Showdown across the Severn

This week, a high-level meeting between Welsh Finance Minister Mark Drakeford and UK Chief Secretary to the Treasury David Gauke fired the starting gun on a multi-billion pound negotiation round that will control how much Wales has to spend on public services for decades to come.

These upcoming talks at a new body called the Joint Exchequer Committee haven’t attracted the same level of attention as the preparations for Brexit negotiations. But similar talks last year in Scotland were an acrimonious 11-month process that involved threat and counter-threat, including the possible veto of new powers for the Scottish Parliament. As in Scotland, these Cardiff-London talks will run alongside the passage of the Wales Bill 2016-17 that’s proceeding through the Westminster Parliament, but will require approval by Assembly Members to become law.

With hundreds of millions of pounds in question, these talks will involve a lot of spilled ink in Whitehall and Cathays Park over the next few months.  Here, we outline the issues that make these negotiations so important for the future funding of Wales.

A Chip Off the Old Block

In the next few years, major new fiscal powers will be handed to Cardiff Bay, bringing in the first Wales-only taxes in more than 800 years. But passing the law was the easy part in implementing these taxes.

The whole argument for devolving taxes to Wales was largely constructed around accountability. Since the establishment of the Assembly the Welsh Government has been responsible for about half of all public money spent in Wales yet has had no obligation to raise any of it. This basic mismatch meant that that most basic democratic choice at elections, where voters assess spending pledges based on the credibility of the parties’ promises on tax, has never really gotten off the ground. What’s more, because there is no link between home-grown revenues and the Welsh budget, the Welsh Government bears no financial consequences from policy failures or successes. Even if a Welsh economic development policy had a transformative effect on the number of jobs or business startups in Wales for example, there would be no impact whatsoever on how much the Welsh Government had to spend.

In order for this accountability link to work in practice, the Welsh Government needs to bear the financial consequences of policy decisions it is responsible for.  But equally, it must not be penalised (or benefit from) the financial effects of policy decisions that are not under Welsh control. In a state with lots of overlapping services, apportioning accountability between the governments is very tricky, and getting the balance right is crucial for these talks. What’s more, depending on the outcome of the negotiations, there is the potential for hundreds of millions of pounds of losses to the Welsh budget within a short number of years.

At some future date to be decided during these talks, the Income Tax rates paid by every taxpayer in Wales will be cut by 10p in the pound, and the Welsh Government will levy a new tax to replace this. In return for handing over these powers and revenues, the Treasury will cut the annual £14 billion “block grant” to Cardiff Bay that currently funds all devolved services like the NHS, schools and highways. The first year this happens, this cut is simple: The budget cut, or “block grant adjustment”, can exactly equal the amount of money the Welsh Government raises from its new Welsh taxes.

So far, so simple. But calculating how much the Treasury should deduct from the Welsh Block gets harder to do in future years. The Treasury won’t (and shouldn’t) agree to cut the block grant by exactly the amount of tax that Wales raises itself, because that would give the Welsh Government a strong incentive to make deep tax cuts which the Treasury would have to pay for. Instead, the amount taken from Wales’ budget should match the amount of money that the Treasury would have raised in Wales had devolution not occurred – or to borrow a term from economics, the “opportunity cost” of devolving income tax.  Unfortunately for proud Welshmen there’s only one Wales: we can’t set up an alternative reality Wales where tax devolution doesn’t take place, so there’s no way to know precisely how much money this will be. It will have to be estimated and set by formula; and that’s is where the negotiation kicks in.

In a series of Wales Governance Centre papers here and here, we argue that all of the methods that were on the table in last year’s negotiation over Scottish tax devolution would have resulted in budget cuts had tax devolution occurred in 2010. There are several reasons for this, and the Welsh Government will want to ensure that the Treasury considers them. First, Wales’ population is growing relatively slowly, at less than half the rate of the UK as a whole: this will mean slower growth in the Welsh tax base over time. Second, because Wales has a higher percentage of lower earners, the UK Government’s policy under George Osborne to rapidly increase the personal allowance (the level of earnings at which you start paying income tax) drew disproportionately more Welsh incomes out of the UK tax base. Such a move would have meant a large cut to the Welsh budget under many methods of adjusting the Welsh block after tax devolution. In fact, we estimate that the disproportionate effects of UK personal allowance increases alone would have resulted in an unfunded annual cut of at least £100 million to the Welsh budget by 2013, and this cut would increase year upon year thereafter.  The section of the negotiations on how to account for effects of UK policy and population will involve strikingly large sums of money.

Four on the Floor

The Block Grant Adjustment formula is a mega-bucks topic, but it’s not the only one for the UK and Welsh Governments to agree on. During Stephen Crabb’s tenure as Secretary of State, the Treasury agreed to the long sought-after “Barnett Floor”. This is a mechanism designed to prevent a deterioration in Wales’ funding called the “Barnett Squeeze”.  During periods of increasing public spending, the famous Barnett formula (a UK government method to calculate public spending levels for Wales, Scotland and Northern Ireland) squeezes Wales’ spending per capita down to average levels for England. In Wales (and Scotland & Northern Ireland), this convergence process is seen as unfair, because higher levels of ill health and disability, a sparser and older population and lower incomes mean that the Welsh Government needs to spend more just to maintain the same level of service that can be provided in England.

At last year’s Autumn Statement, George Osborne implemented a funding floor that prevents funding provided to the Welsh Government from falling below 115% of comparable UK government spending for England. This Floor to stop the Barnett convergence process is good news for the Welsh Government.

Convergence to English spending is more of a theoretical problem than a real one at the moment, because spending restraint (“austerity”) during the current decade has probably resulted in the Barnett squeeze levelling out or even being put it into reverse. Nonetheless, since announcing the Barnett Floor the Treasury hasn’t published details of how the Floor will work, particularly how the Floor will interact with the multi-million pound cuts to the Welsh block referred to above (a “funding floor” is pretty ineffective if the block grant adjustment process results in half a billion of unfunded cuts to the Welsh budget!) Also, the Treasury has only promised a Funding Floor for the current Parliament, so that if public spending were to increase after 2020 Wales’ funding squeeze would return. The Welsh Government will look for these details to be nailed down before signing on the dotted line.

Neither a borrower nor a lender be?

Anyone familiar with UK and worldwide economic trends since the 2007-08 financial crisis knows that tax revenues can be volatile. So within limits, devolved borrowing powers are needed to help smooth this likely annual volatility of Wales’ tax take. And with big budget infrastructure projects such as the M4 relief road, A55 improvements and the South Wales Metro on the table, the new devolved taxes will also be used to support Welsh Government capital borrowing. The upcoming talks will set the limits on Welsh borrowing for years to come, so anyone looking for large-scale infrastructure spending will want to pay close attention.

In last year’s Scottish talks, the Scottish Government’s cashflow borrowing capacity was increased but these powers are governed by a strict set of rules. Scotland’s capital borrowing powers for infrastructure projects also increased from £2.2 billion to £3 billion, with an annual limit of £450 million. The Treasury were reportedly very reluctant to concede more ground on this issue, perhaps fearing a high-spending Scottish Government impairing the UK-wide objective (before the Leave vote in June) to eliminate the deficit by 2020. There are very good theoretical and practical reasons why Treasury limits on Welsh borrowing are necessary for national economic stability – several German states have had to be bailed out by the Federal Government and excessive spending by the Spanish regions was one of the primary causes of Spain’s severe recent fiscal downturn. The limits discussed for Scotland and Wales however are well within a sensible comfort zone.

There is at least an argument that Welsh borrowing powers should be proportional to the powers agreed for Scotland, but what “proportional” means may be contentious. For example, if we take Scottish devolved revenues under the Scotland Act 2012 (which devolved the tax powers that Wales will soon have) and use the ratio of total capital borrowing to the new devolved taxes, it would roughly double the Welsh Government’s capital borrowing limit to around £1 billion.  But using the ratio agreed at the last year’s Scottish negotiations might not greatly increase the Welsh Government’s capital borrowing limit from its currently agreed level of £500 million. The Welsh Government may raise Welsh-specific factors to argue its case, such as the volatile performance of Welsh taxes or the need for large (and expensive) infrastructure projects in Wales.

Couples Therapy

Even in Scotland where almost all Scottish income taxes are set to be devolved, there is a big concern that the institutions needed to manage tax devolution and to resolve complications are just not in place. Unlike the United States where the 50 states have entirely independent taxes from the US government, Wales’ income tax sharing system will inevitably generate conflict between the two governments and therefore requires mechanisms for coordination and dispute resolution. Other countries that share taxes have strong coordinating institutions: either an Upper Chamber in the national parliament where regions are represented; formal, binding and frequent intergovernmental forums; or powerful independent advisory commissions or “fiscal councils”. The UK has none of these and with the Treasury’s attention (already) turning to Brexit, the challenge will be for Wales’s revenue interests to be taken seriously when far bigger-budget items are demanding attention. After all, £500 million might be in rounding error territory at the Treasury but is an eye-watering cut from the perspective of the Welsh budget.

Outside of the big budget items there are other important matters that the Welsh Government will be thinking about. At the moment, the Chancellor’s Autumn Statement – one of the set piece events of the UK government’s year – occurs in late November or early December. This happens to be right in the middle of the Welsh budget scrutiny process in the Assembly which runs from October to February. The Treasury is likely to announce Wales’ multi-billion block grant adjustment at the Autumn Statement, and if this number is higher or lower than the Welsh Government expects, it will have to amend the budget proposal right before the National Assembly’s long Christmas recess. With the small number of backbench Assembly members already a cause for concern in terms of the Assembly’s capacity for scrutinising the government, the important job of dissecting the budget might be condensed into a few short weeks in the New Year.

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The UK and Welsh Treasury teams will have a tough job on their hands, but unlike the Brexit negotiations, we have a precedent in last year’s Scottish negotiations. Although the talks will hopefully be reaching resolution around the time that Article 50 is triggered, don’t be surprised to see one or two fireworks along the way.