Two leading economists are to publish a paper tomorrow (24 October in the Fraser of Allander Quarterly Economic Commentary) restating the case for Scottish fiscal autonomy.

Additionally, they release their rejoinder to a further critique of their work in the current issue of Fraser of Allander Quarterly Economic Commentary.

Professor Ronald MacDonald, Adam Smith Chair of Political Economy at the University of Glasgow and Professor Paul Hallwood, University of Connecticut write that: "Earlier this year a paper of ours on fiscal autonomy for Scotland was attacked in the Fraser of Allander Quarterly Economic Commentary. In that paper we criticize the current funding system for the Scottish Parliament (based on the Barnett block grant from Westminster) for not serving Scotland's economic and financial interests. What our critics argue is that the block grant formula works well to discipline the Scottish government and that the status quo is just fine. Isn't it odd therefore that, other than the Labour Party, none of the leading Scottish Parties find the fiscal status quo palatable?"

In their new paper, Hallwood and Macdonald present detailed economic analysis arguing that the Westminster block grant really does not effectively discipline Executive spending, nor, does it offer good incentives to the Executive to get it right. An analogy is offered to make plain to non-economists what is the basic problem with the present block grant system:

Suppose "a rich Laird gave his son a generous allowance. He links this allowance to an obscure formula that over time basically makes little or no difference to the size of the allowance. He also tells his son that he would like him to earn some money on his own account and to hand it over to him when he gets it. Furthermore, part of the deal is that however much each year the son hands back to the Laird the generous pocket money will always be paid. Anybody can see that this is a formula for a rake's progress. The boy will reason that with the allowance secure 'why bother working to improve myself?'

Hallwood and Macdonald argue that the problem with the status quo is that the Executive does not have to be concerned with fiscal matters such as matching taxes with spending; nor does it have to be concerned for reasons of fiscal discipline with introducing fiscal polices to raises the Scottish tax base by promoting economic growth; nor, if taxes raised in Scotland fall, does the Executive have to worry about balancing its budget by cutting the level of public spending; nor does it have to risk the wrath of voters by raising tax rates (rather than cutting its spending); nor, even, does the Executive have to think about increasing its borrowing by issuing tradable securities against future tax revenues.

Hallwood and Macdonald make the following points in their paper:

ﾷ Besides being in favour of the status quo our critics claim that we marginalized equity-in-the-Union considerations. But this depends very much on the preferences of the electorate - whether it wants to continue pursuing this objective in the same way as in the past. Besides, the current equity settlement reflected in Barnett could well disappear once Barnett is reformed.

ﾷ Our critics essentially avoid the important issue of the incentivising effects of tax changes on private sector behaviour, stressing the potential costs of moving to a more devolved fiscal system. They say that 'the Scottish Parliament can increase or decrease its budget through increasing or decreasing the standard rate of income tax.' However, we argue that the rate of variation allowed is small and we believe would do little to produce incentives for the existing labour force, nor be sufficient to reverse the persistent outflow of talented labour from Scotland evidenced over the years.

ﾷ And it is only income tax the Scottish Parliament can currently change. Changes in corporation taxes and other taxes, such as VAT, seem to have had powerful incentive effects in other countries, but the Scottish parliament currently has no power over them.

ﾷ We argue that cuts in corporation tax could be used to reinforce and bolster Scotland's existing strengths. For example, Scotland has world renowned judicial and educational systems and an important financial sector built on the existence of a well-qualified work force and well-defined property rights. Why shouldn't Scotland aspire to be the leading financial sector in the world (with the sector based in the Glasgow- Edinburgh hub)? Other countries - Switzerland and Luxembourg, for example, have so aspired and have made dramatic inroads in this regard (for example, the authorities in Luxembourg have skilfully manipulated their VAT system vis-a-vis the rest of Europe to build an important financial services sector and a very prosperous economy).

ﾷ Our critics fail to examine the recent empirical evidence which supports the case for increased fiscal devolution for Scotland.

ﾷ They also emphasise the down side costs of the ability to have freedom over tax raising powers. One is the potential spillover effects - in terms of labour and capital movements ﾖ of having tax rates which are quite different to our near neighbour. But for a small economy, such as Scotland, vis-a-vis its much larger neighbour, the negative spillovers for the neighbour are likely to be small while the positive advantages for Scotland are likely to be highly significant.

ﾷ Indeed, it can be argued that the current system has had detrimental spillover effects for Scotland in terms of north-south labour movements. Again, Luxembourg seems to be a good example of a small open economy that has created negative spillovers for its much larger near neighbours, but not incurred their wrath.

ﾷ Our critics are correct to note that a move to more fiscal devolution for Scotland would mean moving away from the insurance function offered by the current system to one which is much more uncertain, relying on the vagaries of the price of oil. However, and as we noted in our previous paper, there are methods of smoothing oil revenues and the Norwegian model seems to offer an excellent example of this.

ﾷ We agree with our critics that with fiscal devolution, the West Lothian question is likely to become even more poignant than it is now. However, we argue that the status quo fiscal-cum-Barnett settlement is not a stable political equilibrium for the UK.

ﾷ We also note an anomaly stressed in our previous work. The UK government has made having sufficient fiscal flexibility as a key test for joining a monetary union: Scotland is already part of a one-size-fits-all monetary union and has very limited fiscal flexibility.

Martin Shannon (m.shannon@admin.gla.ac.uk)

The work on Fiscal autonomy for Scotland by Hallwood and MacDonald should be seen in the context of the following backdrop. There is currently a very live political debate regarding the net subsidy flow in the UK ? the SNP argues it runs north south whilst the Conservative party and other unionist parties argue that the subsidy runs south north. This combined with the so-called west Lothian question mean that the current Barnet funding formula is not a stable solution for the Executive and some alternative financing mechanism will have to be found in the future.

In the report of the Steel Commission, the Liberal party argue for a form of fiscal federalism, while the Conservative party seem to be moving closer to the fiscal autonomy position. The Labour party?s position seems to be to stick with the Barnet formula and avoid discussions of the alternatives.

The full report will be published in the Tuesday 24 October issue of the Fraser of Allander Quarterly Economic Commentary and is also available here: The case for Scottish fiscal autonomy along with the rejoinder by Hallwood and MacDonald to a further critique of their work which is also published in the same issue of the Fraser of Allander Quarterly Economic Commentary.

First published: 23 October 2006