rUK. However, it also suggests that providing the degree of fiscal devolution is sufficient to allow changes in tax and spend that can influence aggregate demand then this option is also available within the UK political union. Further academic research is required on the appropriate form and degree of fiscal devolution for effective stabilisation but there is little doubt that stabilisation at the level of nations and regions within the UK is feasible.

Moreover, if an independent Scotland is part of the sterling monetary union the Bank of England and rUK government will almost certainly require that the Scottish government abide by a set of fiscal rules - see this earlier post. The fiscal framework could be little different under devolution from that under independence. Under devolution, Scotland could have a separate stabilisation policy as well as the benefits from the risk pooling arrangements e.g. social security, bank bailouts etc. that are available as part of the UK. It is true that the high levels of trade with the UK would make it difficult for fiscal policy to chart a radically different stabilisation path from rUK but that would apply to an independent Scotland too.

And the moral of this story?

Scotland does not have to accept a Tory-Lib Dem austerity policy. But it doesn't have to leave the UK political union to do so.

Comments

[Lulu]

Brian,

You talk about Scotland pursuing an independent fiscal policy, but what kind of fiscal policy initiatives would you advocate for? Considering the level of labor and capital mobility, to what extent do you see the stimulus being spent in other countries in either the monetary union or in Europe? And how do you perceive the effect of the additional debt for Scotland, especially since it has no sovereign control over its money supply? How do you think the threat of future taxes will impact economic activity today?

Your post actually inspired some musings on my part on what a devolved fiscal policy structure would look like in the United States. What I considered was that ricardian equivalence would force the subnational units to only pursue stimulus that could increase growth rates to justify the higher levels of future taxes. What are your thoughts on this?

http://synthenomics.blogspot.com/2012/04/fiscal-policy-in-monetary-union.html

[Brian Ashcroft]

You make some important points. A small open economy will have a small expenditure multiplier due to high leakages. I don't see that Scotland having a comparable debt level to the present UK is a problem per se. But it is more of a problem if an independent Scotland or a fiscally devolved Scotland has to pay a significant premium on its borrowings as California, for example, has to do compared to the US government. I don't believe in ricardian equivalence but even if you do, the likelihood of consumption smoothing suggests real short to medium term demand effects from a fiscal stimulus or contraction. So, a demand stimulus or contraction is still feasible and it is not just about promoting supply.