Scottish Economy Watch

Government economists and the Scottish Government

More on the Scotland on Sunday news story and my article, which is also included in my last post.

My paper criticises recent work by Scottish Government economists in the Office of the Chief Economic Adviser (OCEA), which purports to show that increased productivity, investment and exports will raise the growth of the Scottish economy and generate more tax revenues.

That is unexceptional.  

However, the March 3^rd paper, which accompanied the Government’s new Economic Strategy, has the implicit sub text that the new strategy will raise the rate of growth of productivity etc. The March 3^rd paper is careful to say that it is ‘illustrative’ but nowhere does the paper mention the difficulties of getting an effective growth policy, something that has eluded governments for years.

It is the March 9^th paper, which I find most troubling. This is essentially the March 3^rd paper with anther scenario added to the analysis contained in that paper which is branded the first scenario and called the Smith Commission Scenario. The second scenario is branded the Full Revenue Retention Scenario.

What I find particularly troubling with both scenarios is that they ignore the partial or complete loss of Barnett that would have to occur before either scenario could be implemented. The second scenario is simply full fiscal autonomy (FFA) in different words and so would only follow after the loss of Barnett.

In the Scotland on Sunday news story the Scottish Government responds with:

“Going forward, these figures illustrate once again the need for the Scottish Government to have full control of job-creating powers.”

I suspect what they mean with the phrase "Going forward" is that from an initial equilibrium state increased growth would generate more tax revenues for Scotland if Scotland had FFA.

But this is the wrong counterfactual.

The correct counterfactual must be taken into account, which is that in each period future public spending will be lower in Scotland because of the loss of Barnett. The counterfactual used in the OCEA model and in the quote above is that baseline public spending is unchanged. This would only be the correct counterfactual after FFA had been implemented and after the loss of Barnett.

However, given that we currently benefit from Barnett, to undertake an analysis which does not acknowledge this loss is partial at best and dishonest at worst.

I fear that this is a further example of the politicisation of the Scottish civil service. One would have expected in the past that the OCEA would have resisted pressure, had it occurred, to produce such a partial analysis.

This is an issue that clearly needs further discussion and debate.

 

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.

What GERS 2013-14 tells us

The latest Government Expenditure and Revenue Scotland (GERS) published today with data for 2013-14 is hardly a revelation. Scotland is shown to have a net fiscal deficit of -8.1% of GDP - when a geographical share of oil revenues is assigned to Scotland - while the UK deficit is -5.6%.

It is true that the data show that Scotland pays £400 more per head in tax revenues than the UK as a whole but it also enjoys greater public spending of £1,200 per head than the UK as a whole.

The absolute size of Scotland's estimated net fiscal deficit in 2013-14, at a time when oil prices - the principal driver of oil revenues - were almost twice as high as they are now, was £12.4 billion. This means that if Scotland had 'enjoyed' full-fiscal autonomy (FFA) in 2013-14 the Scottish Government would have had to fund that deficit by a mix of borrowing, higher taxes and lower public spending.

If we assume that under FFA Scotland could have been able to borrow to fund a deficit the equivalent of the UK's 5.6% - which would have been a tall order for a sub-state government, or an independent Scotland, at the same borrowing rate as the UK -  then a further £3.8 billion would have had to be funded by higher taxes and lower public spending.

Now we need to be clear about the significance of that.

£3.8 billion amounts to:

• half the cost of the Education & Training budget;
  
• one third of the Scottish Government health budget;
• one sixth of the £22 billion Social Protection Budget in Scotland;
• is 25% greater than the Scottish Government's Transport Budget;
• is 135% more than the Scottish Government's Housing and community amenities budget; and
• is 262% greater than the Scottish Government's Enterprise and Economic Development Budget.

So, it is not a trivial sum, to say the least.

And this greater Scottish deficit in 2013-14 is not a one-off phenomenon. The tables that can be downloaded from the Scottish Government's website to accompany the GERS publication provide runs of data back to 1998-99. The reason for doing this is that a new system of economic and government accounting has been adopted in the UK first and now in Scotland. This system, known as ESA 2010, along with some other revisions, have resulted in, quoting GERS 2013-14

"public revenue, expenditure, and GDP are higher than previously estimated. This has led to revisions to Scotland‟s fiscal aggregates in all years."

The graph below charts the new estimates of net fiscal balance from GERS from 1998-99 to 2013-14.

What is evident from the chart is that in only 4 of the 16 years was the net fiscal balance in Scotland better than in the UK. (I have included data labels only for the largest deficit, Scotland or UK in each of the years.)

What that means is that in 12 of the 16 years if Scotland had 'enjoyed' FFA it would have had to have higher taxes, lower public spending or both than the UK, assuming it was able to borrow to fund the same scale of deficit as the UK - a big ask as noted above.

Of course, the situation will almost certainly deteriorate further in the next fiscal year due to the halving of oil prices in 2014 and the possibility that oil prices may stay considerably lower than the Scottish Government's expected price of $110 per barrel for some time. 

Add declining oil production into the mix and we can reasonably ask: What price fiscal autonomy and what price independence?

 

 

Why we should be concerned about further planned austerity

In the latest Fraser Economic Commentary we discuss the threat to the Scottish and UK economies of the UK Coalition's current plans to increase the pace and scale of austerity  over the next 4 years.

The Institute for Fiscal Studies in their IFS Green Budget 2015 highlight the scale of the UK government’s recent and planned fiscal consolidation programme. The IFS analysis shows that by 2014 £110bn of fiscal tightening measures had been implemented. A further £92bn of fiscal tightening is currently planned. So, on this measure 55% of planned fiscal consolidation has been completed with 45% still to come.

Of the further planned fiscal tightening, a comparison of IMF forecasts for structural borrowing in 32 advanced economies shows that the UK has the largest planned fiscal consolidation between 2015 and 2019 and the 18th largest (or 15th smallest) planned structural deficit in 2019. Some £200 billion of fiscal tightening is nearly 13% of GDP.

If we assume a multiplier of 1.5 – not unreasonable when interest rates are close to zero and there is no scope for countervailing monetary policy - the policy would have served to have reduced GDP by 10% up to 2014 and by a further 9% by 2019.

This doesn’t mean that GDP will fall by 9% between now and 2019 but does imply that private sector output must rise by a substantial amount if GDP growth is to remain in positive territory. Specifically, if the economy is to grow at around 2.5% per annum then the underlying growth rate of the private sector in the face of such anticipated fiscal consolidation would need to be of the order of 4% per annum: a big challenge for the private sector.

The outcome will also be dependent on the result of the General Election in May 2015 because the Labour and Liberal Democrat parties are planning a slower pace of fiscal consolidation and a Conservative or indeed an unspecified Coalition government might alter the scale and pace of current plans or bias any consolidation more towards tax rises than via spending cuts, which could have a different impact on growth.

Why the fall in the price of oil could benefit the Scottish economy.

The underlying basis for the estimate in Fraser of Allander Institute's latest Economic Commentary that the fall in the price of oil could raise Scottish GDP growth is given in the box below:

Fraser Economic Commentary - March 2015

Our latest Economic Commentary, which was published today can be accessed here.

A summary of our findings and forecasts is provide below:

Overview

•  The Scottish and UK economies are now recovering at a reasonable rate from the greatest economic shock since the 1930s. This recovery, slowed by the UK Coalition Government’s austerity programme, has taken longer than from the 1930s Depression or any of the three other recessions experienced since the 1970s.
• But while growth is continuing, the pace of growth seemed to have slowed a little towards the end of 2014.
• The jobs market and unemployment have recovered more strongly than output, resulting in falling labour productivity and hence little improvement in real wages and real household incomes.
• Unemployment now stands at 5.4% in Scotland and 5.7% in UK.
• Despite the better headline unemployment figures in Scotland, there is still more ‘slack’ in the Scottish labour market than in the UK and so despite jobs growth there is little upward pressure on wages.

 

We ask: will the recovery continue? We identify several positive and negative influences that will impact on the pace of the recovery. We examine them under four headings: growth in markets; oil prices, inflation and deflation; UK fiscal and monetary policy; and Greece and the Eurozone.

 

Growth in markets

The key points here are:

• Despite the steady growth in world trade the latest IMF and OECD forecasts suggest a slowing in key countries and Scotland’s key export markets.
• The composition of Scottish and UK growth also continues to be unbalanced with household spending driving growth, and fixed investment making a variable contribution. 
• As we have stressed in recent Commentaries, household spending is being fuelled by rising debt, which is almost certainly unsustainable.
• If the economy is to rely on continued growth in household spending it requires a sustained rise in the real wages and incomes of households. However, this is unlikely to occur unless labour productivity improves, which has been badly hit as a consequence of the Great recession.

 

Oil prices, inflation and deflation

• Inflation is falling right across the global economy. There is a clearly a risk of deflation – a sustained falling price level, leading to expectations of further price falls, postponed spending and reduced spending as the real value of household and corporate debt rises.
• However, while the risk is there for the UK and the US, at this stage it is more apparent than real. Core inflation is around 1.6% in the US and close to 2% in the UK.
• The fall in oil prices has been large, around 50% at the time of writing, and the potential for a sizable boost to spending is significant with some respected analysts forecasting a 0.5% boost to UK GDP in 2015.
• I’ll discuss our estimates of the impact of this fall after Grant has spoken about some of the related issues

 

UK fiscal and monetary policy

• The base rate set by the Bank of England’s Monetary Policy Committee (MPC) is likely to remain at 0.5% for the remainder of this year. So monetary policy should remain accommodating to growth for the foreseeable future.
• The same cannot be said for fiscal policy in the UK.  
• The UK Coalition plans a further £92 billion of fiscal tightening by 2019 if they win the election - more than £200bn in total or a direct reduction in GDP of 13%.
• We estimate, that if the economy is to grow at around 2.5% per annum then the underlying growth rate in the face of such anticipated fiscal consolidation – which might change after the UK General Election in May - would need to be about 4% per annum: a big challenge for the private sector.

 

Greece and the Eurozone

• The new Greek Government led by the Syriza party came to power with a mandate to renegotiate the terms of the 2012 bailout, which most analysts agree is imposing a severe burden on the Greek economy and society.
• GDP has fallen by 25% since 2007 and unemployment is currently over 25%, with youth unemployment 50%! No other democratic country has endured austerity of such size and pace.
• If by June 2015 there is not agreement on a reduction in the pace of austerity, then there is a real risk of ‘Grexit’, that is a Greek exit from the Eurozone.
• This would have significant economic and political consequences for the Eurozone itself and for the global economy, including the Scottish economy.
• When the threat of Grexit was last posed in 2012, the Fraser of Allander Institute undertook a modelling exercise which estimated that a Greek exit would lower Scottish GDP by -1.2% and reduce employment by 49,000 and this is before estimating the potentially greater impact of a wider contagion of bank runs and possible further withdrawals of other peripheral countries from the Eurozone.

 

Forecasts

• Notwithstanding the developments above, we are forecasting growth of 2.8% in 2014, 2.6% in 2015, and 2.4% in 2016, an upward revision to our November 2014 forecasts.  These reflect our view that household spending and investment are stronger than we projected in November.
• We have also raised our forecasts for employee job creation compared to our November forecasts. On the central forecast, we are now forecasting that net jobs will increase by 53,850 in 2014, 51,350 in 2015 and 57,600 in 2016. Our unemployment forecasts have been revised down further again from November, reflecting higher economic activity.
• Our projection for unemployment on the ILO measure at the end of 2015 is 136,600 (5.0%), falling further to 125,250 (4.6%) by the end of 2016.