How the Scottish Budget works and why there's a funding gap

Since this announcement, there have been improvements from better-than-expected income tax revenues, and some extra funding from the UK Treasury. However, spending on pay awards is now higher than predicted back in May.

According to a new, independent analysis by the Fraser of Allander think tank at Strathclyde University, the Scottish Government still faces a £1.5bn shortfall in funding for next year, of which £800 million is on day-to-day spending and £700m on capital (infrastructure) spending. As by law the Scottish Government must balance funding sources with expenditures, this is clearly unsustainable.

READ MORE: Wealth tax and private jet levy could raise millions for public sector

How is the likely notional shortfall calculated?

The Scottish Government is funded partly from an annual Treasury grant based on a proportion of spending in England, known as Barnett consequentials; partly from taxes set by Holyrood itself; and partly from borrowing. A notional shortfall occurs if projected spending runs ahead of income.

Back in May, the Scottish Government already faced a potential shortfall due to voluntary increased commitments and the impact of inflation. Voluntary commitments include fully funding local authorities for a freeze in council tax (£300m) plus another £100m committed to cutting NHS waiting lists. Between May and the UK Autumn Budget, spending pressures on Holyrood – mostly higher than budgeted pay awards – increased by another £930m.

How can the gap be filled?

Legally the gap must be filled – either by cuts or tax increases. Some spending commitments can be pushed back in time (“reprofiling”) but this device has already been used.

The Finance Secretary announced fresh spending cuts for 2024-25 just before this month’s UK Autumn Statement. She laid out plans to further reduce spending by £360m, which means total reductions are around £525m, with Education and Skills (£165m), Transport, Net Zero and Just Transition (£145m) and NHS Recovery, Health and Social Care (£70m) the most severely affected areas. Which suggests there is a need to raise taxes.

What scope does Holyrood have to raise income tax?

Although the Scottish Government has the power to set income tax rates and thresholds that apply to earnings, it does not have the power to change allowances – such as the personal allowance. Since 2017-18, income tax in Scotland has diverged from the rest of the UK. Today, there are two new bands (the “starter” and “intermediate tax” band), as well as changes to the basic and higher rate of tax.

Rumours are rife in the Unionist media that Shona Robison will introduce a wholly new 44% band, applied to Scots’ earnings between around £75,000 and £125,140, when the 47% top rate kicks in. This proposal was originally suggested by the Scottish Trades Union Congress. Robison has dismissed these reports as “speculative”.

How much extra tax could be raised?

The STUC has claimed this new income tax could raise around £92m. However, the Fraser of Allander Institute calculates that between two-fifths and a half of any extra tax yield will be lost through individuals taking steps to avoid taxation – including switching to tax planning, being paid through dividends or even moving to England. But this is at best an educated guess and does not take into account the benefits of living in Scotland including no university fees and the council tax freeze.

What if the shortfall increases?

One danger is that the cost of living crisis and continuing higher interest rates push more families into poverty, adding to the potential budget gap. The Scottish Government is spending a rapidly increasing amount on social security. Devolved social security makes up around 10% of spending, up from 7.5% in 2017-18. The amount paid out in devolved social security benefits has increased by more than £1bn in the past five years.

What responsibility lies with the UK Treasury?

The Tory UK Treasury has imposed a greater tax burden as a proportion of the national income than at any time since the 1960s. Much of this is the result of “stealth” taxes, including not indexing income tax thresholds. Some 2.2m more workers now pay the basic rate income tax compared with three years ago, while 1.6m more people have found themselves in the 40% tax bracket. If Scots Tories vote against a tax rise at Holyrood, they are being hypocritical.

Chancellor Jeremy Hunt

A more open question is that of tax reform in Scotland. Spreading the tax burden through reforming local authority financing or introducing a wealth tax are likely to return to the Holyrood agenda soon.