GROWTH COMMISSION RESPONSE: 4. A REALITY CHECK

23 July 2018

Far from being more realistic, the Growth Commission report is objectively more optimistic than the 2014 White Paper.

Some have reacted to the publication of the Growth Commission’s report by praising its realism compared to the 2014 independence White Paper. We challenge this assessment because, having interrogated the assumptions used, we find that the report is in fact objectively more optimistic.

The Independence White Paper assumed net savings versus the GERS figures of £600m^{1“We expect these changes to deliver savings or increases in revenue totalling around £600 million in a full year.” – Scotland’s Future p.78}, but the Growth Commission assumes net savings of £2,600m.^{2The figures used in the report are presented inconsistently (sometime as percentage of GDP, sometimes in 2015-16 terms, sometimes in 2021/22 terms). Taking the ‘lower spending as percentage of GDP’ claims made under B4.67 and applying them to 2016-17 GDP we get: Defence (0.4% of GDP) = £0.64bn; Debt Servicing (0.4% of GDP)= £0.64bn; savings from allocated UK government spending (0.8% of GDP) = £1.28bn. This totals £2.56bn.} We do not need to go into the detail to see that this is objectively a more optimistic assumption, but we can make the following observations as to why this greater optimism appears misplaced (and the supporting analysis is fundamentally flawed).

The largest claimed saving is for spending reductions compared to allocated UK government spending of 0.8% of GDP.^3B4.67 The justification for this figure in the report is unclear and based on demonstrably flawed assumptions.

The report suggests a comprehensive 2 year review to analyse “where savings could be made where costs need not be replicated” [B4.57]. The report then [B4.58] seems to declare the result of this proposed analysis by stating “This analysis shows an improvement in the public finances of around £1 billion [...] the equivalent of 0.8% of GDP”.
An immediate concern here is that £1 billion is in fact 0.63% of 2016-17 GDP^{4Using 2016-17 GERS figures, 1bn is 0.63% of the £159,389m total GDP figure (or 0.67% of the £150,025m onshore GDP figure). The later modelling appears to take the 0.8% saving as being applied to total GDP, but this assumption is not made explicit – either way, 0.8% is too high.}, but inexplicably the figure of 0.8% is the one the report goes on to use.
An even bigger issue is the way in which the £1 billion figure is justified. It is explained^5B4.58 as being made up of savings of £0.4bn and revenue benefits of £0.6bn.
The asserted potential saving of £0.4bn from costs “that will no longer be required” is supported by a few examples that total just £170m^{6B4.58: £50m associated with running costs of the House of Commons & House of Lords, £20m for the Scotland Office and “more than £100m for Whitehall Department running costs”} and which include a sweeping “more than £100m for Whitehall running costs that will not need to be duplicated in Scotland”.^{7According to the 2015-16 GERS expenditure database, a total of just £36m is allocated to Scotland for House of Commons and House of Lords; the Scotland Office figure is £23m; IPSA is £17m (which we presume in included in the Commission’s ‘House of Commons & House of Lords’ total).}
The revenue benefit of £0.6bn is explained as being associated with £2.4bn of “spending that is allocated to Scotland but takes place elsewhere”.^8B4.58 Not only does this £2.4bn include costs that the report has just assumed will be saved (and so can’t be transferred), the assertion that all of this £2.4bn^{9This figure appears to be made up of total allocated spending (Table 4-2) of £4.7bn less international affairs (£0.8), all economic affairs (£1.0bn), and we presume accounting adjustments and EU transactions (£0.5m)} of spending currently allocated to Scotland takes place outside of Scotland is simply wrong.
To illustrate with just one cost area: the £2.4bn includes £484m^{10Table 4-2} of ‘Public & Common Services’ costs. In 2015-16 the equivalent figure was £467m, a figure we can break down in detail by using the GERS expenditure database.^{11http://www.gov.scot/Topics/Statistics/Browse/Economy/GERS/GERS2017xls} This shows us that not only does this figure include all of the costs that the Growth Commission has explicitly assumed will be saved^{12House of Lords & House of Commons (£36m), Scotland Office (£23m) and various “Whitehall Costs” including Cabinet Office, DfID, HMRC, HMT etc.}, but that it includes spend which already takes place in Scotland. The figure includes, for example, £234m^{13This £234m is categorised as ‘non-identifiable expenditure’ in the database, but this does not mean the expenditure takes place outside Scotland. We suspect this may have been the cause of the Commission’s misunderstanding.} of current expenditure on HM Revenue & Customs, this being Scotland’s 8.3% population share of the total UK figure.^{14£2,838m, defined in the GERS expenditure database as: HMR041-S041A003-UK-TES_CUR-Non-ID-CG-SUB010100} In fact we know that 12% of HMRC headcount is currently based in Scotland^{15Institute for Government, Governing after the Referendum - Figure 2, p.24}, so it is simply wrong to assume that Scotland would benefit from transferring this expenditure to Scotland. In fact, in this specific example it seems likely that Scotland would see economic harm as a result of independence, as a greater share of HMRC employees are in Scotland than Scotland’s population share.^{16Of course to answer this question properly we’d need to know the share of spend, not just share of employment – but the point at issue here is that the Growth Commission’s assumptions are clearly incorrect.}

So the first assumed saving of 0.8% of GDP from spending reductions (compared to GERS allocated UK government spending) falls apart when tested and is clearly heavily overstated.

The report goes on to assume a further 0.3% of GDP (c£0.5bn) will be saved from “creating best in class institutions”.^17B4.59 The possibility that the loss of shared scale may in fact lead to relatively higher costs is not considered.

The second element of assumed saving is 0.4% of GDP from “lower debt servicing costs when a share of net assets is taken into account”.^18B4.67 This assumes a negotiated settlement with the UK government which would seem remarkably favourable to Scotland. The analysis relies on “netting off” the difference between Scotland’s population share of UK assets and those actually “held” by Scottish Government and Local Government according to CIPFA.^{19B3.18, B3.19} This paper does not attempt to validate this assumption, but we observe that it assumes a favourable outcome of an uncertain and complex negotiation.

The final element of assumed saving is 0.4% of GDP on defence. This compares with a saving of 0.49% of GDP assumed in the 2014 independence White Paper.^{20Scotland's Future, p.237: “maintaining the commitment to a budget for defence and security in an independent Scotland of £2.5 billion”; White Paper figures were based on 2011/12 GERS which included £3,236m for defence, implying a saving of £736m or 0.49% of 2011/12 GDP}

The aggregate of the above shows that the Growth Commission has been, net, about £2bn pa more optimistic than the White Paper when it comes to ‘day 1’ cost-savings and that this greater optimism is not justified. £2bn is equivalent to 1.2% of 2016/17 GDP. Reversing this unjustified increase in optimism would move the ‘legacy deficit’ up from 5.9% to 7.1%, which in turn would increase the amount by which spending growth would need to lag GDP growth to satisfy the Commission’s first fiscal rule.^{21Our model suggests this change in assumed starting conditions would mean spending growth would have to lag GDP growth by 1.5% to meet the Commission’s first Fiscal Rule of getting the deficit below 3% within a decade}

It is worth noting that the Commission assumes all of these speculative savings would be used to reduce the deficit rather than to fund any increase in public spending in other areas.

The assumption made by the growth commission that independence could deliver long term +0.7% p.a. higher GDP growth contrasts with the observation made in the White Paper that between 1997 and 2007 “small countries used for comparison” demonstrated a real GDP per capita growth gap of +0.12% p.a. (compared to Scotland’s onshore GDP per capita growth).^{22Scotland's Future, p.619, note 59.}

This highlights both the greater optimism of the Growth Commission’s assumptions^{23For a 0.7% pa GDP growth rate assumption to be less optimistic than a 0.12% pa GDP per capita growth rate assumption, we’d need to assume population growth of 0.58% pa. This compares with a current OBR forecast of 0.27% pa growth (for Scotland’s over 16 population).} and the problem with the Commission’s focus on GDP growth rates rather than the far more useful GDP/capita growth rate as a measure of economic success.^{24As the report observes: “Population trends can be an indicator of economic health, but GDP per capita is a more useful measure of economic performance” [A1.19]; “The overall level of GDP in a country is less important to individuals than the level of GDP per capita.” [A1.41]} This is particularly relevant given that the Commission’s failure to quantify its population growth goals makes the GDP/capita outcome unquantifiable.

The Commission assumes that Scotland would face “total transition-period costs of around £450 million in the two years leading up to independence and the first three years immediately afterwards”.^25B5.17 This is based on work carried out by Professor Patrick Dunleavy of the London School of Economics.

During the independence referendum Professor Dunleavy was quoted as saying the ‘immediate set-up costs’ for an independent Scotland would be £200m. When robustly challenged on this assertion by Professor Iain McLean of Oxford University (who suggested the correct answer was “probably closer to £2bn than £1bn”^{26What will it really cost to set up an independent Scotland? A critique of Patrick Dunleavy’s report, Iain McLean, 26th June 2014}) he responded by suggesting that “the total transition costs over a decade” would lie in a range of £0.6bn to £1.5bn.^{27Debating Scotland’s transition costs: A response to Iain McLean’s critique, Patrick Dunleavy, 26th June 2014}

In early 2017, Nicola Sturgeon wrote to then Prime Minister David Cameron explaining that the “set up costs” just for the limited Welfare powers being devolved as a result of the Smith Commission proposals would be “between £400m and £660m”.^{28Nicola Sturgeon's letter to the Prime Minister on the fiscal framework, 17th Feb 2016}

Audit Scotland have reported that the IT project for rural payments cost £178m.^{29IT project for rural payments ends but significant issues remain, Audit Scotland, 15th June 2017}

In this context, the assumption of “around £450m” as a total transition cost figure for an independent Scotland is simply not credible.

If independence were economically justifiable, transition costs of even £2bn would not make a material difference to the economic case – so we find it strange that the Commission have chosen to ‘low-ball’ this figure so blatantly.

The report claims that the 5.5% ‘legacy deficit’ they project has been arrived at using “very conservative assumptions”.^303.144 Based on the observations above, we do not see how that statement can possibly be justified.

It is fair to note that exclusion of oil revenues from the calculations is an explicitly conservative assumption. But given Scotland’s oil revenues have totalled just £264m over the last 2 years, the conservatism around oil revenues cannot be considered to offset the optimism we have detailed above.

The Commission largely avoids discussion North Sea oil, although it does make the surprising insinuation that the UK Government was at fault for reducing the tax burden on this ailing sector: “However, the UK’s oil and gas tax receipts have also fallen due to policy decisions taken by the UK Government on the taxation of the sector, for example on tax rates (including setting the rate of petroleum revenue tax at zero in March 2016) and tax allowances associated with investment.”^31B4.15This was an action that the SNP explicitly called for at the time.^{32Nicola Sturgeon calls for North Sea oil tax change, The Scotsman, 16th February 2015}

By not discussing North Sea oil and gas revenues, the Commission conveniently also avoids considering future decommissioning liabilities, which are estimated at £40bn – £80bn.^{33North Sea Decommissioning Costs Likely to Double from £39 billion target to more than £80 billion, Intergenerational Foundation Press Release, 30th April 2018}

Excluding oil revenues from the report appears to have been a symbolic gesture aimed at distancing the Growth Commission from the 2014 White Paper which, famously, forecast £6.8bn – £7.9bn pa of offshore receipts.