IFS senior economist David Phillips on the fiscal framework and the future of the Barnett formula

Work from the Institute for Fiscal Studies (IFS) has dominated Scottish political debate over the past few years. From its analysis of full fiscal autonomy (FFA) – perceived as damning to the SNP’s case, after the IFS suggested FFA would leave a £7.6bn gap in the Scottish budget – to its work on NHS spending, and its more recent report on GERS figures, its findings are regularly tossed around the Scottish Parliament.

The IFS has provided a reference point for Scotland’s politicians, and, perhaps more impressively, it has done so while managing to steer clear of accusations of bias.

Holyrood spoke to David Phillips, senior research economist at the IFS, and the man charged with carrying out much of the institute’s work on Scottish devolution, during a trip to Edinburgh to unveil new analysis of the fiscal framework.

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The work examined tensions between two of the Smith Agreement’s recommended aims in agreeing an adjustment to the block grant. On the one hand, the Smith Commission demanded a deal which would satisfy the ‘no detriment’ principle – the idea that neither government should lose out solely as a result of devolution. But on the other, it also called for a deal which maintained ‘taxpayer fairness’ – the idea that neither government should lose out as a result of the policy decision of the other in a devolved area, post-devolution.

In its analysis, the IFS found the two aims were impossible to completely reconcile, with the final fiscal framework agreement prioritising no detriment over taxpayer fairness. As such, after further devolution, Scotland will still receive redistributed revenues from taxes in the rest of the UK which are devolved.

Writing at the time, Phillips said: “During the negotiations, the UK Government had claimed this approach was unfair because it violates the ‘taxpayer fairness’ principle. This begs the question of whether the UK Government has changed its mind or merely conceded the point.”

The deal was only ever temporary, and both sides will need to return to the table in the coming years to revisit negotiations.

Phillips has an infectious enthusiasm for the workings of devolution, even if he is pretty critical about how the process has been carried out. Over the next few years he will lead the IFS’ work on devolved and local government, which he says will include analysis of Scotland, but with a greater focus on English local government. With devolution on the table across the UK, this sort of analysis will be more important than ever before.

He says: “One of the things I find a bit frustrating is that we seem to have these ad-hoc bilateral deals done in the UK, where there is not a kind of first principles assessment to say, ‘what is the purpose of the UK as a fiscal institution?’. We don’t think ‘the system is not working as it could be, how can we design it better’, we take the system we have, which is almost broken, and then we tack something onto it to make it more complicated and more at risk of breaking in the future.

“So in Scotland, for example, we take the Barnett formula and tack on the fiscal framework, borrowing powers and block grant adjustments. In Wales where they say the Barnett formula is not generous enough to them, so we tack on a funding floor. In Northern Ireland, we do something different again with the devolution of corporation tax.”

That seems fair, but it would take a lot of bravery, politically, to change any of these examples. Replacing or scrapping Barnett may make sense from an academic point of view, but any attempt to change it would be met with howls of anguish from all sides of Scottish politics. It has become symbolic of something bigger, particularly since it was given special protection in the Vow.

Phillips nods. “It would be difficult, but I think Barnett is misunderstood. People seem to think that the Barnett formula is what determines the level of spending in Scotland. It’s not, the Barnett formula says how much the block grant will change each year, it has nothing to do with the level of the block grant itself. And actually, in the long run, the block grant is not that good to Scotland.

“Scotland is traditionally very well-funded, in a UK context. We crunched some numbers and found that for comparable spending, the funding on devolved areas is somewhere around 30 to 35 per cent higher, per head, than in England,” says Phillips.

This leads to the Barnett squeeze. Imagine, hypothetically, spending per head went up by £10 per head in the rest of the UK. According to Barnett, that would mean the Scottish Government was given £10 extra per person, through the block grant.

Imagine you had started with spending at £135 per head spending in Scotland, and £100 in England. If you add £10 to each of those – increasing spending to £145 and £110 – the gap is the same in cash terms, but proportionally, it has shrunk. If spending continued to rise over time, the proportional difference would keep getting smaller, until the stage when spending per head is £1000 in England, and £1035 in Scotland, with a gap that was once 35 per cent falling to 3.5 per cent.

Phillips says: “So in the long run, Scotland may be better getting rid of the Barnett formula and replacing it with something else. The thing is, the Barnett formula is just a way of updating the block grant, but it has become shorthand for protecting high levels of block grant. It has become this totemic thing.

“The Barnett formula is just odd. It doesn’t make sense. Report, after committee, after investigation have all said the formula doesn’t make sense in the long run, it was a short-term fix, and it should be replaced. The difficulty is what you replace it with.”

There are parallels between the stop-gap introduction of Barnett and the fiscal framework. Clearly the framework negotiations were a tense affair, with both sides approaching the talks to get the best deal they could, rather than aiming to reach a constitutional settlement capable of enduring over time. Phillips calls it “a zero sum game about who can get the best deal which gets them the most money.”

Most analysis suggests the Scottish Government got a good deal. In fact, work from the IFS suggests that, compared to today, by 2021 an extra £900m of revenues will be transferred from rUK to Scotland. If the current method of block-grant adjustment was continued until 2031, it could mean £2.8bn in additional revenue being transferred to Holyrood. But does the Smith Agreement help Scotland move towards FFA?

Phillips is blunt. “No. Not at all.”

He adds: “The no-detriment principle, which is now enshrined in the framework through the per capita index method for adjusting Scotland’s block grant, says that although Scotland’s revenues per capita are a bit lower than those in the rest of the UK, we are not going to let Scotland be penalised for that. So going forward, we will continue, as would have happened through the Barnett formula, to top up those revenues from the rest of the UK. That is not fiscally autonomous at all.”

In fact, even the positions held by the two parties going into the talks raises questions.

“Think about the policy positions the Scottish and UK Governments have adopted in the past, and supposedly still hold. The Scottish Government says it wants full fiscal autonomy. It thinks Scotland should keep all the revenue it raises and be responsible for all the spending undertaken in or for Scotland. That means ending any transfers across the UK, any risk sharing and equalisation.

“The UK Government says the whole point of the Union is we have these broad shoulders, we can risk share and equalise. But then look at the fiscal framework negotiations, and the Scottish Government were saying, in effect, ‘you can’t cause us detriment by doing this, you’ve got to continue to give us a top up’, and the UK Government are saying, ‘no, you took a devolved tax, you are responsible for it yourself’. They have taken almost reverse policy positions, and that is because it wasn’t approached in a principled way, it was about what deal would be best for each side.”

These sorts of calls have been heard before, though.

Phillips pauses: “I’m not naïve, you know. If we did have this big commission to look into how the Union should be funded, of course there would be politics, with everyone trying to get the best deal they could, but at least there would be an open discussion about what the principles should be, rather than through closed-door negotiations.”

So are the powers devolved coherent?

He pauses: “Yes and no.”

Phillips says the way welfare powers were devolved makes sense. It is an area where there is a clear demand from the Scottish Government for a different approach, and because disability benefits are non-cyclical – the number of claimants remains relatively stable – the package will not expose the Scottish Government to a lot of cyclical risk in the economy.

On tax, though, things are more complicated. Phillips says it is unusual for a sub-national government to have almost full control of income tax.

“It also leaves a pretty strange situation where we have two income taxes in this country. We have income tax and we have national insurance. They are both income taxes, in many respects, though of course, national insurance is just on earnings, not other income. We have one at the UK level, and another at Scottish level. Now the IFS has argued in the past that the two should be merged, because it is confusing to people to have two separate taxes, and a lot of people don’t know what tax they are paying. But having them in two separate places means you can’t merge them anymore.

“I think the reason they decided to devolve income tax is because it is a big tax, it is a very salient tax, it is one people know, and it is a buoyant tax, in that it grows with the economy. So I can see the rationale for doing it, but there may have been a benefit in not fully devolving income tax, going a bit further than the [2012] Scotland Act, say, which gave 10p in each band, and instead saying we will devolve 15p in each band, but also devolving part of national insurance alongside it.

“There would be a wider range of powers, and the broader a government’s tax base, normally the less risky its tax revenues are, because if one tax is going up a lot, other ones probably aren’t going up as much. They tend to be correlated, but not perfectly correlated, which gives you a bit of insurance.

“So I am not saying it is an incoherent package, because you can see the sense of it, but there were alternative packages which could have been delivered which would have brought benefits. So if there was partial devolution of NICs [national insurance contributions], as well as partial devolution of income tax, it would give the Scottish Government an additional lever. When was the last time income tax rates were put up in the UK, apart from the top rate of tax? It was back in the 1980s, and it is because income tax is totemic.

“You cut it, you don’t increase income tax. You can put up NICs, they did it in 2003 and 2011, so the other question is whether the Scottish Government has been given a tax which is difficult to put up.”

Phillips has been at the IFS for ten years, and in that time the organisation has become very influential.

“The amount of media attention we get has always been high, but it has grown over time. I think that is partly because of the growth in online media, but also because we have been commenting on some of the big questions.

“The financial crisis, the recession, and how the government was going to fill this massive black hole, that made public finances a much more important issue, whereas during the boom years of the early 2000s, when I first joined, there were interesting issues but there wasn’t this £150bn deficit to deal with – that really opened people’s minds.”

And so does the IFS have plans to move into Scotland more permanently?

 “We have plans to continue to do some work. We’ll continue to do updates on the overall Scottish fiscal position but we are not planning to do too much on the various parties’ tax positions going into the election. I think for a couple of reasons. One is that we don’t have the time to do it. People seem to either imagine we are just Paul Johnson [IFS director] operating as a one-man band, or that we are this huge organisation, with hundreds of people beavering away. We are actually around 30 or 40 people. That may sound like a lot but we also cover education, health, and investment, among other things – there are only three or four people that do this work on tax policy. Then if you do it for Scotland, why not Wales and Northern Ireland? Then the third reason is, there is a need for Scottish-based institutions to do this.

“It was disappointing when Fiscal Affairs Scotland ran out of funding so soon. Everyone said there was a need for this kind of institution in Scotland, and there was one set up. Now it wasn’t perfect, they had quite a narrow focus on fiscal projections, they didn’t do so much on tax policy changes, but there was a role for an institution like that.

“I saw the Fraser of Allander Institute were planning to take more of a role in stuff like that, and that is welcome, because there is space and a need for a Scottish institution to do more of this type of analysis.”