David Melding argues that fiscal federalism offers an alternative to the shortcomings of the Barnett formula for determining the block grantOctober 17th, 2012
It is often said that the pending referendum on Scottish independence will come down to a basic economic decision. The SNP is keen to show that independence is not only affordable but positively in Scotland’s long-term economic interest. Meanwhile, unionists strive to make Britain a more decentralised economic entity in part to ensure that the devolved governments are responsible for some of the taxation needed to deliver public services.
These debates are not peculiar to Britain. In the last twenty years states all over the world have steadily shifted to more decentralised models of finance in a process called fiscal federalism. But while Britain is not alone in confronting these tricky questions, the challenges here for the Union and its survival are particularly acute.
Full fiscal autonomy for Scotland is sometimes advocated by nervous unionists as a magic answer to stop the feared implosion of the Union. It has more frequently been advanced by the SNP controlled Scottish Executive as an additional option should independence be declined (to use a gentle word). Full fiscal autonomy would leave all Scottish tax receipts in the hands of the Scottish Government which in turn would be wholly responsible for the funding of its public services. There is growing evidence that the Scottish electorate is anxious about the economic implications of independence, while full fiscal autonomy within the UK appears to be attracting considerable support.
The Reformed Union: Britain as a Federation
This is an introduction to the fourth chapter in the online serialisation (here) of the new book by the Deputy Presiding Officer in the National Assembly, David Melding AM. Entitled The Reformed Union: Britain as a Federation, the book is being serialised in eight chapters at regular intervals during 2012-13, continuing with Chapter 4 today:
Online serialisation of a book in this way is a first for ClickonWales and demonstrates the new directions that dissemination of serious thinking through the social media is taking. Responses to this fourth chapter are welcome and can be posted in the normal way. Once all the chapters are published David Melding intends to rework the material in light of any criticism it receives. We will then re-publish the revised edition.
This online publication is a follow-up to David Melding’s earlier work Will Britain Survive Beyond 2020? published by the IWA in 2009, and available here.
Alex Salmond has also been keen to reassure the Scottish electorate that some form of economic union with Britain would continue after independence. This would be secured both directly via bilateral agreements with the British Government, and indirectly via Scotland’s membership of the EU. There is little doubt that the expectation of some economic union continuing within the British Isles is reasonable, but it tends also to weaken the romantic appeal of independence, particularly if sterling is retained as the Scottish currency.
But what would full fiscal autonomy do to the Union? If exercised by all nations of the UK, it would make a transfer union practically impossible. The British Government simply would not have the funds to transfer resources to the poorer nations and regions of the UK. There would be little equity in such a Union. Even if limited to Scotland only, full fiscal autonomy would make Scotland semi-independent within the UK and this would create a highly volatile Union – and it would be a less desirable alternative to an honourable declaration of independence.
As Paul Hallwood and Ronald MacDonald have argued in their 2004 pamphlet The Economic Case for Fiscal Federalism in Scotland, “If all the economic functions of government are devolved it is in essence a de facto sovereign or independent government”. And they further maintain that the “failure of the full fiscal autonomy model properly to address the equity issue is one important reason why we do not in practice observe the full fiscal autonomy model in any nation state”.
The dangers of full fiscal autonomy are aggravated further by the question of North Sea oil revenues. Ownership of off shore resources by substate governments within a federation is exceptionally rare. Some federal states do permit on shore natural resources to be owned by substate governments, but even this is a minority practice. Conceding ownership of North Sea oil to Scotland would dramatically undermine the concept of a British economic union which over time manages and dampens the economic shocks and structural changes that are likely to face the Home Nations. No doubt if North Sea oil ownership is conceded to the Scottish Executive in a desperate ploy to keep some form of Union going after 2014, it may buy only temporary respite. Nationalist rhetoric would soon shift to the demand for compensation to cover lost revenue in the past.
So can Unionists provide a more compelling vision of economic decentralisation within the British state? Is a form of fiscal federalism, well short of full fiscal autonomy, the answer? As in most federations, fiscal federalism in the UK would need to retain sizeable grant funding from the Treasury to the national governments. Such grants are likely to account for at least three quarters of total devolved expenditure, but in principle this share should be reduced if and when possible.
Given that the scale of Treasury funding is likely to remain high for the foreseeable future, the block grant settlements should be determined by an independent Grants Commission which would be appointed by the UK government but subject to the approval of the House of Lords as the chamber of Parliament charged with maintaining the wellbeing of the Union. The Commission’s criteria would include factors such as need, derivation, and equalisation. Grant levels would be set for several years – subject to adjustment for inflation or major economic shocks – to allow for stability in fiscal planning and to avoid the friction generated by an annual allocation process. At last we would get beyond Barnett.
Income tax would be the main lever for the devolved administrations, which would follow proposed practice in Scotland. Powers over income tax should be wide-ranging – i.e. the ability to vary differently the higher and lower rates – and be a tax on base model. Tax on base is a system where the central government sets a base rate (10p is proposed in Scotland) and the substate government sets its rate on top of the base to fund at least part of its own public services. Corporation tax should not be devolved but as an alternative payroll taxes could be considered for transfer to the nations. Income tax and payroll taxes have the advantage of encouraging governments to promote economic enterprise, but care is needed to discourage beggar-thy-neighbour tax competition which ends in a race to the bottom and dysfunctionally low taxation rates.
Borrowing powers would be suffice to allow national governments to manage the fluctuations in revenue that routinely occur with income tax, and to permit a fuller capital programme. However, access to international markets by national governments would be prohibited. Instead a UK agency – perhaps the Grants Commission – should be the source of lending for large and long term capital programmes.
The importance of intergovernmental relations in a federal Britain needs to be clearly understood. While the Joint Ministerial Committee, established by a Memorandum of Understanding in 2001, is a useful framework, it requires substantial reinforcement. Under Tony Blair’s premiership, the Plenary meeting of the JMC – attended by the PM and First Ministers – fell into abeyance. Plenary meetings have been more frequent since the coalition government came to power, but do not have to be called at set intervals leaving the system an informal one. A useful start would be to give the JMC a statutory footing and a permanent secretariat charged with preparing data, studies and reports. At the heart of the strengthened JMC should be an authoritative Finance Minister’s Committee to discuss the parameters for resource allocation in the Union and macroeconomic issues of common concern. A reformed House of Lords could periodically receive a ‘state of the Union’ report from the JMC.
A federal Britain will require a culture of intergovernmental co-operation. Mutual respect will need to be at the heart of the system, a respect based firmly on the expectations of the people – or perhaps we should say peoples – of the Union.
It is fair to say that the economic aspects of federalism are intricate but full of opportunities for states such as Britain in transition from highly centralised to looser constitutions. In the latest chapter of my book http://www.iwa.org.uk/ I examine the political economy of British federalism in some depth – so apologies for the length of this instalment.