The Barnett formula as we knew it is dead. Here’s what that means for Scotland...

KIRSTEEN Paterson’s National article of July 26 covered the Westminster Public Accounts Committee’s recent report on the funding of the devolved administrations.

The PAC report urges greater transparency on the funding arrangements for these administrations – arrangements are ultimately derived from the Barnett formula.

While greater transparency is to be welcomed, the PAC report nevertheless represents a regrettable missed opportunity. What the report fails to do is to dispel certain myths about the operation of the Barnett formula: in fact, it does the opposite, and perpetuates these myths.

Above all, the PAC report fails to identify the significance of the fundamental changes in the way the Barnett formula is operated which took place on the introduction of the post-referendum fiscal settlement. Before we get on to the PAC report, it is necessary to go into some background about the Barnett formula, both in its original incarnation and in its modified, post-referendum form.

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The Barnett formula was introduced in 1978, and was the mechanism through which the old Scottish Office, and later, the Scottish Government, derived most of their funding thereafter. Up until the recent devolution of substantial tax powers to the Scottish Government, the bulk of the funding administered in Scotland came via the mechanism of a block grant from Westminster.

The initial size of this block grant when the Barnett formula was introduced was not based on any rational assessment of how much Scotland actually needed to spend on domestic services, but was simply taken as the level of spend as it stood at that particular time.

On a per capita spend basis, this starting level turned out to be favourable for Scotland. This partly reflected the political weight Scotland had been able to exercise at a time when there had been fresh stirrings towards independence.

What the Barnett formula did was provide a mechanism for determining the changes in the block grant from year to year. The mechanism was simple in concept. Each year, the planned change in expenditure per head on comparable services as administered by Whitehall would be calculated, and the Scottish block grant would be adjusted by the same amount per head. So if planned spend on comparable Whitehall services was going up by £X per head, the Scottish block grant would go up by £X per head.

This was not actually intended to be a particularly generous deal for Scotland. There were two main reasons for this.

First of all, as was perfectly clear when the Barnett formula was introduced, for the foreseeable future Scotland would be producing very significant amounts of taxation revenues from oil – revenues which would go straight to Whitehall.

So, one way of looking at things was that, in “exchange” for its oil revenues, Scotland would be getting the funding it received via the block grant. On any rational view, this turned out to be an outstandingly bad deal for Scotland. Calculations we made in 2014 indicated that, if one assumed that Scotland had paid for the funding it received via the block grant, plus its share of UK administered services like social security, plus a population share of UK defence spend and an inherited share of debt interest, then a Scottish government would have been about £150 billion better off, (on very cautious assumptions), had it controlled its own tax revenues.

The second way Barnett was not intended to be generous was that it was expected to bring about, quite rapidly, convergence to the same level of public expenditure per head on the relevant services across the different countries of the UK.

The logic behind this expectation was as follows. If, as Barnett implied, Scotland was getting the same absolute increment in per capita spend on the relevant services as England, but if the level of per capita spend in Scotland was higher than in England, then that meant Scotland would be getting a smaller percentage increase. With smaller percentage increases in Scotland each year, the levels of per capita spend in the two countries should eventually converge.

And this convergence would be faster, the larger the nominal (ie, money) growth in public expenditure was each year. Given that Barnett was introduced at a time when high UK inflation seemed to be the norm, there were indeed grounds for expecting that Barnett would squeeze per capita public expenditure levels in Scotland down towards the levels in England.

However, this logic turned out to be flawed. For one thing, inflation in the UK dropped, so the nominal growth in public expenditure each year was reduced. And as the nominal growth rate of public expenditure drops, another factor becomes important, which is relative population growth. Historically, Scotland has had a lower rate of population growth than England: reflecting, a nationalist might say, Scotland’s underprivileged position at the wrong end of a malfunctioning UK monetary union.

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The position has varied through time but, commonly, population growth in Scotland has been between 0.2 and 0.5 percentage points per year lower than in England. The effect of lower population growth in Scotland is that the existing block grant is spread over a relatively smaller base, (remembering that Barnett only dealt in increments), so tending to increase relative public expenditure per head.

The interaction between these two factors, namely, relative population growth, and the nominal growth rate in public expenditure, is complex, and needs to be worked out algebraically to be fully understood. (Those who are interested might want to look at a paper by myself in the Fraser of Allander Quarterly Economic Commentary, Vol 26, No. 2, May 2001 on the effect of relative population growth on the Barnett squeeze.)

But the key point is that, when nominal growth rates in public expenditure are low, and when the population of England is growing relative to Scotland’s, then the operation of the old Barnett formula would not bring about convergence of public expenditure per head in the two countries to the same level. Instead, per capita spend in Scotland would converge to a level above that in England, and perhaps significantly above.

In effect, by accident, the Treasury (above) had put in place in the form of the old Barnett formula a system which, in certain circumstances, had some of the features of a more properly functioning monetary union.

If Scotland was underperforming, and this was reflected in lower relative population growth, then, provided overall public expenditure was not growing too fast in nominal terms, Barnett would deliver what was, in effect, a compensating fiscal transfer, which would protect per capita spending levels in Scotland.

So now we are in a position to debunk a first damaging myth, about the “old” Barnett formula. Namely, that it was a generous settlement put in place to protect relatively high levels of per capita public expenditure in Scotland. It wasn’t.

It did nothing to protect Scotland from being ripped off at times when Scotland’s resources were generating relatively large tax revenues (and, indeed, it did nothing to encourage conservation of these resources).

And it was only due to accidental circumstances, of low public expenditure growth and low inflation, that it delivered the relatively generous settlement to Scotland that it did latterly. These circumstances are unlikely to have persisted, particularly now that we have a UK government seemingly intent on destroying the UK economy and debauching its currency.

Does the PAC report give a balanced account of the “old” Barnett formula, and help to debunk the first myth? Far from it. Instead, by saying that the old, relatively high, spending baselines for the devolved countries were “baked in” by Barnett to current funding allowances, the PAC quite perversely perpetuates the first myth.

THE second myth, however, which we now examine, is by far the more damaging. This myth is that the central features of the “old” Barnett system still exist, and that it remains a protection for relatively high public expenditure in Scotland. Nothing could be further from the truth.

To understand what is going on, it is necessary to look at the fundamental changes to the fiscal settlement which were brought in when substantial tax-raising powers were devolved to Scotland from 2017/18. Principal among these was income tax, which is the example that will be considered here.

There is still, in the new system, a block grant, which is still calculated on the basis of the “old” Barnett formula. But Scotland does not receive the whole of this block grant. Instead, there is an abatement to this block grant, to allow for the tax revenues which Scotland now raises for itself.

This block grant abatement is increased every year by a system of indexation: and it is this indexation system which is key to understanding the features of the new system.

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The largest part of the block grant adjustment relates to income tax, and the block grant adjustment for income tax is indexed in line with the growth in per capita income tax receipts in the rest of the UK (well actually, in England plus Northern Ireland). What this does is to force Scotland into a kind of economic race with the rest of the UK.

If Scotland wants to maintain the same levels of public expenditure as it would have received under the “old” Barnett formula, it has to grow its per capita income tax receipts as fast as rUK. If it does better, well and good. But if it does worse, then Scotland is actively penalised.

Neo-liberals might argue that there is a certain brutal fairness about this. However, what the new system actually does is to build in the potential for extremely damaging negative feedback effects, which are quite inconsistent with the operation of any properly designed monetary union.

Negative feedback effects could well arise as follows. If Scotland attempts to offset a decline in available public expenditure by raising tax rates, it may worsen relative economic decline, so increasing the penalty it experiences through block grant indexation, further increasing the pressure on public expenditure, and so on.

There are already worrying indications that we may be in the early stages of such a cycle.

As we have seen, the old Barnett formula, accidentally, and only in certain circumstances, nevertheless had certain of the features of a properly functioning monetary union, where relative decline was to some extent compensated by fiscal transfers. The system we have now is precisely the opposite: relative decline will be penalised, and is likely to accelerate.

And yet somehow the myth persists that the essential features of the old Barnett formula still exist, and that it acts to provide a beneficial public expenditure settlement for Scotland.

All that the PAC report says about the fiscal settlement as it now exists is the following: “HM Treasury told us that the devolution of tax and some areas of welfare policy to Scotland meant that funding arrangements were becoming more complicated. Agreements between the UK government and the Scottish and Welsh governments set out how the block grant will be adjusted to reflect the devolved taxes and spending powers and other nation-specific adjustments.”

The problem with this is that it does not reflect at all the reality of the recent changes to the way the fiscal settlement operates: but is drafted almost as if the old system still operated. What should have been an opportunity to introduce reality into the current debate has been missed.

So we continue to exist in a strange looking-glass world, where it is quite clear that both of the above myths about the Barnett formula are still widely believed.

So, far from appreciating the threats the new system has brought, SNP politicians express concern that recent political changes at Westminster might threaten the Barnett formula, and Boris Johnson, (who has probably been well briefed by the Treasury on what the present fiscal settlement will actually do to Scotland), can “reassure” us that he has no intention of abolishing the Barnett formula.