England & Wales, Scotland Democracy, devolution and governance , Finance

Scottish devolution and funding: the Barnett formula and council tax

Summary

  • This briefing uses two recent reports to examine the place of the Barnett formula and council tax within Scottish devolution.
  • The main focus is on how the Barnett formula operates, the parallels between the two systems are explored and the weaknesses of both are highlighted.
  • It is clear that both systems are in urgent need of reform. This briefing concludes that the prospects for significant changes are limited, at least in the short-term and will be of wide interest to local government officers and politicians.

Briefing in full

This is the second of two complementary briefings on Scottish Government finances that have been prepared in the run up to the Scottish parliamentary elections. The first looked at how devolution has developed and how Scottish Government funding has changed over the past decade. This briefing looks at two areas where reforms are definitely overdue, but seem always to be on the “too difficult” pile: the Barnett formula and council tax.

The first and more detailed part of the briefing focuses on the Barnett formula. The briefing summarises a recent report by the Institute for Government (IFG): Funding devolution – the Barnett formula in theory and practice and looks the main features of the formula including its origins and how it operates. It also assesses some of main recommendations of the report, which include what could result in a major reform to the system: a joint review by Treasury and devolved administrations into the relative spending needs of each part of the UK.

That is followed by a short discussion of the main recommendations of a recent Institute for Public Policy Research (IPPR) paper on council tax reform: Better than before – how local tax reform can help pay for recovery, which include making council tax more progressive or replacing it altogether.

How the Barnett formula developed

The origins of the Barnett formula date back to 1888 when a now long-forgotten Chancellor of the Exchequer, George Goschen, introduced system to allocate government funding more fairly between England and Wales, Scotland and Ireland. Apparently based upon population, the formula delivered 80 per cent of funding to England and Wales, 11 per cent to Scotland and 9 per cent to Ireland. After Irish partition, Scottish politicians successfully argued that the Scottish share should remain at the same proportion of the England and Wales total, and that remained the case through subsequent decades even though Scotland’s population saw a relative decline.  After the Second World War, successive Scottish secretaries negotiated extra funding based on additional needs such as population sparsity and poor-quality housing.

In the late 1970s the Labour government was planning a system of devolution in Scotland and Wales, and the Barnett formula, named after Joel Barnett, the Chief Secretary to the Treasury at the time, was devised as a simple, automatic tool to calculate the funding allocations to the assembles due to be established in Edinburgh and Cardiff. In the event, the plans were abandoned after the 1979 referenda, but the formula was put in place and was used to allocate resources to the Scottish Office from 1979 onwards. The formula was only intended to be a transitional mechanism that would be replaced by a more complex formula based on relative funding needs, but, following the decisive Conservative victory in the 1979 general election, pressure for a new system to allocate resources faded, and the formula was retained by successive governments during the 1980s and 1990s and through devolution itself in 1999. Over the past 20 years, there has been much debate on replacing Barnett, but despite transfers of tax-raising powers and other major changes, the formula remains more or less intact.

How the Barnett formula works

The crucial point to note about Barnett is that it is a mechanism for allocating changes in public spending from year to year. It is not a method for ensuring that funding is allocated fairly between the four nations. When the formula introduced in the late 1970s, it locked in historic baseline funding allocations that provided higher levels of public spending per capita, particularly for Scotland and Northern Ireland, than in England. It is this feature of the formula that is the main reason why government spending per head in the three devolved nations is higher than in England.

In essence, Barnett is a simple mechanism for allocating new public spending (or cuts in public spending) on devolved matters on an equal per-person basis across the four nations. Any changes to public spending in England lead automatically to equivalent per-person changes in the annual block grant allocated by the Treasury to the other three nations.  Such adjustments are known as “Barnett consequentials”.

One complication is that not all services are devolved equally, so the amount of a Barnett consequential will also depend on the proportion of spending that is devolved – known as the “comparability percentage”. For example, the comparability percentage for Transport in Scotland is 92 per cent, so any Barnett consequental arising from a UK change in Transport policy will be correspondingly lower than if the whole of Transport spending was devolved. Another point to note is that Barnett consequentials are not ring-fenced and need not be spent on the service area intended by the UK government.

It is also important to remember that the amount of funding received from the UK government has been reduced in recent years to balance out the tax-raising and social security powers transferred to Holyrood. If, for example, tax revenues increase more in Scotland than in the rest of the UK, then the Scottish Budget benefits and vice versa.

How Barnett distributes resources

The IFG report calculates that for 2020-21 spending levels per head in Scotland were 29 per cent higher than in England. The equivalent percentages for Wales and Northern Ireland are 23 per cent and 29 per cent respectively. As mentioned earlier, these differences are a not product of the Barnett formula itself, rather they reflect historic differences that have built up over decades. IFG analysis shows that as a result of Barnett consequentials, spending by the devolved administrations has moved in parallel with that in England over the past twenty years – but has remained consistently higher.

The Covid-19 pandemic has resulted in a huge expansion in government spending. Some of this has been to fund schemes that cover the whole of the UK such as furlough and support for the self-employed, but a large proportion has been for devolved services such as health care and business support. Amounts devolved services, which IFG estimate to be £9.5 billion for Scotland in 2020-21, have largely been calculated using the Barnett formula.

As Barnett allocates new resources on a proportional basis across the four nations, the devolved nations’ historic advantage should have declined in percentage terms over time, a process known as “Barnett convergence”. In practice, convergence in Scotland is happening more slowly than expected. One reason for this is that although Barnett consequentials are calculated using up-to-date population estimates, there is no adjustment to the baseline to take account of the relative decline in Scotland’s population compared to England, so the amount of baseline funding per person tends to increase year-on-year. A second reason is that during periods of austerity, as experienced over the last decade, if cuts are applied equally on a per capita basis, convergence tends to be reversed or slowed down.

Another factor outside the Barnett mechanism works to Scotland’s advantage. Direct expenditure by the UK government on reserved functions, such as demand-driven benefits, tends to redistribute funding from more to less productive parts of the country, and IFG shows that benefit spending in Scotland was 6 per cent higher per person in 2018-19 compared to that in England. A justification for this is that demand-driven benefits are higher in Scotland because there is greater need.

The report looks in some detail at various attempts over the years to equate funding allocated under Barnett with estimates of need. The conclusions are that:

  • variation in public spending across the UK cannot be explained by reference to underlying need
  • all three devolved nations appear to be funded above their level of need – but the data is uncertain

The report finds that there is no clear rationale for the variation in spending across the UK. There is evidence that the devolved nations do have somewhat higher spending needs from poorer public health and lower economic activity but not to the extent to fully justify their higher levels of spending per person. The report argues that there is a clear need to replace the Barnett formula with a needs-based system, but acknowledges that such a change would be “both technically complicated and politically combustible”.

How Barnett works in practice

The mechanistic features of the Barnett formula should, in theory, take the politics out of the allocation of resources. In practice, there is still considerable scope to argue about some of the inputs.  The process of calculating Barnett consequentials is relatively straightforward where services are fully devolved, but the “comparability percentages” mentioned above are not easy to determine and although representations are considered, the Treasury has retained the final say. Adding to the complexity is the need to take account of the effect of devolving different powers to different administrations, in particular, tax-raising powers, which require further adjustments to take account of income raised.

The report quotes a couple of examples to illustrate some of the problems. The most up to date is that for the HS2 rail link between London and the north of England. The Treasury has classified this as an “England and Wales” project so it generates Barnett consequentials for Scotland and Northern Ireland, but not for Wales.

Another issue that can cause difficulties is that the UK government sometimes exercises discretion to allocate spending completely outside the Barnett mechanism, in what are termed “formula bypasses”. One example that worked to the advantage of the devolved nations is the direct allocation of around £375 million for City Deals and Growth Deals, and at the same time allowing Barnett consequentials to reflect similar spending in England.

A more serious example is the disagreement of how European structural and investment funding (ESI) is to be replaced following Brexit. Over the last ESI funding round, the devolved administrations were allocated about 36 per cent of the UK’s total, much higher than their population share of 16 per cent. Under the replacement UK Shared Prosperity Fund, it appears that UK ministers will have wide discretion over spending on devolved policy areas such as economic development, providing infrastructure, supporting cultural activities and education and training. Apart from the obvious impact on spending autonomy, the added concern is that UK government may opt to allocate resources into UK-wide schemes which would reduce Barnett consequentials and risk wasteful duplication between programmes being run in Whitehall and in Holyrood.

The fact that there is no formal requirement to account for decisions about bypassing Barnett is a source of frustration for the devolved administrations which, the report argues, is being exacerbated by political differences and poor relations at ministerial level between UK government and the devolved administrations.

Two other issues with the current system have been highlighted by Covid-19:

  • Devolved autonomy over spending decisions is constrained in a crisis – Barnett provides the devolved administrations with extra resources only when UK government chooses to spend more in England. The report argues that having to wait for Whitehall to make decisions has made it more difficult for Scotland, Wales and Northern Ireland to respond proactively to the Covid-19 crisis.
  • Limited fiscal flexibilities – Barnett works to insulate devolved budgets from falls in tax revenue that affect the whole of the UK, but they lack flexibility to respond to demands for higher spending, because of limits on borrowing and constraints on transferring money between years.

The Treasury has recognised some of these constraints through the announcement in January that the technical conditions for a “Scotland-specific economic shock” had been met. This has given Scottish government the power to double its borrowing to £600 million a year and to withdraw unlimited funds from its reserves (usually limited to £250 million a year). Greater flexibilities have also been introduced on transferring funding between years.

IFG’s recommendations

The report recognises that Barnett has survived so long because of the political difficulties of replacing it. Any new system would inevitably create winners and losers, and all three devolved nations would be likely to lose under a reformed system, but the current arrangements are “hard to explain or justify”. The report calls for greater clarity, more independent scrutiny and strengthening of dispute resolution arrangements, but the main recommendation is that the Treasury and devolved administrations should jointly commission a new assessment of spending needs for each part of the UK. The long-term objective should be to “move towards a system that shares out resources in line with a clearly stated set of funding principles which are applied consistently and transparently to devolved governments across the UK”.

Council tax reform

IPPR Scotland’s short paper on council tax reform looks at a different but related aspect of Scotland’s finances which will also contribute to the success or failure of Scotland’s economy in the years ahead.

IPPR Scotland anticipates that in order to begin recovering from the pandemic, the next Scottish parliament will need to be a tax raising one. Scottish parliament is likely to need to raise significantly more tax revenue just to ensure that spending cuts in Scotland are no worse than in the rest of the UK. Whilst some of this extra income may come through income tax, the paper argues that it is important to look at how wealth and property can be taxed more effectively, and to focus particularly on how council tax could be reformed.

The paper repeats the familiar criticisms of council tax: that it is out of date, it does not reflect the current property market, it is regressive in terms of both value and income and, in Scotland, does not raise enough money.  Three priorities are identified:

  • the council tax gap between Scotland and the rest of the UK should be closed
  • no one in poverty should be asked to pay council tax
  • a fundamental reform of council tax should be a priority for the next Scottish parliament.

Those priorities have led IPPR Scotland to develop five recommendations for the next Scottish Government:

  1. Commit to closing the tax gap in council tax revenues (worth between £600 million and £900 million per year) between Scotland and the rest of the UK.
  2. Implement higher increases on bills for properties in higher bands throughout the next parliament. Increases of 3 per cent (plus inflation) for Bands A-D and of 4 per cent, 5 per cent, 7.5 per cent and 10 per cent (plus inflation) for Bands E, F, G and H respectively each year of the parliament could raise an extra £380 million per year by 2025-26.
  3. Extend the council tax reduction scheme so that no one in poverty is asked to pay council tax by the end of the parliament. If in place today this could cost up to £300m per year.
  4. Introduce primary legislation to reform or replace the council tax within the first year of the new parliament. Reform should take the form of a new percentage value tax introduced alongside the ongoing council tax system or replacing council tax altogether.
  5. Work with councils to test and introduce new local taxes in the next parliament, to build a basket of taxes at the local level in Scotland. These could include a local inheritance tax, local green taxes and other (unspecified) behavioural change taxes to “promote fair work, just transition and to narrow economic inequalities”.

Comment

Although they serve very different purposes, there are several parallels between the two systems. Both have been around for about forty years, both have been widely criticised for producing unfair results and for both, successive governments have failed to heed repeated calls for reform.

For council tax, the political scars of Mrs Thatcher’s poll tax policy run deep. The arguments that council tax is regressive and fails to take adequate account of changing property markets are unanswerable but, after the turmoil of poll tax, the political reality is that council tax works, it is relatively easy to collect, and it is local authorities rather than governments that take the flak for annual increases. It is not surprising, therefore, that council tax reform has not been a priority for either Westminster or Holyrood.

For Barnett, the difficulties are slightly different but no less intractable. It is clear that Barnett delivers greater spending per person in the devolved nations than in England, and that greater spending is not correlated with any realistic assessment of need, but it does serve a political need. From Scottish government’s perspective, Barnett generates good levels of funding, which helps keep taxes down, so why seek reform? Equally, Westminster’s priority is to maintain the Union, so why seek to further alienate Scotland, particularly when calls for reform remain relatively muted, even south of the border?

Of course, the argument is more nuanced than that. Focusing on spending per person figures at national level ignores variations between regions, and it may be when measures of need are taken into account, the outputs of Barnett are distributing funding fairly. The trouble is, nobody really knows.

The IFG report and the IPPR Scotland paper both help to highlight the need for change but, as we struggle to recover from the economic shock of Covid-19, it is hard to see reforms to Barnett or council tax being political priorities for Whitehall or Holyrood. Remember, developing measures of need are not easy; English councils are still waiting for the results of the “Fair Funding Review” which began way back in 2016.

The debates on both systems will no doubt continue, but perhaps the best we can hope for is that a new Scottish Government commits to a radical review of council tax, to create a more equitable system, perhaps supported by other local taxes, that could make sure there is medium and long term financial stability for Scottish councils through both pandemic recovery and Scottish independence, if indeed the later becomes a reality.

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