What are the implications of coronavirus for fiscal devolution in the UK?

The UK’s 1999 devolution settlement means that decisions about the public health response to Covid-19 are made by the three devolved governments of Scotland, Wales and Northern Ireland. What are the implications for the economic policy response and the future of fiscal devolution?

The initial weeks of the Covid-19 crisis have exposed both the complexities of, and confusion about, the nature of UK devolution.

Since their establishment in 1999, the devolved legislatures in Scotland, Wales and Northern Ireland have exercised significant policy autonomy in areas including health, education, justice and policing, economic development, the environment, and culture and sport.

An implication of the UK devolution settlement is that decisions over the public health response to the Covid-19 crisis – including the extent of restrictions placed on workplaces and educational establishments – are made by the three devolved governments.

To date, the UK government and the three devolved governments have liaised to ensure a coordinated and largely consistent approach to restrictions. But there has been some divergence in guidance (in Scotland for example, slightly stricter guidance in relation to the construction sector), and emerging signs that differences may be more pronounced when it comes to the way in which restrictions are lifted.

Devolution has implications too for the economic policy response to Covid-19. The major policy responses in the labour market – including the Coronavirus Job Retention Scheme and changes to Universal Credit rates and Statutory Sick Pay – are ‘reserved’ policy matters that apply across the UK.

But some of the UK government’s policy responses have been in areas that are devolved. As such, they do not apply in the devolved nations. Where a UK government policy applies in England only, any additional spending in England as a result of that policy generates additional grant funding for the devolved institutions. This includes spending on health, local government and transport, and changes to business rates, which are devolved.

Of course, the Covid-19 crisis does not just have implications for what governments spend, but for what they raise in revenues too. Major changes to the devolved funding have been implemented in recent years, in particular through the devolution settlements (in Scotland and Wales) of property transactions taxes and partial devolution of income tax. The current crisis raises questions around the extent to which this increase in fiscal responsibility exposes the devolved governments to unforeseen budgetary risks – and the extent to which these risks can be adequately managed.

This article focuses on the way that devolved governments in the UK are funded, and the influence that Covid-19 might have on debates about the future direction of fiscal devolution to Scotland, Wales and Northern Ireland.

Related question: How will Covid-19 affect Northern Ireland's economy?

Related question: Will Scotland's economy be hit more or less than the UK as a whole?

Fiscal devolution in the UK

The UK’s three devolved governments have traditionally relied on a block grant from Westminster to finance the majority of their spending. Recent years have seen moves to devolve additional tax-raising powers to enhance the accountability of devolved institutions and to provide greater policy flexibility.

The Scottish Parliament has set rates and bands of income tax in Scotland since 2017; and the Welsh Assembly took on more limited powers over income tax in 2019. Property transactions taxes (stamp duty in England) and landfill taxes have been fully devolved in Scotland and Wales since 2015 and 2018 respectively.

There are plans to devolve air passenger duty to Scotland and to assign half of VAT receipts raised in Scotland to the Scottish Parliament, although both these plans have been subject to delays for various legislative reasons. Plans were also afoot to devolve corporation tax revenues to Northern Ireland, although these plans have been substantially delayed by the suspension of the Northern Ireland Assembly.

Accompanying the new tax powers in Scotland and Wales are new ‘fiscal frameworks’ agreed between the UK government and Scottish and Welsh governments respectively (HM Treasury, 2016a; HM Treasury, 2016b). These set out rules around grant allocation, forecasting responsibilities and borrowing powers.

In addition to new tax powers, substantial devolution of social security spending to the Scottish Parliament is also underway. Eleven social security payments – relating to old age, illness and disability, including Personal Independence Payment, Carer’s Allowance and the Winter Fuel Payment – are being devolved to Scotland over the period to 2025. The Scottish Parliament also has powers to create new social security payments or top-up benefits administered by Westminster.

What does economic research tell us?

What does economic research tell us about which fiscal powers should be devolved under which circumstances?

A longstanding body of research in economics explores which fiscal (tax and spending) functions are most appropriately allocated to different levels of government (Oates, 1999). This work is sometimes referred to as ‘fiscal federalism’. Despite its name, the research area does not presuppose any particular constitutional form, and is equally as applicable to analysing devolution within a unitary state as it is to analysing federal states.

The body of research argues that fiscal devolution can improve economic outcomes in several ways. Devolution allows spending and taxation decisions to be better tailored to the preferences of a sub-national electorate. Fiscal devolution can also enhance the accountability of devolved politicians, in the sense that it strengthens the linkages between devolved policy decisions and economic outcomes. And devolution can have wider benefits at national level if divergent policy aids analysis of policy effectiveness.

But fiscal devolution can also entail costs (Rodriguez-Pose and Gill, 2005). These might include:

Diseconomies of scale in providing certain public services at a sub-national level.
Loss of coherence for people or businesses about how they are affected by a combination of national and sub-national policies.
Exacerbation of spatial inequalities if different territories have different spending needs or tax-raising capacities.
Inefficiencies resulting from ‘spillover effects’ – for example, if tax devolution results in sub-national territories engaging in downward competition for a mobile tax base; or conversely, over-taxation of a tax base that is shared by different levels of government.
Inefficiencies from ‘agency problems’ where devolved government face perverse incentives – for example, if sub-national governments borrow excessively, knowing that they will ultimately be bailed out by the national government.

The extent to which fiscal devolution might yield benefits and impose costs depends on a wide range of economic and institutional factors. These include, for example, the economic and political context (how divergent are public preferences for public service provision; and how mobile are tax bases across regions), which functions are devolved, and the design of institutions and rules to support that devolution – including rules on grant allocation and sub-national borrowing.

Economic research does not provide definitive conclusions about which fiscal powers should be devolved under what circumstances. But it highlights key trade-offs.

For example, devolving greater power over tax-setting or borrowing can enhance the accountability of devolved institutions, but raises the risks that spillovers or inefficiencies might result. Grant allocation can be designed to minimise the risks of spatial inequities, but in doing so, it might influence the incentives that devolved governments face to implement particular types of policies or programmes. The challenge is to design institutions and governance arrangements that are capable of realising the benefits of devolution while avoiding the potentially negative effects.

How reliable is the evidence?

A large body of research examines the relationship between fiscal decentralisation and economic outcomes such as economic growth (Baskaran et al, 2016), income inequality (Tselios et al, 2012) and political accountability (Polvari, 2015).

There are significant challenges in identifying these relationships and their robustness. It is hard to take into account the role of supporting institutions and governance arrangements in quantitative empirical analysis (for example, specifics around the operation of powers, the design of inter-governmental grant-sharing mechanisms, and so on). For similar reasons, it is difficult even to assess whether there has been an ‘economic dividend’ from devolution in the UK (Pike et al, 2012).

There are other methodological challenges too, including circularity – does fiscal decentralisation lead to faster economic growth; or does faster growth provide the conditions that support fiscal decentralisation? Even where a relationship has been identified robustly, there is a question about the extent to which a relationship for one set of countries over a given time period might transfer to another specific country setting.

Overall then, the empirical evidence as to whether fiscal decentralisation leads to improved economic outcomes is inconclusive, beyond making the observation that governance and institutions matter (Filippetti and Sacchi, 2016; Baskaran et al, 2017), reiterating the findings alluded to earlier.

Where next for fiscal devolution in UK?

It is worth considering two broad sets of issues:

First, how do the devolved fiscal frameworks in Scotland and Wales – including the rules around grant allocation and borrowing – enable the devolved governments to manage the implications of the health and economic crisis effectively?
Second, how might the crisis influence discussions about the appropriateness of devolving further fiscal powers?

Managing different needs and risks

A core principle of the devolved fiscal settlements is that the UK government bears the risk of UK-wide fiscal shocks.

On spending, increases in spending by the UK government in England on policies that are devolved automatically generates increases in the block grants allocated to the devolved governments through the operation of what is known as the Barnett formula.

While the Barnett formula is not part of formal legislation, it is governed by a Statement of Funding policy with a fiscal framework for Scotland and Wales (with various mechanisms for appeal should either side believe it is being administered inappropriately). Increases in health spending and the provision of grants for small businesses in England have resulted in billions of additional resources being allocated to the devolved governments since March. The devolved governments can use these resources in whatever way they choose (within their areas of policy competence).

The speed with which these resources have flowed to the devolved governments, and the flexibility with which they can be used, is a strength. But the process takes no account of devolved governments’ relative spending needs. There is some concern that the spending needs of Covid-19 may turn out to be higher in one or more of the devolved territories. This could occur, for example, if the demographics made the population more vulnerable to the virus, or if the costs of providing a given package of business support were more expensive in a devolved nation relative to England.

If the spending needs of devolved nations do differ materially from those in England, one or more of the devolved governments may make a case to the Treasury for additional funding outside the normal operation of the devolved funding settlement. It should be noted that the devolved governments do not have the ability to borrow to fund public services spending, and so their ability to respond to a different set of circumstances is quite limited.

In terms of the devolved revenues, the UK government insures the devolved budgets against the risk of UK-wide revenue shocks. For example, if income tax revenues in Scotland were to fall 10% relative to forecast in 2020/21, that would not have any budgetary implication for the Scottish government as long as equivalent revenues in the rest of the UK fell in the same proportion.

But the devolved budgets are exposed to the risk that devolved revenues fall disproportionately compared with the rest of the UK. This could arise if economic restrictions are lifted more slowly in one nation compared with others (as a result of health advice), or if one territory is more exposed to an economic sector that is particularly affected by the crisis (the Scottish economy is particularly vulnerable to the performance of the oil and gas sector, where oil price weaknesses have direct effects on employment and incomes).

A difference in revenue growth of just a few percentage points can easily add up to a budgetary impact of several hundred million pounds, but the ability of the devolved governments to manage these sorts of fluctuations is heavily constrained.

It remains to be seen to what extent these concerns around differential spending or tax impacts will materialise, and if they do, the extent to which the Treasury would countenance the suspension of ‘normal rules’ to accommodate the resulting budgetary impacts. Both the Scottish and Welsh governments have written to the Treasury to seek temporary flexibilities to support budget management during the crisis.

The flexibilities sought include being able to use capital spending budgets to fund day-to-day public services spending, and temporary extensions to borrowing limits and the ability to drawdown from reserves. The Treasury is likely to be wary about ‘special circumstances’ opening the door to more permanent changes, and by the end of July had not responded to these requests.

Related question: Which parts of the UK have been hit hardest by the Covid-19 economic crisis?

Devolving further powers?

At this stage, it is difficult to say how the current crisis might influence demands for further fiscal devolution, but the question is clearly bound up with the question of how the responsibility for particular fiscal risks is balanced in the wider devolution framework. (The Scottish government has, since the start of the Covid-19 crisis, reiterated its objective of ‘full fiscal autonomy’).

In reality, the capacity of governments to think seriously about these broader issues is likely to remain low for the immediate future. But it will also be interesting to see, as we move into the economic recovery phase, how effectively the existing balance of devolved, reserved and shared powers rub up against each other.

The economic recovery will involve the gradual withdrawal of some UK government policies such as the Coronavirus Job Retention Scheme, coinciding with investment in skills and active labour market programmes for which responsibility is devolved. Business support measures will be unwound – some of which are managed at the UK level and some at the devolved level – and superseded with new support for business diversification and in managing new social distancing rules.

Difficult decisions about how to work towards a sustainable UK fiscal position while protecting household incomes may have implications for the allocation of grant to the devolved governments, the design of personal taxation (elements of which are shared with the devolved institutions in Scotland and Wales) and changes to social security payments, some of which are devolved to Scotland. New initiatives – such as a jobs guarantee programme – would very much cut across reserved and devolved competencies, depending on which organisations were tasked with delivering it.

It is clear that there are some technical aspects of the current fiscal framework, particularly for Scotland, that might need to be reviewed in the light of Covid-19 (Eiser, 2020). In particular, the Scottish government has expressed concerns that the restrictions on borrowing and the use of the Scotland Reserve (for example, there is a capital borrowing limit of £450 million and the government cannot borrow for ‘additional’ revenue spend but only for ‘forecast error’) are not adequate in the current crisis.

The Scottish government – with input from its Economic Advisory Group (Scottish Government, 2020) – has argued for additional temporary fiscal flexibilities in 2020, before a formal review of the fiscal framework takes place in 2021. But of course, any review is likely to reignite debate about funding levels across the UK, with Scotland receiving higher spending per head vis-à-vis many other parts of the UK.

There is clearly scope therefore for frictions to emerge in the way that devolved and reserved competencies work together to support the recovery, and for tensions to emerge between the governments in relation to the adequacy of their funding levels and policy flexibilities.

On the other hand, there may be scope to reflect on some of the positives of the existing fiscal settlement, which include the relatively stable allocation of funding, and the protection of the devolved budgets from major economic shocks.

Quite how all these factors will play out to influence fiscal devolution over the coming years is difficult to know. The main conclusion of economic research is that decisions over how to trade off the benefits and risks of fiscal devolution are political rather than economic. As in the recent past, it seems likely that fiscal devolution to Scotland, Wales and Northern Ireland will continue on an ad hoc basis, determined by political power balances rather than a coherent set of economic objectives.

Related question: The job furlough scheme is coming to an end: what happens next?

Where can I find out more?

A guide to the Scottish Parliament’s new financial powers by Audit Scotland.

The Fraser of Allander Institute at the University of Strathclyde provides a regular update of devolved fiscal issues, with a particular focus on Scotland.

The Wales Governance Centre at the University of Cardiff provides regular analysis and commentary on devolution in Wales.