The economics of UK constitutional change: introduction.

Armstrong, Angus ; Ebell, Monique

The tectonic plates of UK economic and political power are shifting. The Glorious Revolution in 1688 brought institutional reforms, including the Bill of Rights, that aligned political and taxation power in Westminster. In their famous study, North and Weingast (1989) interpreted this alignment as a necessary condition for the industrial revolution to take place in England. Local government functioned through parishes, boroughs and counties which survived most of the next century before consolidating into regional authorities. Over the next two centuries, UK government became increasingly centralised in line with political enfranchisement.

Today political and fiscal powers in the UK are moving once again. After the Scottish referendum, significant taxation powers are being devolved to north of the border. The Scottish government will be one of the most powerful sub-central governments, in terms of control over spending and taxation decisions, in the OECD. If the promised 'English votes for English laws' is implemented, income tax, the most visible and highest yielding source of tax revenue, will be put beyond the direct control of the UK government for the first time since it was introduced in 1799. The big unknown is whether and how political and economic power can be decentralised in England. This government's 'city regions' initiative devolves political and spending power but it remains to be seen whether this will be followed by meaningful taxation powers.

This shift in power in the UK may be rather piece-meal to date, but institutional changes are fundamental to the prospects for long-term prosperity. This issue of the Review brings together four papers by economists at the forefront of research on the current constitutional changes in the UK.

Unions, nations and localism

A resurgence towards regional autonomy can be observed across Europe. The Scottish referendum last year showed that citizens choose whether to stay in the UK. There was an unofficial poll in Catalonia in Spain covering an estimated 30 per cent of eligible voters which showed 80 per cent in favour of becoming an independent state. This was not recognised by the Spanish government who steadfastly refuse to authorise a referendum. The Basque Country and Navarre region, which currently enjoy a mostly autonomous status in Spain, are also thought to have strong independence leanings. Flanders, the largest region in Belgium, and some northern states in Italy have substantial independence movements.

To steal from Tolstoy, each unhappy state is unhappy in its own way. Each region seeking autonomy or independence has an appeal to some particular cultural heritage. Yet for all the heterogeneity between European nations there may be common reasons for this resurgence. The rise of globalisation and the new economic challenges demand a response from governments. Globalisation impacts on communities very differently depending on skill levels and specialisation which may shift the need from central to local provision. It may be that more local levels of government can better reflect the needs and preferences and cost of delivering services than central government.

A supporting factor may be that citizens of the EU have guaranteed access to the second largest economic market in the world, which removes a justification for the creation of some nations and unions in the first place. For example, even after the Union of Crowns in 1603, England continued to rule the waves. It was an ill-fated Scottish venture to colonise Panama to create a whole new trade route which led to the eventual Acts of Union in 1707 which brought political, fiscal and monetary union in return for access to trading in the Empire. The origins of the European Union are in part a determination to rid the continent of devastating conflicts forever, but also leading statesmen's awareness of a lack of geopolitical power as separate nations. After the US forced the withdrawal of the UK and French forces at Suez, Chancellor Adenauer is reported to have said there "remains only one way of playing a decisive role in the world; that is to unite to make Europe". (1) The single currency may be first step in the evolution of a political boundary around European nations.

It is unlikely that EU membership would change with a consensual change in national boundaries. This means that the sovereignty of smaller states may no longer be inconsistent with access to global markets. In short, regions can respond to the challenges of globalisation without having to fear losing access to their main market including the use of a common currency.

Being part of a union of nations, or part of a nation, also comes with shared responsibility. The political momentum for devolution is at odds with the economic constraint of public debt. Spain, Belgium and Italy all have federal debt to GDP ratios in excess of 100 per cent. It is also notable that Catalonia, the Basque Country and Navarre are affluent regions in Spain. Catalonia makes a substantial contribution to the federal budget (being 16 per cent of Spain's population). In Belgium Flanders is far more prosperous than Wallonie. In Italy the northern states have long made net contributions to the national government. If these regions were to secede, the finances of their already heavily indebted central government would be considerably worse. This may also explain why these regions seek autonomy.

Scotland appears to be the exception to this rule that the net contributors seek greater autonomy. Excluding London, Scotland's level of prosperity is exactly the same as the rest of the UK. This may also explain why the rest of the UK was prepared to grant Scotland an independence referendum. The campaign had a fatal economic weakness in that ending political union would also end monetary union with the rest of the UK. While Scotland could unilaterally use Sterling or establish its own currency, as long as it would have to inherit its fair share of existing UK public debt this would be a difficult task (see Armstrong and Ebell, 2014). As in Europe, public finances were the constraint on the options for an independent Scotland.

Bell and Eiser (in this issue) use survey evidence to uncover the motivation for further devolution. They start by showing the proportion of residents in Scotland describing themselves as British "has increased quite markedly from 23 per cent in 2001 to 32.5 per cent in 2014". Moreover, looking at the British Attitudes Survey they find no statistical evidence of "significant differences in preferences between Scotland and the rest of the UK across these scales". Yet there is a clear preference revealed by the survey data for devolution of taxes and benefits to the Scottish parliament. However, when those who support full or partial further devolution are asked whether they would prefer higher or lower rates, the dominant answer was to maintain the same rate as the UK. For example, income tax is to be fully devolved to Scotland yet 63 per cent of those who favour devolution want the same rates as the UK (excluding 'don't knows'). Bell and Eiser suggest that the substantially higher level of trust toward the Scottish rather than the UK parliament may be a better explanation than simply heterogeneity of preferences.

Regional imbalances

A striking feature of the UK is the degree of regional inequality compared to continental Europe. Figure 1 shows quintiles of income per capita across the EU by major socio-economic regions, as classified by Eurostat, benchmarked to the average for the EU. The large countries in the eurozone may or may not have higher income levels than the UK--much depends on the conversion rates between UK to Euro Area output in purchasing power parity terms. (2)

Our focus is on the within state inequality. The UK has regions in all five quintiles. No other large economy in the EU has this degree of variation. At the next level of disaggregation (NUTS3 in the Eurostat data), the degree of inequality is even greater. Inner London has by far the highest level of income in the EU while we still have some regions which are similar in income to the poorest of the original eurozone nations. Greater London (which includes inner and outer London as shown in the map) has primary per capita income 80 per cent higher than in Northern Ireland and the North East of England. (3) It is worth noting that the population of Greater London is 8.6 million.

Travers (in this issue) raises the fascinating issue of how public finances redistribute resources between the constituent nations of the UK (higher public spending in the lower income nations). By contrast there is no mechanism to achieve similar redistribution within the regions of England. In both cases the difference between nations and regions has been remarkably constant over decades. "A highly centralised system of taxation and public expenditure is not, it would appear, a guarantee of territorial economic equalisation". Travers raises the question of cause and effect. It could be that centralisation has "adverse consequences for the competitiveness of regions and cities" and may have "contributed to regional and city-regional differences". This would suggest prima facie support for greater devolution of economic power. The counter argument is that the regional differences would persist even without large transfers. Travers suggests that one reason why devolution has not occurred in England is that this "would represent a challenge to the power of Whitehall departments." And that "without full control over the expenditure of every municipality, the Treasury would not have been able to force local government to bear such a disproportionate share of expenditure reductions which have been such a large part of cutting the deficit."

[FIGURE 1 OMITTED]

This government is encouraging a new form of localism through 'City Deals' intended to increase local participation while recognising regional differences to improve decision-making efficiency, especially in infrastructure. O'Brien and Pike (in this issue) provide the first national comparative analysis covering 32 interviews of the lead actors in City Deals announced to date. City Deals come about when local actors in the private and public sectors to form partnerships to approach central government with requests for support for specific transactions. While the approach has been piece-meal, the 28 City Deals signed so far cover 48 per cent of the population. Most of these transactions involve infrastructure and a new form of financing arrangement and come with greater local accountability such as Metro and City Mayors, Combined Authorities and Economic Growth Boards. O'Brien and Pike argue deal-making raises substantive and unresolved issues for governance in the UK that are especially pertinent as the new government pledges to widen and broaden this approach as a central component of its devolution strategy.

Macroeconomic framework

The most important economic issue in the world today is the fate of the euro as the currency of the EU. It is worth pausing to note the root cause of the fragility of the single currency. The euro was introduced in the hope that political union would follow allowing some form of fiscal union to enable risk sharing across the union. This is necessary to soften economic shocks in the absence of currency and monetary policy options. High levels of debt were a further limit on the room to manoeuvre by economically weaker nations. Chancellor Kohl fully understood the need for political union to accompany monetary union at the time of the Maastricht Treaty.

Armstrong and Ebell (in this issue) look at English votes for English laws (EVEL) and the complication of devolving fiscal power within a monetary union where there is a high degree of asymmetry between the size of nations. They note that it is often asserted that smaller members in monetary unions suffer from inappropriate monetary policy which is more closely aligned to the needs of the larger members. One example includes the ECB tightening in 2011, which might have been appropriate for Germany, but was wholly inappropriate for peripheral eurozone countries. Armstrong and Ebell show that similar issues are likely to arise in the UK under EVEL. When two regions in a monetary union are heterogeneous--either because they have different preferences, or because they face different economic conditions--then they will choose differing fiscal policy stances and union-wide monetary policy will be set as a weighted average of the appropriate policy for each region. In this way, the fiscal policy of one region influences monetary policy for the whole union. When one region is as overwhelmingly large as England, then its fiscal policy will have a much larger impact on the smaller regions than vice versa.

How much is this likely to be an issue? The government proposes that a Grand Committee of English MPs will have a veto on English only legislation. This will most likely include income tax. In some circumstances, the majority of English MPs may not be of the same party as the UK government. In other words, the UK government would not have full control over income tax revenues. If a future UK government proposed, say, higher income taxes which the Grand Committee decided to veto, then, all else equal, this would be accompanied by higher interest rates for the whole of the UK. In the midst of a debt or financial crisis, these ambiguities and imbalances may be a significant issue just at the wrong time.

NOTES

(1) Quoted in Kissinger (1994), p. 547.

(2) An important caveat is warranted that the lack of regional consumer price indices in the UK could lead to an overstating of regional imbalances.

(3) ONS Regional Gross Disposable Household Income per Head 2014.

REFERENCES

Armstrong, A. and Ebell, M, (2014), 'Scotland: currency options and public debt', National Institute Economic Review, February, 227, I, R14-20.

North, D.C. and Weingast, B. (1989), 'Constitutions and commitment: the evolution of institutions governing public choice in seventeenth-century England', Journal of Economic History, 49/4, pp. 803-32.

Kissinger, H. (1994), Diplomacy, Simon and Schuster.

Angus Armstrong and Monique Ebell *

* National Institute of Economic and Social Research and Centre for Macroeconomics. E-mail: a.armstrong@niesr.ac.uk or m.ebell@niesr.ac.uk.