Home rule fiscal autonomy ‘doesn’t add up’

The news story in Scotland on Sunday about my article is here. The article itself does not appear to be on the Scotland on Sunday website yet, so here it is:

On March 9th the Scottish Government published a news release "Greater gains from more fiscal control" The release claimed that

" ... new Scottish Government analysis will demonstrate that if Scotland was able to retain and reinvest all the proceeds of improved economic performance, through holding greater economic powers, the overall positive impact on GDP, employment and tax revenue would be significantly increased."

This analysis presumably by government economists in the Office of the Chief Economic Adviser (OCEA) was first released on March 3rd as a simulation exercise demonstrating how improvements in Scottish total factor productivity, investment and export performance could boost GDP employment and tax revenue. The March 9th version includes additional analysis. It first rebrands the original March 3rd analysis as a 'first scenario' which

" ... reflects the situation under the Smith Commission powers where the majority of additional tax revenue generated by increased economic activity are retained by the UK Government and cannot be directly reinvested back into the Scottish economy."

The March 9th paper adds a 'second scenario' where

" .... all additional tax revenue generated by the expansion in the economy are assumed to be retained in Scotland and reinvested back into Scotland’s public finances and public services. This scenario is referred to in the paper as ‘Full Revenue Retention’”.

No technical paper has been released by the OCEA to explain the nature of the modelling underlying the analysis. So we are forced to guess.

In the absence of official information I suspect that the analysis has been produced by a Computer General Equilibrium (CGE) Model, which was originally developed by my colleagues in the Fraser of Allander Institute at the University of Strathclyde. The model was used in November 2011 to simulate the impact of a reduction in the corporation tax rate in Scotland. The model allows system-wide, or economy-wide, impacts of economic shocks/changes to be modelled and identified.

The OCEA and the Scottish Government should be applauded for using rigorous modelling to assess the impact of economic shocks such as policy changes. However, in this case the model has been used inappropriately to suggest political-economy outcomes that are fanciful and are lacking in economic rigour.

Let me explain.

What we can say is that the OCEA economists have brought together a general economic modelling approach with a very partial political-economy analysis.

First, in the March 3rd paper reference is made to the new Scottish Government Economic Strategy, which has the objectives of "achieving a productive, cohesive and fairer Scotland." It seeks to achieve this through desiring to boost investment, innovation, internationalisation, and inclusive growth.

Now since this is merely a wish-list the March 3rd paper simply offers an illustration of the consequences for Scottish GDP, employment and tax revenues of arbitrarily assumed small increases in total factor productivity, investment and exports. It is true that these increases relate in some sense to Scottish Government targets but as everyone knows you can have any target you like, the issue is how realistic is the target and the underlying policies adopted to achieve the targets. Not surprisingly the OCEA papers are silent on that. What must be understood at this stage is that simply having a target is obviously no guarantee of success.

Secondly, in the March 9th paper, the March 3rd analysis has become what the situation would be under Smith Commission powers as stated in the second quote above. It is not at all made clear how in the modelling the Smith Commission powers lead to an increase in productivity by 0.1% per annum over 10 years, a narrowing in the gap in investment between Scotland and its international peers, and boosting exports by 50%. This is simply assumed. There is no rigorous analysis of how policy gets productivity, investment and exports to rise. It is fanciful. It is surely not the job of the Government Economic Service in Scotland to simply and unquestioningly affirm the dreams of Government politicians.

Thirdly, and in many respects more damningly, the second scenario generates greater GDP, jobs and tax revenues because of the so-called ‘Full Revenue Retention’ concept, as all the tax revenues generated by growth are re-spent in Scotland, in contrast to the Smith Commission powers. Full Revenue Retention" presumably means what it says - that the Scottish government would retain all the revenue from Scottish taxation and use it to pay for the public services that Scotland receives. This is just another phrase for the idea of Full Fiscal Autonomy, which is now the policy of Ministers. It is wholly unrealistic to imagine a policy in which in addition to the Barnett formula the Scottish government also received any increases in Scottish tax yield.

So, the Scottish Government economists are in their second scenario effectively assuming full fiscal autonomy (FFA) plus Barnett. Yet, elementary political economy tells us that with FFA Barnett would be abolished and there would be no risk pooling or sharing of revenues between rest of the UK and Scotland.

I noted in my post this week on GERS 2013-14 that nearly £4 billion would be withdrawn, through higher taxes and lower public spending from the Scottish economy if Scotland had had FFA in 2013-14 and had run the same deficit as the UK. Why doesn't the OCEA include that in its analysis, or the even larger withdrawal of £6.6 billion estimated by the IFS for 2014-15 by the IFS? It is not as if it is rocket science.

On the Scottish Government website it states that one of the key aims of OCEA is to

" ... provide high-quality analytical support for Ministers and colleagues across the Government on all aspects of the Scottish economy and public finances."

Might I suggest that, on this occasion at least, that aim has not been met.