Growth incentives and devolved fiscal systems

ABSTRACT

This paper explores the characteristics of a range of stylized devolved fiscal systems that have been applied, or proposed, as a means of funding the devolved Scottish government. The central aim is to identify those schemes that most effectively provide incentives for the pursuit of growth-promoting policies by the regional government. Using simulations with an intertemporal, computable general equilibrium model for Scotland, it did not prove possible to uniquely rank a range of devolved fiscal systems in terms of the extent of growth incentive they provide. Moreover, rather counterintuitively, tax-sharing regimes do not necessarily improve growth incentives relative to more basic block grants.

KEYWORDS:

• regional fiscal autonomy
• regional fiscal systems
• applied general equilibrium
• growth incentives

JEL:

• D58
• H24
• R13
• R15

ACKNOWLEDGEMENTS

The authors are grateful for the comments made by three anonymous referees and an associate editor, which have significantly improved the paper. They also acknowledge the comments of participants at both the European Regional Science Association (ERSA) Conference, Cork, Ireland, 2018, and the International Input–Output Conference, Glasgow, UK, 2019, on earlier versions of this paper.

DATA AVAILABILITY

The core data used in this study are the Scottish Input Output table for 2013. For Scottish government-produced tables, see https://www.gov.scot/publications/input-output-latest/.

DISCLOSURE STATEMENT

No potential conflict of interest was reported by the authors.

Notes

1. The nature and extent of devolved powers differs across the three devolved UK regions. For Scotland, the areas of responsibility transferred to the Scottish Parliament include: agriculture, forestry and fishing; education and training; health and social services; tourism and economic development; housing; law and order; local government; and sport and the arts. Powers reserved to the Westminster Parliament include defence, foreign policy and immigration. For details on the Scottish budget, see https://www.gov.scot/publications/scottish-budget-2020-21/pages/2/.

2. All these options are, or have been, used by the devolved Scottish government.

3. Different model configurations could include aspects such as the economy’s openness to trade, the nature of the labour market (e.g., allowing for skill differentiation) or the determination of investment. In the present paper only the time scale under consideration is varied.

4. Essentially, it is more convenient in our analysis to express equations (1) and (2) in terms of indices.

5. See also the Organisation for Economic Co-operation and Development’s (OECD) up-to-date database which contains measures of levels of decentralization (https://www.oecd.org/tax/federalism/fiscal-decentralisation-database/).

6. This is simply a decomposition. The tax base is expressed in this way for analytical convenience. It could be decomposed in greater detail or in a different way.

7. This means that employment reacts to short-run variations in labour demand only through changes in the employment rate (with a corresponding change in the unemployment rate). The demographic characteristics of migrants are also assumed to be the same as those of the initial regional population.

8. The basic tax-sharing regime was the option favoured by the UK government during negotiations to establish a new fiscal framework for Scotland (HM & Scottish Governments, 2016). However, following concerns from the Scottish government around demographic pressures, the per capita tax-sharing regime (considered below) was implemented, though the framework is due to be reviewed by the end of 2021.

9. The proposals of the Smith Commission (2014) were agreed by the HM and Scottish Governments (2016). This established Scotland’s new fiscal framework. Bell et al. (2016) and Eiser (2017) provide an analysis of this scheme together with a comparison with the basic tax-sharing scheme favoured by HM Treasury.

10. It is thought that in negotiations around the formula, the Scottish government was concerned about future reductions in the Scottish population, relative to the UK as a whole.

11. Public expenditure per capita is significantly higher in Scotland than in the RUK. The associated implicit public sector deficit in Scotland is effectively financed by taxpayers in the RUK. The Scottish government has very limited independent borrowing powers.

12. The effects tend to be small (McGregor et al., 1999) because Scotland represents < 7.5% of UK GDP.

13. The labour demand curve is a general equilibrium relationship that incorporates all the effects of a change in real wages, including those on consumption demand. While not inevitable, the labour demand curve for an open regional economy is expected to be negatively sloped, where competitiveness effects dominate the income effects of wage changes. The theoretical framework is developed more formally in Lecca et al. (2014).

14. Had the initial shock reduced labour demand, the labour demand curve would initially move to the left. But again, a long-run equilibrium reinstates the original employment and real wage rates, but in this case through outmigration.

15. Council tax is a system of property taxation levied locally on each domestic property in Scotland. Each council sets its own rate for its local authority area and spends the revenue on the provision of local public services.

16. As shown in the next section, if under the per capita block grant scheme the 2.31% increase in the budget is spent with the same sectoral composition, economic activity would increase. This generates a further population increase so that the total improvement in the devolved budget would be 3.50%.

17. We assume for simplicity that government expenditure has no direct supply-side impacts, such as might be expected to accompany increased expenditure on education and health, for example.