An independent Scotland: what would be the options for economic success?

If Scotland were to become independent, there would be significant short-term economic challenges. The prospects for the nation’s economy over the longer term are uncertain and would rest on the outcome of tough choices about currency, public finances and membership of the European Union.

If the UK Supreme Court deems a second referendum on Scottish independence to be lawful, the people of Scotland could be heading to the polls again in just one year’s time. The Scottish Independence Referendum Bill, published in June 2022, proposes 19 October 2023 for the vote.

Voters are likely to be presented with the same question on the ballot paper as in 2014, when 55% of them selected ‘no’ in answer to: ‘Should Scotland be an independent country?’

Economic issues were important to how voters chose between independence and remaining part of the UK back in 2014. If asked to choose again in a second referendum, the major economic events in the intervening years – from Brexit to the fluctuating value of North Sea oil – mean that the economic arguments in a second referendum campaign are likely to look a little different.

Amid all the uncertainty around Scotland’s future, economic research can help voters and policy-makers to understand the big decisions that an independent Scotland would face and whether its choices would be in the best interests of its economy and its people.

Should an independent Scotland re-join the European Union?

In the 2016 Brexit referendum, 62% of the Scottish electorate voted in favour of the UK remaining in the European Union (EU). The UK’s departure from the EU has fuelled the Scottish government’s demand for a second independence referendum. Indeed, polling data suggest that Brexit is a factor in attitudes to independence.

Would EU membership be in Scotland’s best interests?

There may be many reasons for wanting to be part of the EU again, but on the critical subject of international trade, research suggests that an independent Scotland may be better off outside the EU.

It is true that re-joining could expand trading opportunities with EU member states for Scotland by reducing border costs. These are the costs that stem from import tariffs, customs checks and differences in regulations between countries, among many factors.

An analysis of international trade in goods finds that border costs between EU countries are 13% lower than those between countries where at least one of the partners is not in the EU. This is why most economists expected Brexit to make the UK worse off (Sampson, 2017).

But the costs of trade between EU countries are still higher than trade costs within the same country. Border costs within the EU are 23% more than trade costs between US states, for example (Comerford and Rodriguez Mora, 2019).

Four out of Scotland's top five international export markets are in the EU: the Netherlands, Germany, France and the Republic of Ireland.

But Scotland’s biggest export market overall is the rest of the UK, comprising 60% of Scotland’s total exports, including North Sea oil, whisky and seafood.

The magnitude of the change in border costs between Scotland and the rest of the UK if Scotland were to become independent is highly uncertain, and would depend on the outcome of negotiations between the governments of Scotland and the rest of the UK.

Some estimates suggest that they could increase by 15-30% if Scotland were to remain in a common market with the rest of the UK (Comerford and Rodriguez Mora, 2019; Huang et al, 2021). This is similar to the expected effects of Brexit on trade costs between the UK and the EU (Scottish Government, 2018; Bevington et al, 2019).

On balance, research suggests that for as long as the rest of the UK remains Scotland’s most important trading partner, Scotland would be better off prioritising integration with the rest of the UK. This means not re-joining the EU. That said, there are countries that have found new markets for exports in the EU following independence, including the Republic of Ireland, the Czech Republic and Slovakia. While these changes in trade patterns are possible, they also happen over decades, if not longer.

Could an independent Scotland rely on North Sea oil and gas revenues?

The fortunes of North Sea oil and gas have been on a tumultuous journey in the past decade. They have bolstered pro-independence arguments when profits have been plentiful, but played a smaller role in independence debates at times of severe decline.

Research suggests that the sector’s recent rise in revenues – thanks to rocketing oil and gas prices – could offer a short-term boost to Scotland’s economy but cannot be relied on over the long term.

While offshore revenues played an important role in the 2014 referendum debate, between 2014 and 2020/21, the industry faced a sharp fall in the price of oil. This had knock-on effects on Scotland’s economy and North Sea tax revenues, which dropped from £7 billion a year to just £500 million.

This has had a significant impact on the onshore economy, and it is a big reason why Scotland’s economy has grown more slowly than that of the UK as a whole over the past few years.

Russia’s invasion of Ukraine has precipitated a spike in global energy prices, with oil prices rising from $18.38 per barrel in April 2021 to $117.25 in March 2022. Over the same period, gas prices rose from £0.55 per therm to £3.14. As a result, North Sea revenues soared to £3.2 billion in 2021/22 and are now forecast to reach levels not seen in over a decade.

The effect has been a slightly larger reduction in Scotland’s net fiscal balance compared with the UK’s, although it remains roughly twice the size. Scotland’s net fiscal balance fell by just over 10 percentage points: from 22.7% of GDP in 2020/21 to 12.3% of GDP in 2021/22. In comparison, the UK’s fell by just over 8 percentage points, from 14.5% of GDP in 2020/21 to 6.1% of GDP the following year.

But this revenue stream is clearly volatile, and the long-term trend for oil and gas revenues is for a phased decline. Production peaked in 1999, and remaining reserves are now in more challenging and costly areas of the North Sea. At the same time, governments – including the Scottish government – are committed to reaching net-zero carbon emissions, which means moving away from fossil fuels.

Relying on high oil and gas revenues would not be a safe long-term option for securing a sustainable source of tax income for an independent nation. Tough choices on tax and spending, and efforts to improve economic growth beyond what North Sea reserves can offer, would be needed.

Which currency should an independent Scotland use?

The question of currency continues to be controversial. Independence would offer Scotland a choice of currency and choosing one of its own would give the country control over its monetary and fiscal policy. But research suggests that sticking with sterling would have benefits for Scotland’s economy.

In the 2014 referendum, the Scottish government’s official policy was to remain part of the UK’s formal monetary union. This was despite George Osborne, then Chancellor of the Exchequer, ruling out this option. Uncertainty over currency is seen as a big reason why more people voted ‘no’ than ‘yes’ to independence in 2014.

The Scottish National Party (SNP) now says it favours the continued use of sterling even without a formal agreement. Many in the pro-independence movement favour a transition to a new separate currency in the future.

The use of sterling in an informal relationship has never been tried in a country of Scotland’s size or level of economic development. There would be no typical ‘lender-of-last-resort’ and the health of Scotland’s economy, including its public finances, would be closely tied to its balance of payments position. Scotland is currently estimated to run a deficit on both its public finances and its balance of payments.

Continuing with sterling would have the benefit of preventing an increase in the costs of trade with Scotland’s main trading partner, the rest of the UK. There are the conversion costs, but also the uncertainties that come from fluctuating exchange rates that, with them, affect the value of goods and services. The sterling option also avoids the costs of setting up a new currency – not just for government, but also for households and businesses.

It is also possible that a newly minted currency would be more volatile, at least during the early stages. In 2014, such costs were argued to be between 0.5% and 1% of GDP for Scotland – between £500 million and up to £2.5 billion (see MacDonald, 2014).

Scotland could also look to the Republic of Ireland for historical lessons on currency. Over the past century, since independence, Ireland has had five currency regimes, including sterling, its own currency and the euro. In the immediate post-independence era, sterling was Ireland’s default currency, followed in 1927 by a one-for-one peg with sterling against the Irish punt – that is, the value of the punt was tied to sterling.

Sterling was the obvious peg of choice as the UK was Ireland’s main trading partner – as would be the case for Scotland today, Irish banks had sizeable sterling assets in London, and sterling was seen as a stable currency.

At first, this relationship cushioned the punt from the effects of global volatility – a world of economic depression and hyperinflation. But in the longer term, maintaining the sterling peg constrained fiscal policy considerably, effectively keeping the Irish economy tied to the turbulent fate of the UK’s.

Scotland’s choice of currency has major implications for its fiscal institutions too. At independence, Scotland would be likely to want to set up its own central bank and debt management office, and to expand the powers of its fiscal watchdog. Its currency would shape what these institutions could do.

For example, a new Scottish currency would not only give Scotland more power over fiscal and monetary policy, it could also allow its central bank to become involved in political issues.

Central bankers around the world may debate how far they should be involved with issues like inequality or climate change, forming policies that redistribute wealth, for example, or which manage financial risks brought by rising temperatures. But Scotland’s central bank would be limited in its ability to influence these issues without its own currency.

What would be the effects of independence on Scotland’s public finances?

Should Scotland become independent, it would need to make big decisions to ensure a better balance of public finances. As things stand, it is likely to have a large budget deficit – the gap between public spending and tax revenues – which may mean its government would have to make spending cuts or increase taxes.

One major consequence of independence would be that Scotland would have the power to oversee the collection of broad-based taxes, such as income tax and VAT. Even though the Scottish government can vary tax bands and rates on income tax, administration is still undertaken by HM Revenue and Customs (HMRC).

Total public expenditure – which comprises spending by the UK government for and on behalf of the people of Scotland, as well as Scottish government spending in devolved areas – is currently higher than tax revenues raised in Scotland (hence the negative net fiscal balance mentioned earlier).

For example, during the period between 2014/15 and 2019/20 spending per person in Scotland was £1,550 (or 12.3%) higher than the UK average, while tax revenues were £325 (or 2.8%) lower per person.

In the short term, independence might weaken Scotland’s economy and reduce rather than increase tax revenues. A harder border between Scotland and the rest of the UK, for example, would suppress trade.

To avoid higher taxes or lower spending continuing in the longer term, stronger growth would be needed post-independence to make up for the loss of money from the rest of the UK. This longer-term picture would depend on how Scottish policy-makers choose to respond to the challenges and opportunities presented by independence.

Independence would give the Scottish government additional powers – currently held by the UK government – potentially to strengthen the economy. Faster growth is easier to promise than deliver, and many of the key elements of a successful economic strategy would take time to have an impact.

There are a number of policy areas where a different path might be taken. For example, independence would give Scotland an opportunity to develop a different immigration policy to the UK’s. This might help to attract skilled migrants into Scotland and ease the pressure of the country’s ageing population and skill shortages.

Similarly, there may be opportunities to use trade policy to shift trade away from the UK and towards other countries, as Ireland did in the late 20^th and early 21^st century. But these changes take time, with changes in trade patterns likely to take decades rather than years.

What can Scotland learn from other countries?

There is no precedent for establishing a new economically advanced country, which adds to the uncertainties when debating Scotland’s future. But in making its choices around whether to be independent, and what to do with independence if achieved, Scotland could turn to other newly independent and/or small countries for economic inspiration.

Other countries may offer hope that things could work out well for an independent Scotland in the long term, despite initial economic difficulties.

The experiences of Ireland and the Czech Republic/Slovakia offer some clues to life post-independence. Disruption and short-term costs followed the split of Czechoslovakia in 1992, for example, and unemployment in Slovakia rose sharply. But the longer-term picture has been one of rising prosperity.

Both the Czech Republic and Slovakia joined the EU in 2004 and are also members of the OECD. In terms of GDP per capita, both are making progress at closing the gap with the EU average. But a big part of their success lies in the strong economic ties that they have maintained with one another. This would suggest that an independent Scotland would have much to gain from keeping its strong links with the UK.

Pro-independence campaigners often point to the successes of small independent countries elsewhere in the world, especially Nordic ones – claiming that these show that a country can be both small and prosperous.

Smallness has the benefit of strengthening public sector accountability because citizens can monitor bureaucrats’ behaviour more easily. Communication and coordination are also easier. But evidence suggests that it is medium-sized countries that tend to have the most effective bureaucracies, all else being equal (Jugl, 2019).

A medium-sized population of between 15 and 94 million gives a country economies of scale for efficient public sector spending. Any smaller, and a country runs the risk of an over-stretched government that lacks specialist skills and knowledge.

With a population of just 5.5 million, Scotland’s size falls below this ‘golden mean’. But an effective bureaucracy at this scale is clearly not impossible. The lesson here is that an independent Scotland would have to take steps to improve its administrative effectiveness and reduce inefficiency.

This would need strong communication and coordination between agencies and departments, with a greater focus on common goals and ‘big picture’ questions. Research shows that some smaller European countries – such as Estonia, Iceland, Latvia and Luxembourg – have mastered this challenge (Sarapuu and Randma-Liiv, 2020; Jugl, 2020).

But being small also comes with challenges: from the risk of greater economic volatility and less scope to manage fluctuations in the economy. Smaller countries typically have to run tighter fiscal policies as they have less influence over international capital markets.

Some smaller countries also have lower economic diversity and often depend on larger economies for much of their exports. It is also possible that smaller countries can lack influence over major economic decisions, for example, at the International Monetary Fund or the World Trade Organization, and in the setting of international standards in areas such as financial services.

Ultimately, Scotland’s success or otherwise as a small independent state would depend less on its size than on its leaders’ ability to exploit the benefits and overcome the disadvantages of small population size.

Yes or no?

If there is one conclusion that can be drawn from the research, it is this: in the run-up to a possible second referendum, any bold claims – made by either side of the debate – stating exactly what will happen to the Scottish economy after independence need to be taken with a pinch of salt.

Post-independence, it is likely that there would be a number of significant economic challenges in the short term. But over the longer term, the path would depend heavily on Scottish leaders’ choices and abilities.

Polls show that recent voting intentions among Scottish people are close: 47% say ‘yes’ to independence, and 53% ‘no’, as of September 2022. But the polls also show that the balance towards either answer regularly flips.

Research shows that some voters will say ‘yes’ to independence if they can’t see that the economy would be any better off by sticking with the UK. This was true of some pro-Leave voters in the UK’s EU referendum in 2016 (Curtice, 2017).

This means that in the event of a second referendum, unionists would need to demonstrate clear economic benefits of staying with the UK to win the argument. For nationalists, on the other hand, a draw might well be enough.