Control of income tax not a shield to public expenditure cuts

With the economy bound to be one of the key election battlegrounds, Holyrood asks a number of economists to sum up Scotland’s economic outlook for the year ahead. 

“Prediction is very difficult, especially about the future,” so let’s not make a forecast, let’s look instead at risks for the UK and Scottish economies. And let’s base that assessment on the implausibilities surrounding the forecast for the UK produced by the Office for Budget Responsibility (OBR). As most economic, fiscal, and monetary powers are reserved rather than devolved, and continue to be so after the referendum, the economic fate of Scotland will be largely determined at UK level.

The UK currently runs substantial deficits, of around 5 per cent of GDP, on both its public sector account, and on its international current account. The public sector deficit is the gap between the government’s expenditures and revenues while the current account measures the position on the UK’s trade, international transfers and investment income. The OBR’s latest forecast for these measures is that the public sector deficit will have moved to surplus by 2020, and that the current account deficit will be less than half what it is now.

The OBR’s forecast implies that:
a) The world will avoid major shocks, and also avoid major deflation, with the annual rate of growth in the UK’s potential export markets more than doubling. 
b) The elimination of the UK’s public sector deficit occurs mainly through cutting public expenditure. Between 2014/15 and 2019/20, UK public expenditure will fall, relative to GDP, by an amount equivalent to 6.05 per cent of GDP. By 2019/20, public expenditure as a percentage of GDP will be lower than at any time since before WWII. 
c) But the economy will absorb the loss of employment in the public sector, and overall employment will grow at almost 1 per cent per annum and the UK will overcome its recent dire productivity record, with productivity growth increasing from 1 per cent per annum to 2.3 per cent. 

This scenario looks implausible. Not only are external risks currently large, but it is extremely doubtful if the forecast cuts in public expenditure are actually achievable – cuts which would take public expenditure back to levels relative to GDP not seen since before the welfare state was created. And even if the cuts can be achieved, it is very doubtful if the private sector will grow at the rate anticipated, particularly since recent employment creation in the UK has been associated with low wage (indeed subsidised) jobs, a pattern of job creation which is unlikely to be correlated with high productivity growth. 

At some point, it will become clear that the UK is not solving its deficit problems. At this point, international investors are likely to lose confidence in the UK, thus forcing a sharp rise in UK interest rates. This would put a halt to UK growth and the decline in asset values as interest rates rise could threaten a further financial crisis. 

Of course, one big imponderable is – will this occur in 2015? Quite possibly. Either adverse economic data, or the result of the 2015 UK General Election, could provide a trigger exposing the implausibility of the current ‘official’ view of the UK economy. 

So here is a risk assessment for 2015. Aside from the current turmoil on oil, the major risk for Scotland in 2015 is a forced rise in UK interest rates, as events expose the implausibility of OBR forecasts.

And in the longer term, as public expenditure cuts force privatisation down south, Scotland will be under extreme pressure to follow the privatisation path. Control of our own income tax, if Smith is implemented, will provide no shield against the public expenditure cuts we will import via the Barnett formula.

Jim Cuthbert is an economist and statistician who was formerly Scottish Office Chief Statistician. Margaret Cuthbert is also an economist and statistician who among other things lectured in econometrics at Glasgow University.