Smile of a tartan taxman; Politicians love to spend our money on

Economics being 'the dismal science', its practitioners have to take their humour where they can find it: hence the joke that fiscal autonomy should not be confused with the legendary Irish folk singer Fisgael O'Tonomie.

Seriously though folks, that issue of how Scotland raises its taxes is now of vital importance for a devolved political system which has been designed to worry more about how to spend them. It is at the heart of the SNP strategy to "complete the powers of the Scottish parliament". It is also favoured by a minority of Scottish Tories and their media fans, who think tax powers would instill responsibility into the country's handout-grabbing MSPs, and might even open the door to tax cuts.

The pressure on the current funding of devolved Scottish powers through a block grant is causing growing unrest among English Labour and Tory politicians at Westminster. With a new impetus to English regional government in the Queen's Speech, there is a day of reckoning coming for the Barnett Formula by which Scotland has been funded for 23 years. A poll for The Herald last month showed 57% of Scots for, and 30% against Holyrood having more of the tax powers currently held by Chancellor Gordon Brown.

But the idea remains just that: a principle or a theory rather than a plan. That gap is being filled by a special edition of the academic journal Scottish Affairs, guest edited by Professor David Heald of Aberdeen University, to be published next week and previewed exclusively today in the Sunday Herald. With six articles by 11 of Scotland's top economists, it offers contrasting perspectives on how the country could extend its fiscal powers within the UK, while some of the figures are important to the independence debate as well.

This is partly a response to a letter from 12 economists written to The Scotsman ahead of last year's general election, arguing that MSPs should be trusted with setting the nation's tax rates. Fellow economists decided that the argument needed more basis in fact, so they have produced 140 pages of dense analysis and argument.

No prizes for guessing that they don't agree. But at least two points of consensus emerge; that the Barnett Formula allows Scotland and the UK to avoid some difficult political choices: and that however attractive fiscal autonomy may look, it is no simple solution. So the Sunday Herald's economics exam starts here:

What is wrong with Barnett?

The idea behind it is to ensure Scotland (plus Wales and Northern Ireland) receive a proportion of any increase in spending for equivalent Whitehall departments such as health and education, without strings being attached. This is aimed at ensuring that each part of the UK, including the poorer and remoter parts, have broadly equal standards of public service. It helps explain why government spending per Scottish head averages 25% more than in England, fuelling envy in poorer parts of England.

The SNP complains that the formula is being squeezed to bring Scottish spending into line with England's, but Professor Arthur Midwinter of Strathclyde University dismisses their claims: any squeeze only relates to a diminishing share of the rapid rise in UK spending, he says, and the figures show no sign that the fears of a Barnett Squeeze have come to anything.

Midwinter says not to give up on Barnett just yet. But Professor David Bell and Alex Christie at Stirling University find it unjustifiable to stick with a formula based on the needs assessment of the late 1970s. They expect pressure will build to change it.

What would happen if there is another needs assessment?

Nobody knows, but it is hard to find anyone who thinks Scotland would get more cash. The calculation of what Scotland and other parts of the UK need to sustain a standard level of public service would be based on more complex data than 1979, and reflect economic shifts between parts of the UK. Midwinter says that Scottish indicators for poverty, sparsity and health remain justification for a similar share- out. The key question raised by several contributors is who would do this calculating; an independent commission, or the Treasury? Is long- term care for the elderly, and the high proportion of students, Scottish needs or expensive policy choices? And how would disputes between Whitehall and Edinburgh be resolved; by a constitutional high court or Treasury diktat?

If not a new needs assessment, then what?

That is where fiscal autonomy comes in - or at least revenue- raising autonomy, as it is pointed out Scotland already has considerable autonomy over spending. At one end of the spectrum, it would see all tax powers handed by the Treasury to Edinburgh. One flow of money would go from Scots back to London, to pay for shared services such as defence and foreign affairs. Another flow would head north to compensate for Scotland's relatively high level of need. There are lesser versions of this with only some tax powers handed over.

It is calculated that devolution has already handed Scots control of 15% of spending, if it makes full use of council tax, business rates, user charges and the tartan tax-varying power (3p up or down on basic rate income tax - though it is striking how irrelevant that limited power has become).

Any combination of other taxes could be devolved. A team led by Glasgow University's Professor Anton Muscatelli argues from analysis of international comparisons that it would be unwise to devolve powers over tax on items which can swiftly depart the country, such as business, capital and income. Better to go for fixed assets, such as property, which council and business rates already do.

Jim and Margaret Cuthbert (Scotland's former chief statistician and his economist wife), whose economic analyses are cited by Nationalists, take the opposite view that it is the most mobile items that Scotland should be able to tax, and it should use that power to undercut its neighbours with low business tax.

They recognise there are problems with that idea though, and suggest the Treasury itself could set different income and corporation tax rates in different parts of the UK. In Scotland, lower tax would compensate for the damage the unity of the UK economy has done to Scotland, they argue, since interest rates were harmonised in 1845. But there again, they are in agreement with their critics in conceding that European Union rules are making such variation of VAT, sales and income tax increasingly difficult.

Is there a gap between the money Scotland could raise from fiscal autonomy and the expenditure it needs to sustain current public services?

This is the most hotly contested of arguments where economics meets politics, and it goes to the heart of the independence argument as well as devolved fiscal autonomy. The SNP says that with oil revenues, an independent Scotland would be in surplus.

Not so, says the Scottish Executive's chief economist, Dr Andrew Goudie, who breaks with tradition by emerging from civil service shadows with a contributed paper. This looks at official statistics begun in 1978 for the share of spending that goes to Scotland, set against evidence of revenues raised.

His findings give the first indication we have had of trends over time, and show Scotland has a structural net deficit, averaging 5-7% over the long term, even after taking into account the degree to which the UK is itself in fiscal deficit over the economic cycle: that is, during economic slowdown as well as in the good times, the gap between tax take and government spend on Scotland consistently puts the public finances into the red. Without oil revenue, Scotland's average deficit was (pounds) 6 billion during the 1990s and with that revenue included, it fell but only to a deficit of (pounds) 4.4bn. With oil tax, Scotland was last in surplus in 1989.

Goudie says the SNP's own figures and an accountants' report which put Scotland into surplus are out of kilter with the trends found by others. Midwinter then takes the Nationalists to task for what he alleges is a (pounds) 4.6bn gap in the party's calculations. The SNP have long questioned unionist assumptions underlying official statistics, but the evidence from this reckoning does not look good for them.

How would any gap be filled if Scotland had fiscal autonomy?

Being poorer, it is assumed that Scotland could expect an equalisation grant from London, but that returns to the problem of how that is decided. London could use it to penalise Scotland for undercutting Treasury tax rates. Continental experience shows models where central government attaches strings and accountability to its grants, unlike the current Barnett system. Spain and Italy in particular suffer political tensions over the flow of funds to help balance richer and poorer parts of each country.

Are there lessons to learn from other European taxation systems?

The Muscatelli team find UK public finances are relatively heavily centralised. Before devolution, central government did 78% of public service spending, compared with a German 38% and Spanish 44%. They found trends internationally towards more fiscal autonomy as well as more local needs assessment. One idea from Germany and Austria is tax sharing, where the centre and devolved administrations have joint control over tax rates and take a portion of tax yield. Another possibility is to rely more on user fees: raising revenue with motorway tolls, congestion charges or a fee for visiting your GP?

Would separate Scottish taxation stimulate or stifle economic growth?

The Cuthberts argue that if Scotland's economy could grew faster, its larger tax base would fill that fiscal gap. But others point out that mechanism is unproven. The Cuthberts concede that there is a problem in the transition: while there is a deficit, it would have to be plugged by higher taxes rather than lower ones. Higher taxes mean companies and mobile, better-off, growth-stimulating people would move elsewhere.

In short, there are substantial dangers involved in opening this jumbo-sized can of economic worms. There is a consensus that it is good in theory to have politicians take responsibility for the tough tax decisions as well as the easy spending ones. But it is clear that a move in that direction would complicate the tax system and lead to new tensions between all parts of the UK. Professor Midwinter concludes it will take constitutional conflict between different parties in power north and south of the Border before this thistle is grasped.

For copies priced (pounds) 7.75, contact Lindsay Adams, Scottish Affairs, Chisholm House, High School Yards, Edinburgh EH1 1LZ: ladams@ed.ac.uk: 0131 650 2456.

How Scotland funds its public services is at the heart of next year's election campaign. The current block grant from the Treasury is under growing pressure for change, though Whitehall opposes reform. Nationalists, some Tories and a majority of Scots think MSPs should be given power over taxation.

Copyright 2002 SMG Sunday Newspapers Ltd.
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