Gus O’Donnell: Seeking fiscal prudence

A MARK of a truly independent country is the ability to manage its own fiscal policy. That means deciding how much the government will spend, how that spending will be allocated and how it will be financed.

There are also choices about which taxes to use, how much spending should be met by charges and whether to run surpluses or deficits. Three requirements of a good fiscal policy may be identified that should underpin any debate regarding the implications of potential constitutional change.

The first requirement of a good fiscal policy is that it is sustainable. In other words, the spending should be broadly matched by financing. If this doesn’t happen, the level of debt will rise and, with it, debt interest payments – which can lead to an explosive situation.

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There are real challenges on both the spending and the revenue sides of the balance sheet. The number of older retired people relative to younger workers is likely to carry on rising. This will be expensive for governments and the current Scottish system is, of course, more generous than that in England. On the revenue side, as global competition increases, there is downward pressure on all costs, including taxes and energy costs. The reliance of Scotland and the UK on North Sea revenues is a particular problem, given that these natural resources are being depleted every day.

The second requirement of a good fiscal policy is that it should support the economy. The “macro” side of this involves fiscal policy acting as a stabiliser to the economy, putting money into the system during downturns and reversing that during upturns. The “micro” side of a good fiscal policy relates to the impact of particular tax-and-spend policies on incentives and behaviour and the resulting consequences for growth and wellbeing of the population.

One possible advantage of Scotland having control of its own taxes would be that a Scottish Government could decide what special “tweaks” to give to the system to suit national needs. For example, there might be an objective to establish a different tax rate on goods where the goals were to discourage consumption (for example, fatty foods and alcohol).

One particular “micro” fiscal issue is important when considering Scottish independence: should both countries agree to consult on fiscal issues that could end up in competition that damages both? Consumers would, of course, want to pay the lower tax, so businesses would lobby both governments to reduce the VAT rates for their products. It is undoubtedly the case that different VAT rates in certain goods between the two countries would lead to problems. In general, UK governments have welcomed tax competition between countries, but it will not always be beneficial.

A third requirement of a good fiscal policy should be the capacity of the system to address issues of equity. There is growing concern at the problem of increasing income inequality and all that goes with it. Governments can and do redistribute large amounts of income through the tax and benefit system. However, higher taxes can damage incentives and efficiency, so there is a trade-off to be made.

An independent Scotland might choose to make this trade-off in a different place to the UK, but there are no free lunches here. What you gain in equity, you lose in efficiency; at least that is the theory. In practice, our current system has become so complex that there might well be changes that improve both efficiency and equity. These changes should be made by any government, but the power of vested interests and the bias towards the status quo – remember, losers always shout and winners keep quiet – mean that we haven’t ended up with a perfect system. In theory, Scotland could do better, but the political forces that have added complexity and inefficiency to the system are likely to be just as prevalent in Scotland as in the UK.

To help, my first suggestion is that a government should be clear about what it is trying to achieve. This clarity has been achieved in many countries by using targets or rules for debts and/or deficits. My second suggestion is to set up an independent monitoring body. The Office for Budget Responsibility in the UK is one example. This enhances the credibility of the fiscal system. My third suggestion is to provide electorates with the information they need to make informed voting choices. This could mean, for example, as is done in the Netherlands, having an independent body to explain the fiscal consequences of each party’s manifesto.

All of the above refers to the case of any country with its own currency and specifically to the constitutional option of a newly-independent Scotland with its own currency. But what does good fiscal policy entail if you share a currency with one or more other countries?

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The key lesson (of the euro crisis) is the need to establish the necessary rules and to ensure that they are actually followed. Credible surveillance and sanctions regimes are a necessary component of this regime. So, if Scotland and the rest of the UK (rUK) were to share a currency, both partners would want to ensure that the other does not run unsustainable fiscal policies. This means agreeing some rules, which should not be too difficult, and finding a way to ensure they are obeyed, which is likely to be extremely difficult.

From the rUK’s point of view, it would want to be sure that Scotland did not run an unsustainable fiscal policy. Similarly, Scotland would not want the rest of the UK to have an unsustainable policy, as this would considerably push up Scotland’s borrowing costs. Enforcement is the key issue. One solution would be an Office of Budget Responsibility for the Sterling Area, which would have the job of assessing the two countries’ fiscal policies and, crucially, the power to ensure the rules were followed.

What are the fiscal issues that arise if Scotland remains within the UK? There may well be a debate about whether more powers, including tax and spending powers, should be devolved. Many of the issues discussed before remain relevant. The Treasury has responsibility for the state of the UK’s finances and will not want to delegate powers that would lessen its control without ensuring strong safeguards.

It will worry, at the macro level, that more autonomy for Scotland might lead to an unsustainable UK fiscal position. And it would worry at the micro level about the harmful tax competition and distortions caused by having different tax and/or benefit rates in different parts of a single currency region.

Any major extension of devolution of fiscal powers would almost inevitably raise questions about the Barnett Formula. There would be a strong case for a return to fundamentals and sorting out a new principles-based formula for allocating spending around the UK.

An independent commission could be set up to bring forward proposals for a new formula. It is possible that in the period following a Scottish independence referendum, it might suit all parties to reach such an agreement. There could be service-level agreements, for example, for departments such as Work and Pensions, to provide services to Scotland that were different from those in the rUK.

Why would the UK be willing to enter into any of these questions, assuming that the referendum supported the status quo? It is in the rUK’s interest to have a flourishing Scotland. If, by choosing slightly different tax rates and allocating spending differently, Scottish growth is higher, then this should also raise UK growth.

This assumes the measures do not include ones that simply reallocate spending between Scotland and rUK to minimise tax. In practice, greater devolution, if used wisely, has the capacity to improve performance. But the reason we have a UK government and do not devolve tax powers to every region in England is that the Treasury believes that the incentive to compete with each other would lead to a “race to the bottom” and that overall revenues would suffer. Everyone wants to spend more and tax less, and at the national level that does not add up to a sustainable fiscal policy.

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• Lord Gus O’Donnell is a former UK Cabinet secretary and head of the UK Civil Service and is currently senior adviser with Frontier Economics. This article is an extract from a chapter in Scotland’s Future: the economics of constitutional change, a new economic commentary on constitutional options facing Scotland, edited by Professor Andrew Goudie, of the University of Strathclyde. Readers of The Scotsman can buy Scotland’s Future for the special discount price of £13, just go to The code is SCOT1