Fair funding and no representation without taxation

Devolution has been a hot topic in Wales, Scotland  and Northern Ireland for more than a decade and has even attracted some attention in England. True, the one English region offered minimal devolution, the North-east, rejected it in a referendum. As Schumpeter pointed out, democracy means rule by politicians and sometimes the English distaste for politicians trumps their absent-minded attachment to democracy. Still, the Labour party points to devolution as one of the successes of its time in office.

Now, with another devolutionary step about to be taken in Scotland as Westminster prepares to legislate on aspects of the Calman Commission proposals to devolve further taxation powers, systematic attention needs to be given to the UK system of funding the devolved authorities. It is unfair in its distribution of resources, both among the devolved areas and with respect to English regions. Moreover, that unfairness means that plans to devolve more taxation powers to Scotland at least will be a dead letter. No devolved government will dare to use fiscal powers while it also receives a block grant so open to challenge for its arbitrariness.

Finance for devolved authorities is currently provided via the Barnett formula. It starts with the increase in expenditure per head each year in England on those government functions that are devolved in the other countries of the UK. It then adds the same cash amount per head of population to the previous year’s grant to the devolved authorities.

The rationale for the size of the original grant is lost in mists of time. Is the grant appropriate? The Barnett formula answers with a shrug. That has its political advantages. If there are no acknowledged criteria for making a grant, it cannot be criticised. It is simply an arbitrary procedure that hands out money and avoids the need for argument or horse-trade.

It was set up in the 1970s as a temporary expedient and, as Joel Barnett chief secretary to the Treasury at the time has remarked, it was not expected to last more than a fortnight. The present government is on record as saying both that the formula is approaching the end of its useful life and that it has no plans to do anything about it.

However, the pressures for change are growing because the problems with the formula are more acute than the government acknowledges. The Richard Committee of the House of Lords conducted an enquiry last year, interviewing Treasury ministers and secretaries of state, and roundly concluded that the Barnett formula was not fit for purpose and should be replaced by a needs-based formula.

Evidently the notion of ‘need’ is a contested one. Is my need real or merely something I would like to have? And how are multiple needs to be weighed against each other? While such questions can be difficult they are not unanswerable. Indeed, governments answer them all the time. In the UK, for example, formulae are used to distribute resources to health authorities around the country, and formulae are used to provide local authorities with revenue support grants that make up over three-quarters of their funding.

Until quite recently formulae were also used to distribute spending on education.  All were based on indicators of need. The formulae are complicated but basically need per capita reflects three fundamental factors:

• Demographics – more young people, more schools, more old timers, more health expenditure.
• Deprivation – more poverty means worse health and other phenomena requiring public intervention.
• Cost – it is more expensive to provide services for example in sparsely populated areas.

The Welsh Government’s Independent Commission on funding for Wales analysed the formulae and showed they could indeed be boiled down to a much simpler formula with a few proxies for those three key factors. The simple formula was able to explain over 95 per cent of the variation in relevant public expenditure per head across the localities of England, Scotland and Wales. It therefore extracted the existing distributional choices and preferences of governments and showed these could indeed be expressed in a simple formula.

When we applied the formula to the English regions and the other UK countries the Richard Committee conclusions received dramatic support. Relative to the English average (=100) Scotland’s needs per head were assessed at around 105, compared with 112 for the North-east, 115 for Wales and 121 for Northern Ireland, based on demographics, population sparsity and measures of health and income deprivation.

However, allocations from the last spending review gave actual expenditures around 120 for Scotland and 112 for Wales, while Northern Ireland is fairly close to the needs-assessed level. New budgets for the devolved administrations will be decided as part of this autumn’s spending review, but relative expenditure per head in the devolved countries is unlikely to be very different from these levels. Three English regions, the North-east, North-west and West Midlands, as well as Wales, have greater needs than Scotland but all receive much lower spending per head.

The current UK government response was that it could not afford to address the issue until budgetary consolidation had been achieved. Its position is nonsensical since the results imply that if English regional expenditures are maintained at their current level, Scotland should get some £4 billion less annually than it does while Wales should get a few hundred million more and Northern Ireland might not change much, if at all. The net effect is a saving of over £3 billion a year. Evidently it would be impossible to make that saving at a time when expenditure was already being cut. Changes would have to be phased in and could well take more than a decade to complete. But there is no implication that reform would cost more. Rather, the reverse, it would eventually save money.

Moreover, the government is proposing to legislate on the Calman Commission proposals to give more fiscal powers to Scotland, including devolving 10p of income tax and allowing the Scottish Parliament to alter that rate as much as it likes. Yet the Calman Commission itself acknowledged that Scotland must expect the block grant to be changed to a needs basis eventually.

How can the government legislate on taxation without facing Parliamentary challenge on the block grant? Surely Northern English MPs will propose amendments, to say nothing of the House of Lords. The political difficulty of adjusting the Scottish grant may be daunting but the Calman settlement provides the best opportunity a Westminster government is ever going to get – and parliamentarians know it.

None of this is to dispute the central finding of the Calman Commission, that further devolution of fiscal powers is necessary for proper accountability of the Scottish parliament. It is anomalous that a public body should be responsible for spending billions of pounds of public money without having the responsibility to raise any of its own finance. Public finance theory and experience both suggest that is not a situation in which the money will be best spent.

And with one government raising the money and another spending it, the clear accountability of both for public services is compromised. But fiscal powers will, as for local authorities, only provide part of the finance. Much will still come from a central grant. If fiscal devolution is to be meaningful it requires solidity of the grant which should not be subject to political backlash if devolved taxes are changed.

Scotland has had limited powers to change income tax rates since devolution began but has never used them. A number of academics in Scotland have attributed that fact to the knowledge that the Scottish grant was generous and any reduction of Scottish taxes would focus attention and lead to a furore in England.  Giving Scotland more theoretical powers will not change that situation. The Scottish Parliament will continue to be hamstrung unless its grant is based on reasonable and transparent criteria and we are on a path to fairness. Fixing the grant is therefore a precondition for meaningful fiscal devolution.

Once that is achieved, another question will immediately impose itself. If the principle of proper accountability requires fiscal devolution to Scotland, how are the other devolved territories different? The answer is that they are not.

Devolution in Wales and Northern Ireland has created democratic bodies able to reflect their people’s preferences but which are nonetheless public finance monstrosities – bodies with no accountability for raising finance or for the level of taxes their electors pay, but spending billions of pounds of those taxes. If Welsh and Northern Irish electors demand similar fiscal powers to those envisaged for the Scottish Parliament, there is no principled basis for refusing them. It is time to look logically and systematically at the foundations of devolution finance and base it on principles that hold across the UK. Ad hoc improvisation has not served the UK too badly but the time has come for some tidying up.

All that, of course, assumes we are talking about devolution within an essentially unitary state. The line of the SNP minority government in Scotland is different.  They want to side-step the discussion by claiming all Scotland’s taxes, including their share of North Sea oil. They claim Scotland would then be self sufficient and not require any grant at all. Of course, the plausibility of that claim depends on the oil price. Generally Scotland has not achieved notional fiscal balance except at the peak of oil price cycles. Instead, it has been in moderate deficit, though one can argue about Scotland’s share of expenditures like defence and debt service.

Nonetheless, there is a coherent position that goes some way towards the SNP, without entailing Scottish independence. It involves making the UK a formally federal state where each part of the federation has its own revenue and engages in explicit transfers with other parts. Most federations have payments from states to the centre for central services, like defence and customs, and other equalisation payments among the states to balance up revenue per head and limit inequality of public services. Whether Scotland would be better off under such a system would depend on the rules and nature of such transfer payments.

That contrasts with a unitary system where taxes are common to the whole state, apart from those explicitly devolved. Hence Scotland does not charge the rest of the UK for oil, any more than Wales charges Birmingham and Liverpool for their water. Natural resources belong to the private entity that owns them and the taxes they generate are regarded as common to the UK. Expenditure is then allocated on the basis of need.

That is the current framework except for the anomalous Barnett formula, which takes no account of need. Federalisation of the UK is logically possible but it is not clear what advantages it confers that could not be achieved by appropriate reforms of the existing system. Moreover, it is likely to throw up practical difficulties as long as England resists its own regionalisation.

Meanwhile, in the world as it is, introducing the Calman reforms for Scotland presents a unique political opportunity to reform Barnett and rationalise devolution finance across the UK.

References:

Commission on Scottish Devolution (Calman Commission), Serving Scotland Better: Scotland and the United Kingdom in the 21^st Century, 2009.

House of Lords Select Committee on the Barnett Formula (Richard Committee), The Barnett Formula: report with evidence, 2009.

Independent Commission on Funding and Finance for Wales, Fairness and accountability: a new funding settlement for Wales, 2010.