Mackay Hannah conference: The Scottish Parliament’s new powers, 27 June 2016
Scotland’s new financial powers: the opportunities and risks
SLIDE 1
Good morning.
I imagine that Scotland’s new financial powers haven’t felt like the most important political development for any of us over the last few days. As I was going over my notes for this conference yesterday evening, in between checking Twitter for the latest intervention or resignation, I couldn’t help wondering if anyone would be interested in taking time out to think about the new financial powers, and the opportunities and risks they bring with them.
But on reflection, however things unfold, those opportunities and risks will be even more important in this new political landscape, and it feels very timely to take stock.
It’s almost two months since the Holyrood elections. Now that the Parliament has welcomed our new MSPs and established its new committees, the months ahead will bring big changes in Scotland’s public finances, as the Parliament takes on a substantial increase in its financial powers.
The debate about how to use those powers has only just begun and, given the very different manifesto commitments from each of the political parties, as well as the events of the last few days, there will continue to be a debate over the life of the new Parliament – in particular, whether to use the new tax powers, and how to spend the revenues they raise. 
This new chapter in Holyrood’s history brings big opportunities but also some significant financial risks. As Auditor General for Scotland, I’m particularly interested how we ensure that public money is well spent and provides value for money – and we all have an interest. Today, I’m going to focus on the opportunities and risks to the public finances. 
Devolution has been a long and complex journey for Scotland, and it’s still evolving. Here’s a brief history so far. 
SLIDE 2: History of devolution
The first step was the Scotland Act 1998, which set the foundations for the Scottish Parliament. The Act set out the matters that are reserved to the UK Parliament, and those that are devolved to Scotland, including health, education, housing and justice. Essentially the Parliament was determining how best to spend the money that flowed to it from the UK exchequer through the Barnett formula. The powers to vary the rate of income tax were never used.
Fast forward to 2012, and a new Scotland Act introduced limited new financial powers, with greater responsibility for revenue raising including: 
•	The requirement to set a Scottish rate of income tax to replace 10p in each tax band for those identified as Scottish taxpayers.
•	Two new devolved taxes to replace stamp duty and landfill tax in Scotland. 
•	Capital borrowing powers, up to a total of £2.2 billion.
We then saw the referendum on independence in September 2014. 
In the run up to what looked like an increasingly close vote, the leaders of the UK Conservative, Labour and Liberal Democrat parties made a commitment – ‘The Vow’ - to give Scotland further devolved powers in the event of a ‘no’ vote. 
This led to the establishment of the Smith Commission, on which all the political parties with members in the Scottish Parliament were represented. The Smith Commission worked quickly and reported in November 2014, setting out recommendations for the devolution of significant further powers. This in turn led to the Scotland Bill 2015-16, introduced to the UK Parliament in May 2015. Following intensive and widely reported negotiations between the UK and Scottish Governments, the Bill was passed by the UK Parliament and enacted on 23 March this year. 
SLIDE 3: Scotland Act 2016
The Scotland Act 2016 will give the Scottish Parliament a range of new financial powers:  
•	For all practical purposes, it will have full control of income tax from next April, including the rates and bands of income tax levied on all non-savings, non-dividend income for Scottish taxpayers. 
•	Responsibility for 11 social security benefits worth an estimated £2.7 billion will be devolved, mainly relating to disability. Parliament will also have the power to introduce new benefits in future. 
•	The first 10p of the standard rate of VAT raised in Scotland will be assigned to the Scottish budget. 
•	Two further taxes - Air Passenger Duty and Aggregates Levy – will be fully devolved.
•	And finally, the Scottish Parliament will have increased borrowing powers from April 2017, with aggregate borrowing limits of £3 billion for capital expenditure, and £1.75 billion for revenue. It will also have the power to build up to £700 million in a reserve, to help smooth spending and manage tax volatility.
SLIDE 4: Taxation as share of devolved expenditure
There’s no doubt that the Scotland Act represents a substantial increase in the financial powers of the Scottish Parliament. 
The proportion of devolved spending funded by devolved and assigned revenues:
•	Was 10 per cent prior to the powers introduced by the Scotland Act 2012 – limited to non-domestic rates and council tax;
•	That figure has risen to 22 per cent in 2016/17, as all the powers in the Scotland Act 2012 go live;
•	And the proportion of devolved spending funded by taxes raised in Scotland will ultimately rise to around 50 per cent as the powers included in the Scotland Act 2016 come on stream. This includes a rise in spending on the social security powers of around £2.7 billion. 
These powers are underpinned by a new fiscal framework, which was agreed between the UK and Scottish Governments in February. This sets out the rules within which fiscal policy should be conducted, including how the block grant will be adjusted to reflect the new tax powers, and the how the new borrowing powers and the cash reserve can be used.
All of these changes provide the Scottish Parliament with more control over Scotland’s public finances and the opportunity to take new approaches, but they also bring new financial risks that will need to be managed. 
SLIDE 5: Opportunities and risks 
Greater financial power means more flexibility on policy choices over tax and spending for the Scottish Government. Pressure on the public finances will remain a challenge during the next session of Parliament:
•	UK government’s commitment to running a surplus by 2020 – and there seems little doubt that the result of the EU referendum will make that harder
•	financial pressures from policies like the national living wage and changes to pensions
•	demographic pressures and rising expectations of services
•	policy commitments on education, health and social care.
It seems very likely that the Scottish Government will want to demonstrate that it’s using its new tax powers to mitigate some of these pressures. This was a big feature of the debate over the Scottish budget for 2016/17, with the limited power over income tax that came into effect that year. And proposals for the use of the new powers, in particular the ability to set income tax rates, were front and centre in the political manifestos and debates in the run-up to the election last month. 
At the same time, the Government is developing plans for using its new social security powers. It’s likely to take a different approach from the rest of the UK, following the First Minister’s commitment to tackle inequality and produce a fairer, more prosperous country.
All of this means that the Scottish Government, and the Parliament, will have the opportunity to take a more strategic view of the public finances than was necessary when most spending was funded by a block grant transfer from Westminster. There will be scope, at least in principle, to raise additional revenues to pay for distinctively Scottish policies and services. And there will also be the chance to think in the round about social inclusion and a more inclusive economy – how can expenditure on education and lifelong learning sit alongside new social security benefits to help more people into work, with benefits for them as individuals and more tax revenues for the Scottish government? If we get it right, it takes devolution to an entirely new place – and of course there are no magic bullets.
So what about the risks?
First, the new powers will mean greater volatility. Tax revenues and social security spending are both volatile, and both are difficult to predict. So, for example, if tax revenues are lower than anticipated, or social security spending is greater than planned – and quite possibly both at the same time – the Scottish Government will have to manage the consequences. 
Their options include revenue borrowing, drawing on reserves, or cutting spending – where that’s possible. The new fiscal framework contains some provisions to accommodate the specific fiscal risks that the Scottish Government may face, but these provisions are complex, and they incorporate set limits on borrowing and the use of the new Scotland Reserve. 
Second, the fiscal framework is critical to making the new powers work. The framework was the result of lengthy negotiations between the two Governments, and was only finally settled by a compromise over how the block grant from Westminster will be adjusted for the first five years. There will then be an independent review of the framework, and once again the UK and Scottish Governments will have to agree a mechanism for the longer term. It’s a complex package, and it’s also politically very sensitive. The relationship between the two governments will be crucial in making it work, and that relationship is unlikely to be easy – and again, the events of the last few days add another layer of uncertainty.
Third, the performance of the Scottish economy will have a direct impact on Scotland’s public finances and the Scottish budget in future. If the Scottish economy performs poorly, it will limit the amount available to the Government for investment, and at the same time increase demand-led spending, such as social security. On the other hand, if the economy performs well, then more taxes than anticipated may be collected, providing opportunities for additional spending or reduced taxation.
There’s a debate to be had about how far the new powers represent a coherent package of levers that can genuinely influence economic growth. But whatever your view, managing significant new revenue streams from taxes and VAT, and spending on social security, will mean a much closer eye needs to be kept on economic growth. The Government’s budget will also depend heavily on good forecasts for the first time. The implications of this, and the knock-on effects for public spending, will only really become apparent over time, but it’s clear that we’re entering an entirely new phase. SG review of enterprise, development and skills agencies.
What we can say at this stage is that there are undoubtedly implications for parliamentary scrutiny, and for the role of audit in supporting Holyrood to carry out its role.
SLIDE 6: The role of parliamentary scrutiny and audit
The fiscal framework forms part of the wider system for the Scottish public finances, and there’s now an urgent need to develop that wider system to reflect the new powers. This is especially important given the continuing financial pressures on Government, and the ambitious programme of public sector reform underway in areas such as health and social care, education and communities. 
Three areas stand out for me: 
•	Firstly, the case for comprehensive, transparent, reliable and timely reporting of Scotland’s public finances has never been stronger. A key element of this is an overall account of the revenues, expenditure, assets and liabilities of the Scottish public sector as a whole – we have Whole of Government Accounts for the UK, which incorporate Scottish information, but we don’t yet have the equivalent picture for Scotland. We need to know how much is already committed to long term investment through borrowing and public private partnerships; the cost of pension liabilities; and the value of assets like buildings, roads and other infrastructure, in order to make good decisions about future tax and spending.
•	Secondly, there’s a need for much greater transparency to enable Parliament, government and the public to understand and debate the basis on which policies and decisions are made. It’s critical that the Parliament develops a new budget process that enables it to scrutinise tax as well as spending proposals, and includes clear and robust information on the most important issues. This will include things like:
•	revenue and expenditure forecasts, and the reasons for movements between years. Performance of HMRC; assignment of VAT revenues?
•	changes in the Scottish block grant. The Barnett formula is already criticised for being opaque, but it’s going to get much more complex. The Barnett formula is enshrined in the fiscal framework, along with separate mechanisms for making baseline adjustments to the block grant for each devolved tax or benefit, and for indexing those adjustments into the future. The formula and the way it works in practice will also be politically very sensitive.
•	the use of capital and resource borrowing powers, and their long-term revenue consequences
•	and last but certainly not least, there’s a need to link spending proposals more clearly to outputs and the desired outcomes in the National Performance Framework. This isn’t new, but there is an opportunity to make the link between spending and outcomes clearer as budget scrutiny develops.
•	Finally, there will be a new urgency to understanding the financial sustainability of Scotland’s public finances. There will be a need for longer-term thinking and planning, and the development of financial strategies to manage the greater volatility of funding and spending – while at the same time making sure public services make a real difference to the people of Scotland. There is a role for audit, alongside the new Scottish Fiscal Commission, in supporting the Parliament to scrutinise the management of the public purse, and to hold the Government to account for its spending and policy decisions.
The Smith Commission recommended that Holyrood should develop its arrangements for scrutinising the use of the new financial powers, and we’re committed to supporting the Parliament. The pace and scale of change mean that there are real challenges for the Government, the Parliament and everyone else involved. But, it’s also a rare and exciting opportunity to shape Scotland’s fiscal future for generations to come.