Fiscal devolution to Scotland

The Smith Commission was broadly seen as a success: it made wide-ranging proposals for further devolution, including extensive tax-raising powers that were agreed by all parties, within a deadline of little over two months.

However, the completion of its work in November 2014 marked the end of the beginning: there remain details to be agreed and ambiguities to clarify before the Commission's proposals can be put fully into effect. That could mean serious negotiations during this Parliament, especially on how tax-raising and spending powers are to be devolved.

Closing the fiscal gap

The Commission detailed, among other things, £15bn of taxes and £2.5bn of welfare spending to be devolved to Scotland. Devolution of income tax rates and bands on earnings have grabbed the biggest headlines (unsurprisingly, given that £11bn is raised from this tax in Scotland); but the Commission also agreed that the aggregates levy, air passenger duty and a proportion of the UK's VAT receipts should be devolved.

Once implemented, the proposals, which were put into draft legislation published in January 2015, will make Scotland one of the most fiscally decentralised sub-central governments in the world, just behind the Canadian provinces and Swiss cantons. In the process, they will close the 'fiscal gap' between the Scottish Parliament's spending responsibilities and its tax-raising powers.

Chart: devolved tax revenues as a proportion of expenditure

After the implementation of the Smith Commission proposals, the 'fiscal gap' between what the Scottish Parliament has responsibility for spending, and what it raises in tax revenue, will become much smaller.

Although the Commission's report was specific about which taxes should be devolved to Scotland, it was less precise about how the new powers should fit in with the current funding regime, the type and level of risks that should be taken on by each Government, and the borrowing powers required by Scotland to manage tax volatility.

Adjusting Scotland's block grant

A key element of fiscal devolution still to be agreed is how Scotland's main source of revenue, the 'block grant' from the UK Government, is to be adjusted to reflect its new revenue-raising and spending responsibilities.

For the Commission, effective block grant adjustment meant neither Government being left worse off simply from the initial transfer of power. In the first year of devolution, an adjustment along these lines should be straightforward: a new tax power would see a decrease in Scotland's block grant equivalent to the revenue forgone by the UK Government, whilst a new spending power would see an increase equivalent to the UK Government's spending on the area in Scotland.

But in the years that follow, making these adjustments in a way that is fair and acceptable to both Governments, and leaves neither worse off, could be difficult. The adjustment made for the first year cannot generally be applied in subsequent years because economic growth and inflation typically lead tax revenues and spending to grow over time: future adjustments will have to adjust each year to reflect this.

Recent experience illustrates the difficulties and potential pitfalls of block grant adjustment: the Institute for Fiscal Studies calculated that the adjustment made to reflect the devolution of business rates that took place under the Scotland Act 1998 was "flawed", and left Scotland receiving £1bn more in 2015–16 that it would have had a "correct" adjustment been made.

Meanwhile, a long-term agreement between the Scottish and UK Governments has still not been reached on how the block grant should be adjusted to reflect the devolution of stamp duty land tax under the Scotland Act 2012.

New borrowing powers

Replacing the block grant – a relatively predictable source of revenue – with less predictable tax revenues will impart volatility to the Scottish public finances. Just how much volatility will depend on how the block grant is adjusted, but it is likely that under any arrangement, the Scottish Government will require further borrowing powers to manage the fiscal risks resulting from tax devolution.

Negotiations on borrowing powers could be contentious. The UK Government is likely to underwrite any Scottish debt, so it may seek to limit not only the maximum amount of borrowing the Scottish Government can undertake, but also the circumstances in which it can take place.

It may also want to see rules and mechanisms to guarantee fiscal responsibility and accountability. On the other side, strict limitations on Scottish borrowing, and requirements for its Government or Parliament to account to others for its decisions, may be perceived as undermining the spirit and purpose of fiscal devolution.

The road ahead

There is still some way to go to achieve what the Smith Commission report describes as a "responsive, durable and stable" devolution settlement.

A lot has been agreed in a short space of time; but the devil will be in details that will be negotiated against a backdrop of a larger SNP presence in the Commons, and that will have financial implications for both Governments.

How much welfare spending devolution?

The Smith Commission proposed to devolve several areas of benefits policy, such as the housing element of universal credit, administrative areas of universal credit, most disability benefits, and the social fund.

The Commission also said that the Scottish Parliament should "have new powers to make discretionary payments in any area of welfare without the need to obtain prior permission from DWP".

With no definition of discretionary payments offered, this sentence has been interpreted by some as amounting to near-total devolution of welfare spending, provided any changes are in a more 'generous' direction.

Others, including George Osborne, have suggested that the powers proposed are much narrower, and would only enable greater welfare generosity in "particular circumstances when particular groups of people are affected" by rules set for the rest of Great Britain.

Party Lines

• Conservatives: retain the Barnett Formula and ensure where responsibility for taxation has been devolved, tax changes only affect public spending in Scotland
• Labour: maintain the Barnett Formula, allow rates of income tax to be set in Scotland and devolve social security spending
• Liberal Democrats: retain the Barnett Formula
• SNP: support more extensive devolution of welfare, wages, taxation and the economy in Scotland
• UKIP: (…) replace the Barnett Formula