Scottish Economy Watch

No End to Austerity

Several UK newspapers today trumpet the Chancellor's Autumn Statement yesterday as heralding the end of austerity. Nothing could be further from the truth.

Chart 4.10 in the Office for Budget Responsibility's (OBR) Economic and Fiscal Outlook shows the size of the state in Britain continuing to shrink dramatically.

From around 46% in 2010-11 total public spending as a percentage of GDP is projected to fall to 36.4% in 2020-21. This is as low as it was in 2000-01 after the long decline from around 48% after eighteen years of Conservative government - the 1997 Labour government initially adopted Conservative spending aggregate plans in an attempt to gain fiscal credibility. Prior to 200-01 the last time total public spending amounted to around 36% of GDP was in the mid 1950s.

The Chancellor may have done a U-turn on his plans to cut tax credits but he still hopes to cut the size of the British state by 20% in ten years, twice as fast as the paring back of the state under the Thatcher/Major governments.

Scottish Labour Market in July-September 2015

The latest labour market data show the situation up to end September. The data clearly show the slowdown that has recently occurred in the Scottish economy. Some comfort can be perhaps be obtained from the latest quarter's data, which could be interpreted as showing that the slowdown is coming to an end. I think, however, that would be a premature conclusion until we see more data.

Employment did rise by 3,000 in the latest quarter and by 9,000 over the year. But as the chart shows there is clear evidence that job creation has been slowing down in Scotland leading employment to fall further behind the UK. So, by Jul-Sep 2015 UK employment was 5% above its pre-recession peak whereas Scottish employment was only 2.1% above.

The same conclusion can be drawn by looking at the unemployment rate which has now risen to 6% in Scotland compared to 5,3% in the UK. The next chart shows the rate in the two jurisdictions.

What is revealing from the chart is that the unemployment rate in the UK has now moved below where it was just before the recession started whereas in Scotland it is more than 40% higher.

The next chart, which graphs the employment to working population ratio shows that there is still a lot of 'slack' in the Scottish labour market.

The ratio stand at nearly 3% below its pre-recession peak. On this basis we should not expect there to be much pressure on wages in the Scottish economy.

This downturn may be the effect of the sharp fall in the price of oil and if so we should expect this to begin to unwind soon with job creation picking up and unemployment moving on a downward path again. But if not, then we might be witnessing the end of the recovery.

Business rates and the Scottish economy

Magnus Gardham writes in the Herald on Tuesday 10 November that 

'Some of Britain's biggest retailers have warned stores could be forced to shed jobs in Scotland unless business rates are overhauled. Boots, Marks & Spencer and John Lewis are among 40 firms and business organisations that have called for a fundamental reform of non-domestic rates. They say business rates, which raise £2.8billion, place an "unsustainable burden" on them. In an open letter to The Herald, they describe rates as "a tax on jobs and growth" that "acts as a drag on the Scottish economy".

Gardham also reports that John Swinney, the Finance Secretary, defended Scotland's business tax regime as "already the most competitive in the UK".

My advice to John Swinney is that he should be a little skeptical of such special pleading by a business lobby.

The theory and evidence on business property taxation offers little support for the view that Scottish business rates are "a tax on jobs and growth” - see here and here.

John Swinney could have reasonably responded to this retail lobby that business rates:

• Are only a small percentage of business costs usually ranging from 2% to 4%
• Allow many companies to obtain tax reliefs and non-domestic rates can be set against Corporation Tax.
• Allow local authority public service benefits to be received by firms; and
• That the burden of non-domestic rates is in the long run unlikely to be borne by the users of the property such as the retailer: the incidence of the tax will differ from where the tax is levied.

A key question here is the tax incidence: Who bears the burden of a property tax?

In answering this question we need to distinguish between the short run and the longer run.

 In the short run, theory and evidence suggests that the tax reduces profits, and in limited degree is shifted forward to consumers in the form of increased prices. The fact that profits of retailers and other payer of the tax may fall in the short run is likely to reduce investment and so those lobbying John Swinney do have a point. Moreover, the tax clearly introduces a distortion into the economy by disadvantaging property intensive economic activities and investments.

However, in the medium to long run the users of property will be able to negotiate a reduction in rents as a result of the tax. This is because the land and property is effectively fixed in supply, can’t be switched to other uses – especially the land = so there is little or no impact on economic behaviour. Its supply, to use an economic term, is zero elastic. Any reduction in rental value as a result of the property tax will generate a corresponding reduction in capital value. Hence this process is known as ‘tax capitalisation’. Evidence is typified by this study, which found that:

“The average capitalisation effect obtained was not significantly different from 100% implying that all of the local tax exemption benefits accrue to the owners of the property."

And this is why studies tend to find little or no effects of business rates on jobs and output in rated activities and hence why we should be skeptical of the current business lobby against the current levels of business rates in Scotland.

This does not of course mean that business rates are a ‘good tax’ and should not be abolished.

Business rates tax both land and property. As we noted above, because the supply of land is effectively zero elastic a tax on land simply takes away economic rents and does not distort behavior. However, taxes on investments in, and improvements to, property per se are a tax on business activity and so will distort behavior. The former land element of the tax is ‘good’ the latter property alone element is ‘bad’.

The logic of this argument is that John Swinney should respond to the current lobby against business rates by accepting the distorting effects of the property element and that he will seek to abolish the property element by moving towards a land value tax (LVT).

The case for replacing business rates with a LVT and the associated costs and benefits is well set out by Nobel prize winner Professor Jim Mirrlees in chapter 16 of his review of taxation in the UK for the Institute of Fiscal Studies, which can be accessed here.

It is on such rigorous theory and evidence based reviews that policy should be based and not the lobbying of self-interested groups

Never say never?

I see the well-known economist and FT columnist John Kay has suggested that the financial services sector in Scotland will never recover from the failure of its two largest banks at the height of the banking crisis in 2008. Specifically, John Kay is reported as saying that

“We’re never going to recover the position that we had for centuries in banking – and that’s a tragedy.”

On the other hand, Owen Kelly, chief executive of industry organisation Scottish Financial Enterprise, responded with the comment that

“Scotland’s diversity as a financial centre – we’re not just providing banking but also asset management, pensions, insurance, asset servicing all kinds of other services – has given us resilience. In terms of job numbers, we are roughly where we were in 2008 – a much better outcome that some were expecting."

So, what is the evidence?

On the real value of output, the evidence to date favours Professor Kay as the chart below shows

Source: Scottish Government GROSS DOMESTIC PRODUCT 2nd QUARTER 2015, and FAI calculations

The real value of output in financial services in Scotland is currently -13.4% below the sector's pre-recession peak. This is little different from the -15.5% that was lost to financial services in Scotland as a result of the recession.

But, perhaps, one should never say never!

Podcast - Fraser Commentary - November 2015

For those who can stand it the latest podcast for the Commentary is here (click on picture):

 

 

 

 

Fraser Economic Commentary - November 2015

 

I           Overview

 In the latest Economic Commentary  we note that Growth in both the Scottish and UK economies is slowing and in the second quarter a gap opened up between Scotland and the UK.

• The chained volume measure of GDP rose by 0.1% in Scotland in the quarter, while UK GDP rose by 0.7%.
• UK GDP (ex oil & gas) stands 6.9% above the pre-recession peak compared to 3.0% in Scotland. UK GDP - ex oil & gas - has had an even stronger recovery from recession than Scottish GDP.
• Scottish GDP has recovered by 8.4% since the trough of recession while UK GDP - ex oil & gas - recovered by 13.8% from its trough by 2015q2, compared to 12.8% when oil and gas output is included. In the latest quarter, UK GDP ex oil and gas rose by 0.5% - less than the 0.7% when oil & gas is included, suggesting a pick up in offshore activity - and by 2.7% over the year – four quarter on four quarter.

 

II          Industries and sectors

 The pattern of growth between Scotland and the UK again differed considerably in the fourth quarter. 

• In Scotland it is the construction sector that is providing the main impetus with public spending on infrastructure underpinning growth.
• In the UK in contrast, the service sector is the main driver with construction weakening.
• In Scotland, weakness in the service sector has been affected by the onshore implications of the fall in the price of oil hitting business services in particular as well as mining and quarrying. 
• Manufacturing growth is weak in both Scotland and the UK, which seems to be a reflection of weakening external demand for UK exports reinforced by the strength of sterling, the current crisis in the UK steel industry being a sad, example.

 

III         The labour market

 The latest labour market data show that the recovery in the labour market is slowing in both Scotland and the UK, while the recovery remains stronger in the UK.

• In the quarter to August 2105 employment fell by -6,000 (-0.6%) to 2,610,000 while unemployment rose again by 18,000 (0.6%) to 170,000 with the rate rising to 6.1%.
• In both the jobs market and in output the recovery has been stronger in the UK than in Scotland. On jobs, employment was 2.2% above the pre-recession peak in Scotland at the end of the second quarter, while UK jobs were 4.4% higher than the peak.

 

IV         Factors influencing the recovery

 (i)             Domestic demand

 Domestic demand in Scotland and the UK continues to be boosted by:

• low inflation;
• net immigration into the UK;
• low interest rates; and some pick up in wages and earnings.

 To be set against these positive influences are actual and potential threats to the growth of domestic demand:

• further planned austerity by the UK Conservative Government exemplified by the planned cuts to tax credits; and
• the continuing high levels of household debt, which for some households paying a variable interest rate will become an increasing burden if rates rise in the near future.

 (ii)           External demand

 External demand for Scottish and UK goods and services is being boosted by:

• the continued resilience of the US economy;
• a gradual pick up in growth in the Eurozone as the risks of deflation appear to recede while the problems of Greece are, for the short term at least, resolved;
• and the world economy is forecast by the IMF to grow by 3.1% this year and by 3.6 % in 2016.

 To be set against these positive influences are actual and potential threats to the growth of external demand:

• the high sterling exchange rate against the Euro, which appears to have been boosted by the short-term market expectation of an imminent increase in UK interest rates;
•  the IMF’s forecast for global growth in 2015 and 2016 represents a slowdown from the 3.4% achieved in 2014;
• China’s transformation from dependency on high domestic investment, forced saving and a disproportionate reliance on external demand to a greater reliance on household consumption and associated structural reforms will lead to slower growth; and
•  the effect of what the IMF calls ‘policy normalisation’ of monetary policy in the United States as interest rates begin to rise is expected to have global repercussions, which will serve to slow growth especially in emerging markets.

 

 V          Forecasts

 (i)             Output

• Our GDP forecast for 2015 is 1.9%, which is revised down from our forecast of 2.5% in June of this year due to the evidence of a slower than expected rate of growth in the second third quarters of 2015.
• For 2016, we have also revised down our forecast to 2.2% from 2.3% in June, in recognition that the slow down in the rate of recovery will continue into 2016 as exporting continues to be difficult due to the high pound sterling and because of the lingering effects on Scottish onshore activity of the low price of oil.
• On our central forecast, we are forecasting a pick up in the rate of growth in 2017 as the economy rides out the challenges of 2016. We have therefore raised our forecast for 2017 to 2.5% from 2.3% in our June forecast.

 (ii)           Jobs

• The number of total employee jobs is forecast to continue to increase in each year, and at a faster rate than that seen during 2014 (although not as strongly as in 2013).
• Our forecast for the number of jobs added in 2015 has been revised down since June’s forecast, from 51,250 to 49,400. The number of jobs at the end of 2015 is now forecast to be 2,433,400, an increase of 2.1% on 2014 (the same percentage growth forecast in June’s Commentary).
• Our current central forecast is that the Scottish economy will add 45,000 jobs in 2016, down by 4,600 from our June forecast, while we forecast the addition of 54,650 jobs in 2017, an increase of nearly 3,000 on our June forecast.

 (iii)          Unemployment

• On unemployment, the most recent figures show that unemployment rose again by 18,000 (0.6%) to 170,000 with the rate rising to 6.1%. Unemployment in Scotland rose by 19,000 over the year, or 0.7%.
• Despite the recent increases, the improvement in the labour market is forecast to continue with unemployment rates and numbers falling to end 2017.
• Our projection for unemployment on the ILO measure at the end of 2015 is 169,150 (6.2%), falling further to 155,450 (5.7%) by the end of 2016, and 118,400 (4.6%) by end 2017.

 

 

Annex: Fraser of Allander Institute Forecast Tables

 

Table 1: Forecast Scottish GVA Growth, 2015-2017

GVA Growth (% per annum)	2015	2016	2017
Central forecast	1.9	2.2	2.5
June forecast	2.5	2.3	2.3
UK mean independent new forecasts (October)	2.5	2.3
Mean Absolute Error % points	+/- 0.26	+/- 0.80	+/- 1.37

© Fraser of Allander Institute, November 2015

 

Table 2: Forecast Scottish Net Jobs Growth in Three Scenarios, 2015-2017

	2015	2016	2017
Upper	54,950	65,500	88,800
June forecast	62,100	72,650	80,600.
Central	49,400	45,000	54,650
June forecast	51,250	49,600	51,700
Lower	43,800	24,450	20,500
June forecast	40,400	26,550	22,800

© Fraser of Allander Institute, November 2015

 

 

Table 3: Forecasts ILO unemployment 2015-2017

ILO unemployment	2015	2016	2017
Rate (ILO un/TEA 16+) June forecast	6.2% 5.1%	5.7% 4.5%	4.6% 3.9%
Numbers	169,150	155,450	118,400

 © Fraser of Allander Institute, November 2015

 

  (V) Growth

 Analysis by the Institute on the long-term growth performance of the Scotland’s economy leads to the following conclusions:

 

On long-term growth performance, the main conclusions are:

• Scottish ‘trend’ GDP growth over last 50 years is identical to UK growth at 2.3% p.a;
• Scottish ‘trend’ GDP per head growth over last 50 years is 2.2% p.a. faster than UK’s 2% p.a. – due to falling or slower population growth in Scotland.
• We note that there has been a relative weakening of the Scottish economy since 2010.
• It follows, that to secure a sustained increase in the growth rate overall the economy will have to raise its competitiveness.

 

On raising competitiveness, we show that Scottish labour productivity while growing is weaker than in UK.

• We cite recent research evidence from Durham University’s Professor Richard Harris and Dr. John Moffat that Total Factor Productivity (TFP)  - the productivity of all factors: labour, capital and land – is also lower in Scotland than UK.
• They find that on average Scotland has had significantly lower productivity compared to the rest of the UK since the end of the 1990s. Overall, the ‘gap’ was around 11% across all sectors in 2012 (and 22% below the leading UK region).
• There is an academic and policy consensus that we get stronger productivity growth through improvements in: innovation/R&D; exporting (especially in small open economies); skills; investment, and enterprise.
• Scotland is shown to be weak in varying degrees on all of these determinants of competitiveness.
• We look particularly at export performance and find that there has been a long-term decline – since the early 2000’s - in manufacturing exports abroad. This has affected the performance of overall exports to the rest of the world.
• In addition, there is clear evidence of the growing importance of exports to the rest of the UK, which peaked at 68% of total Scottish exports before the recession. Exports to rest of UK are heavily dominated by service sector exports and financial services in particular. That importance dipped during and immediately after the Great Recession to 2012 with the contraction of financial services activity but picked up again after that.
• Another pointer is that exports to the rest of UK track GDP much better than exports to the rest of the world. This in part reflects the scale of rest of the UK exports to both GDP and total Scottish exports