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.

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.

A Fiscal Dividend: UK Union or Scottish Independence?

The publication today of Government Expenditure and Revenue Scotland 2014 (GERS) provides information on Scotland's fiscal position in 2012-13 with revisions for earlier years. The document is obviously important since it is the last one in the series before the independence referendum on 18 September.

What is the prospective voter in the referendum to make of the figures contained in it?

Danny Alexander, Chief Secretary to the UK Treasury states:

The Scottish government's argument for independence has been undermined by their own figures. It shows that in 2012-13, the Scottish deficit per person was almost £500 worse than that of the UK.

While Alex Salmond, First Minister of Scotland argues:

Today's Gers report confirms what independent commentators and analysts have been making clear - Scotland is one of the wealthiest countries in the world. The figures show that tax revenues generated in 2012-13 were £800 higher per head in Scotland compared with the UK, meaning that now for every one of the last 33 years, tax receipts have been higher in Scotland than the UK

So who is correct?

Well, in a sense, they both are!

The problem is that these statements do not really give much of a guide about the fiscal position in an independent Scotland compared to the position within the UK union. This is of course a complete unknown because economic conditions and policies will be likely to be different in both a future UK union and a future independent Scotland.

However, what might be of help is to conduct a form of thought experiment. In this experiment we can ask has Scotland over the past five years enjoyed a fiscal dividend in the UK union or has it suffered a fiscal cost compared to independence?

Clearly, such an analysis cannot change policies or economic conditions but I still think it is an illuminating exercise none the less.

We know from GERS what Total Managed Expenditure (TME) has been in Scotland over the last five years. We also know the GERS estimate of total tax revenue. We can proxy tax revenues under independence by adding in a geographical share of North Sea oil revenues. We can proxy public spending under independence by taking a Scottish population share of UK TME, so that the Scottish people are no worse off in terms of public services than their rUK counterparts.

That done, we can then compare with the estimated spending and revenues in GERS published today, which is what the table below shows:

	(£ million)
Fiscal   Year	2008-09	2009-10	2010-11	2011-12	2012-13
Spending
Total   Managed Expenditure for Scotland	59,440	62,087	64,095	64,869	65,205
Scots per capita share of UK   TME	53,393	55,219	56,271	56,934	57,538
Excess spending	6,047	6,868	7,824	7,935	7,667
Tax Revenues
With Geographical share of oil revenues	55,349	47,733	51,773	56,315	53,147
Scots tax revs plus Per   capita share of oil revenues	44,820	42,557	45,023	47,264	48,118
Excess revenues	10,529	5,176	6,750	9,051	5,029

 

Excess spending shows the gain to the Scottish people in the UK union - loss under independence - of the spend on public services compared to the rest of the UK, which is the assumed counterfactual minimum that would be expected under independence.

Excess revenues shows the gain in tax revenue under independence - loss under the UK union.

The figure below charts the two and the figure after that the difference between the two:

So there is a fiscal dividend from independence in two of the five years and a fiscal dividend from the UK union in three of the five years. Taking the five years together there is a net dividend in favour of independence of £193 million. This amounts to 0.3% of average TME in Scotland over the five years, or £39 per person or roughly £8 per year.

The following points can be made:

• The fiscal dividend to independence can therefore be considered to be very small and appears likely to be negative in the near future.

• There is no estimate of the economic and fiscal transition costs of Scotland becoming an independent state, which if included would additionally make the dividend negative.
• In the fiscal year 2008-09 oil prices and oil revenues were high. In the future, oil revenues are likely to decline as the volume of production falls considerably from the position in 2008-09.
• During the last five years the Scottish people have had returned to them in higher public spending almost all of the oil tax revenues that went to the UK Treasury.
• We cannot determine the fiscal position of an independent Scotland in the long-term because different economic conditions and policies in both rUK and Scotland will determine whether there is a fiscal dividend, or a fiscal cost to independence.

Scotland's Public Sector Net Debt

Yesterday the Scottish Government produced a paper where estimates are provided of Scotland's historical notional share of UK debt interest payments and public sector net debt.

The paper identifies UK public sector net debt at the end of 2011-12 as £1,100 billion, which amounted to 72% of UK GDP. Applying a per capita share to Scotland, produces an estimate for Scottish public sector net debt of £92 billion. This amounts to 62% of Scottish GDP, since with a geographical share of oil Scotland's GDP per capita is estimated to be greater than the UK.

One can accept this estimate provided one does not then conclude that the burden of debt in an independent Scotland is ten percent points lower than the UK. We cannot conclude this because, as I and others have noted, an independent Scotland will be faced with a higher interest rate on its long-term government borrowing than the UK.

More controversially, the Scottish Government's new paper goes on to estimate an illustrative historic share of UK net public debt. The Scottish Government describe this estimate of Scotland's net public debt as being based on:

estimates of public spending and tax receipts in Scotland over the past thirty years, in other words, on the basis of what Scotland has actually contributed to UK tax revenues

On this basis, the Scottish Government estimates Scotland's share of UK net debt to be £56 billion, equivalent to 38 per cent of GDP.

These estimates lead Deputy First Minister, Nicola Sturgeon to conclude that:

Both of the methodologies show that Scotland's estimated share of national debt takes up a smaller proportion of our economy than is the case for the UK - which means that in all circumstances Scotland will be better off with independence.

I have already noted that these estimates ignore the cost of borrowing, which is likely to be higher in an independent Scotland. But a moment's further thought should lead one to question the Scottish Government's illustrative historic calculation.

First, it seems a reasonable logical argument that as part of the United Kingdom Scotland should broadly be expected to share on a per capita basis in UK public spending, taxation and debt. Asking Scotland to take a per capita share of UK debt if Scotland decided to leave the UK union would seem to be reasonable, since everybody in the UK might be said to be in the same boat together.

However, the Scottish Government suggests that a historic calculation may be more appropriate. But in computing their 'historic' estimate they confine the calculation to the cumulated fiscal balance, including a geographic share of oil revenues, since 1980/81. This is then expressed as a ratio of the cumulative UK deficit over the same period (5.1%) and that ratio is taken to be Scotland's notional share of UK public sector net debt (£56 billion).

But if we are to compute Scotland's share of UK debt on an historic basis, shouldn't we also allow for special Scottish factors that directly affected the level of UK public net debt?

One obvious and significant omission is the bailout of the two Scottish banks in 2008-09.

The National Audit Office estimates that the amount of cash - requiring to be borrowed - for the bank bailout was £124 billion. The share of the two Scottish banks amounted to £67 billion. If we assume that a population share of this number is allowed for in the Scottish Government's 'historic' estimate, this leaves a further £57 billion to be added to the £56 billion debt estimated by the Scottish Government. £113 billion of debt amounts to 77% of Scottish GDP including a geographical share of oil value added.

The new estimate is shown along with the Scottish per capita estimate and the UK net public debt share in the following chart

On this basis and adjusting to gross debt figures as the Scottish Government do in their Chart 4, Scottish gross debt on an historic basis would rise from 44% to around 90%. This would raise Scotland in the debt EU-15 debt ranking from the Scottish Government's rank of 14th from 16 (adding Scotland to the EU-15) to 6th from 16.

This, and remembering the point about borrowing costs, certainly doesn't appear to support Nicola Sturgeon's contention "that in all circumstances Scotland will be better off with independence."

 

Scottish Tax and Spend

Today the Scottish Government published a two-page document providing a summary of trends in total Scottish tax receipts since 1980-81. The summary allocates to Scotland a geographical share of North Sea Oil revenues and draws from experimental statistics of Scotland's fiscal balance which are published on the Government Expenditures and Revenues Scotland (GERS) website here.

The data are not new. The fiscal balance estimates were updated for the GERS exercise to include 201-2 fiscal data and published on 5 March. Nevertheless, the Herald thought the information to be of sufficient importance to run the story as its main feature under the headline "New Report: Scots paying more tax than rest of UK" Given prominence in the story was a quote by Finance Secretary John Swinney from the government Press Release accompanying the report:

These figures confirm what we have known all along. Scotland more than pays her way in the UK. They show that the average tax receipt per person in Scotland has been higher in each of the last 30 years than it has been across the UK as a whole.

As the chart below shows John Swinney's comment is correct.

However, what was not reported in the Herald, wisely in my view, was John Swinney's further comment in the Press Release:

With the full control of our finances we could have invested this money for the people of Scotland, creating jobs and investing in public services.

The 'new report' does not contain any information on spending. An examination of the spending data on the same per capita basis as the tax data and taken from the GERS website reveals the following:

Yes, spending per person in Scotland has also been higher in each of the last 30 years than it has been across the UK as a whole.

So, broadly, these greater tax receipts were invested for the people of Scotland, creating jobs and investing in public services.

The Scottish people have received a significant dividend from North Sea oil revenues, much more than people in the rest of UK.

Now, it is clear that oil revenues were exceptionally high in real terms in the 1980s - as the tax receipts chart indicates. The Scottish people might legitimately note that the greater spending received in that period was much lower than the tax receipt surplus.

A sense of this can be gained from the final chart, which expresses per capita spending in Scotland and UK as a ratio of per capita tax receipts. This is really another way of expressing the fiscal balance data as I did in this post.

The large scale of oil revenues in the 1980s meant that Scotland would have been in surplus - ratio less than one. But from 1990 the spending to tax ratio has tended to be similar in Scotland as in the UK, in fact a little higher in Scotland at 1.11 compared to 1.10 in the UK.

So, if we are to talk about a country 'paying her way', we need to bring into account spending as well as revenues. Public spending per capita has averaged more than ten per cent (10.86%) higher in Scotland than in the UK since 1990/91, while tax receipts (including a geographic share of oil revenues) have averaged less than ten per cent (9.67%) higher in Scotland than in the UK since 1990/91.

With the independent Office of Budget Responsibility predicting (page 102 of its March Economic and Fiscal Outlook) a sustained decline in future oil revenues from £11.2bn in 2011-12 to £4.3bn in 2017-18, Scottish tax receipts are set to fall relative to the UK.

And of course I have not brought into this discussion the issue that an independent Scotland is likely to have to pay higher borrowing costs than the UK as I noted in this and this post. It is not just the size and relative size of a government deficit that matters.

Funding costs must also be considered.

Nicola: don't forget the day job!

It is inevitable that the media should focus on Nicola Sturgeon's new role responsible for Scottish Government strategy and the constitution. The talented minister will be responsible for leading negotiations with Westminster on the referendum and piloting the referendum bill through Holyrood.

But all of that is in addition to her 'day job' as the new minister for infrastructure, investments and cities.

Alex Neil, whom she replaces, has for many years been a passionate advocate of the need for more investment to raise the long-term rate of growth. I have crossed swords with him in the past because I felt that he did not pay enough attention to the quality of investment. Investment per se is not enough. It needs to be innovative and embody new technologies. But subject to that caveat, investment in both plant and machinery, R&D and infrastructure is crucial, as well as in human capital. There is some debate about the relevant importance of each but that is an issue for another day.

If we look first at gross investment to GDP, we see in the chart below that the SNP minority and then majority government at Holyrood presided over a decline from just under 20 percent of Scottish GDP to just above 15 percent in the first quarter of this year. In the UK the share declined from a peak of just above 18 percent in 2007 to just below 15 percent in the first three months of this year. The Scottish data are drawn from the Scottish National Accounts Project (SNAP) and are experimental, with work continuing to improve the quality of the statistic. Readers - and authors! - should therefore be careful in drawing conclusions from the dataset.

Clearly, the Great Recession and its aftermath appears to be primarily responsible for the fall.

But there are longer-run trends at work.

The UK gross investment share has clearly been on a downward trend since 1998, although that does not seem to have been the case in Scotland. Andrew Smithers of Smithers & Co argues, supported by sophisticated modelling on executive compensation contracts and macro instability from the New York Federal Reserve, that the falling investment share in the US and the UK and lower future growth is a direct consequence of the growth in the corporate bonus culture. This has been particularly prevalent in financial services. One interpretation is that spending on investment reduces profits in the short-term even though it will raise them in the long term. If executive compensation is linked more to bonuses, which in turn are linked to the short-term profit numbers, then there is a built bias in the corporate reward system against investment: a perverse incentive.

Maybe the bonus culture has not developed as strongly in Scotland. It is certainly true that those parts of the financial service sector where this culture is more in evidence such as hedge funds and the shadow banking sector are less represented in Scotland. But it is certainly something that the new minister should be urging Scottish Financial Enterprise, the CBI, the IOD and other industry bodies to discourage.

The UK's record in investment is clearly not one which neither industry or government can be proud.

In the latest CIA World Factbook the UK ranks 137 out of 150 countries for gross fixed investment as a percentage of GDP. It is true the United States ranks lower at 142 but that perhaps makes Andrew Smither's point!

Net government investment in the UK is also in decline and that decline is forecast to continue due to fiscal consolidation as the chart below shows.

The situation on public sector net investment is likely to be much the same in Scotland as in the UK. Which brings me back to Nicola.

It is too easy to argue that if only Scotland can get out of the UK union everything will in the end be ok on the investment front and the wider growth of the Scottish economy. As I and others have argued, see here and here, an independent Scotland's fiscal position is likely to be no better than under the present arrangements and probably worse. Given that, it is difficult to see an independent Scottish government make a radical switch from current to capital spending. The short-term political cost would be extreme.

So, if Scotland is going to raise radically its investment spending then it is down to the private sector. Inward investment can play a role. But we note that despite recent successes the attraction of inward investment has done little to arrest the slide in the investment GDP ratio.

More demand in the economy would certainly help. But it is really down to Scottish companies being prepared to put investment spending over short-term profit. A challenge for any Infrastructure, Investment and Cities minister no matter how competent.

So, Nicola. Don't forget the day job!

Anti-Austerity Policy: Independence or Devolution?

In this post I argued that

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. .... 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.

However, I wasn't able to offer any numbers. I suggested that

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.

Full and detailed research is still required but I am now able to offer some 'ready-reckoner' type estimates that give some idea of the magnitudes involved. They should be viewed as illustrative and not definitive.

The first point to note is that small open economies such as Scotland, whether politically independent or not, tend to have smaller fiscal and other multipliers than larger states. This is because when the propensity to import from a pound/dollar/euro of extra spending is high much of that spending will 'leak out' of the economy. Ray Barrell, Dawn Holland, and Ian Hurst have recently produced this paper for the OECD, which looks at fiscal consolidation in 18 OECD countries. Using the National Institute Global Econometric Model (NiGEM) they provide estimates of first-year multipliers for different types of fiscal intervention. These multipliers are shown to be larger the bigger the country and the lower the degree of import penetration.

The chart below reproduces their data for the relationship between temporary spending reduction multipliers and import penetration:

Using the estimates provided by Barrell et al we can estimate a spending multiplier for Scotland using a measure of import penetration drawn from the 2007 Scottish Input-Output tables - see here. Scotland's share of imports in GDP/GVA is 0.66, which compares with 0.70 for the Netherlands, 0.72 for Ireland, and 0.80 for Belgium. This gives a spending multiplier of -0.17 for Scotland using the average relationship derived from Barrell et al's work. But this value could be too low if Ireland is a close comparator so we also use the value of Ireland's multiplier of -0.33 in the exercise below.

We now assume that the UK government introduces a fiscal spending consolidation equal to 1% of GDP which can be either temporary or permanent. The impact on Scottish GDP is estimated in Table 1 for different constitutional states:

Under the status quo it is assumed that the UK fiscal multipliers apply, from Barrell et al. GDP falls by a temporary 0.74 percent for a 1 percent of GDP reduction in UK public spending. The permanent fall in GDP is less because the NiGEM model allows for UK monetary policy affects as long-term interest rates fall boosting demand and production.

But under independence Scotland will have its own tax and spend regime and we assume that direct fiscal consolidation applies only in the rest of UK.

However, Scotland is not unaffected.

Around two thirds of Scottish exports go to the rest of UK, representing a 34 percent share of Scottish GDP. So, even under independence with no fiscal austerity from the Scottish Government GDP falls - by 0.25 percent. The permanent impact is lower too under Scottish independence, because we assume that an independent Scotland remains in sterling and therefore interest rates in Scotland move in line with the UK.

What about the impact under devolution?

Under Devo-Max, or full-fiscal autonomy, the GDP effect is assumed to be the same as under independence.

But under Devo-Plus, where we assume the Scottish Government has responsibility for tax and spend equal to 50 percent of its revenues and expenditures, the fall in GDP is greater than under independence but less than the status quo for both temporary and permanent fiscal consolidations.

If a Scottish Government seeks to defend against the fiscal austerity practised by the UK Government, what would be a fiscally neutralising response?

Table 2 illustrates.

Table 2 shows what a Scottish Government would be required to do if it wished to neutralise the impact of a 1 percent UK fiscal austerity on its GDP. Under Independence and Devo Max it would need to raise spending by 0.77 percent to 1.43 percent of GDP. The lower figure is based on Ireland fiscal multiplier of 0.33, the larger figure is based on the 0.17 multiplier derived from feeding Scotland's import share into the relationship estimated from Barrell et al's paper.

What is interesting about these estimates is that size of the neutralising spending increase required under Devo Plus: from 1.5 per cent to nearly 3 percent of GDP. The present UK Government's fiscal consolidation programme is seeking effectively to remove 6 per cent from GDP. So, this would be exceptionally difficult to fully neutralise, if not impractical, under Devo Plus. It would also be a tall order under Independence or Devo Max.

But let no one rush off and seek to argue that this analysis supports the view that Independence is the only constitutional state that would allow Scotland to defend against UK fiscal austerity.

In order to raise public spending to defend against UK fiscal austerity, the Scottish Government would need to increase its budget deficit. To do so it would have to borrow - sell bonds. It is likely that an independent Scottish Government would face long-term borrowing rates that are higher than the UK - see my post here and here. It would also, if using sterling, have to operate under fiscal rules on deficit to GDP and debt to GDP set by the Bank of England. Two issues follow.

First, if deficit and debt levels are already high then an independent Scottish Government's room for manoeuvre to offset UK Government austerity, even partially, may be limited, if not precluded all together by financial market constraints.

Secondly, it is a moot point whether an independent Scotland would be faced with a higher long-term borrowing rate than a devolved Scottish Government borrowing with UK Treasury backing.

In sum, a Scottish Government of whatever constitutional ilk would be severely constrained in defending against a large UK fiscal austerity programme. This is because the Scottish economy is highly integrated through trade and labour market links such as migration with the rest of UK. Political independence would not change this much.