Public Audit and Post-legislative Scrutiny Committee

Meeting date: Thursday, January 11, 2018

Official Report 527KB pdf

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Section 22 Report

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“The 2016/17 audit of the Scottish Government’s Non-Domestic Rating Account”

Under agenda item 3, we will take evidence from Audit Scotland on a section 22 report. I welcome Caroline Gardner, the Auditor General for Scotland; Stephen Boyle, assistant director at Audit Scotland; and Michael Oliphant, senior audit manager at Audit Scotland.

I invite Caroline Gardner to make an opening statement.

Welcome back, convener. I wish all members of the committee a happy new year.

My report today is on the 2016-17 audit of the Scottish Government’s non-domestic rating account, under section 22 of the Public Finance and Accountability (Scotland) Act 2000. Stephen Boyle is the appointed auditor responsible for the audit, and his independent opinion on the account is unqualified. That means that he is satisfied that the account properly presents the receipts and payments for the year ending 31 March 2017 and the balances held at that date.

The purpose of my report is to support the Parliament’s scrutiny and understanding of non-domestic rates at a time when Scotland’s public finances are becoming increasingly complex with the arrival of new financial powers. In particular, I will draw the committee’s attention to issues that are highlighted by the audit relating, first, to the financial position and, secondly, to the transparency of the account.

The first point to make is that the operation of the non-domestic rating account is complex. In simple terms, the account is prepared annually to show the amount of non-domestic rates collected by councils and pooled by the Scottish Government and the amounts that are distributed back to councils by the Government as part of the annual local government financial settlement.

The balance on the account will always be in surplus or deficit at the end of the year due to forecasting and timing differences. At the end of 2016-17, the account showed a deficit balance of £297 million, which means that, in recent years, the Government has paid out more to councils in non-domestic rates than councils have collected. This is the third consecutive year in which the account has had a deficit balance. In February last year, the Government signalled its intention to bring the account back into balance over a number of years, but, as my report highlights, there is not yet a formal plan to do so.

The second area to emphasise concerns the transparency of non-domestic rates, which form a significant component of the Government’s annual budget and its funding to local government. I have recommended that the Government should increase the consistency and transparency of financial information on non-domestic rates as part of its commitment to longer-term financial planning. That includes publishing details of how the amount that is distributed to councils each year is calculated and how the Government expects the non-domestic rating account balance to change over time. That will help the Parliament to better understand how non-domestic rates contribute to the wider Scottish budget and its long-term sustainability as well as the impact on local government. The establishment of the Scottish Fiscal Commission provides an opportunity to increase transparency in the area.

We are happy to answer the committee’s questions.

Thank you very much. Colin Beattie has the first question.

Given that the audit of the account is unqualified, will you explain why there is a section 22 report?

Absolutely. As the committee knows, section 22 reports are the route that I have for bringing to the attention of the committee and the Parliament matters that arise from the audit of the various accounts that I am responsible for auditing each year. The reports are sometimes used when there is a qualification on the accounts, but, more often, they are brought because there is an issue of public interest or of strategic importance that I think merits the committee’s attention. In this case, as I said in my opening remarks, given that we have had a deficit balance in the past three years, which is now approaching £300 million, and the fact that the transparency of non-domestic rates can be improved in the context of the Scottish Government’s budget becoming more complex with the new financial powers, I decided that it was appropriate to report on the account for the first time in my term of office.

Has the Government accepted your recommendations?

The Government has made a general commitment to increase the overall transparency of its financial reporting and budget information, and it has accepted the recommendations of the budget process review group, which were published last June. The issue fits neatly within that. There are clearly choices about the way in which that is done, but the principle has been accepted.

The main issue is the deficit and how it is to be dealt with. You said that part of the issue is to do with timing. How much of the deficit relates to timing?

I will ask Stephen Boyle to give you some information on that, but initially it might be worth referring the committee to exhibit 2 on page 8 of my report, which shows the surplus or deficit in each of the past six years and the way in which those have combined to form a cumulative surplus or deficit. The exhibit shows that, over the past three years, we have had a deficit balance building up and that we have had deficits in each of the past four years, so it is not just a year-on-year movement.

Much of the deficit relates to timing. From exhibit 2, you can see that there are fluctuations from one year to the next. Exhibit 1 sets out the movement between 2015-16 and 2016-17. The account is complex, as it is subject to post-year adjustments and the effect of any resultant allowances or disallowances from the previous year. Although a timing element contributes to the scale of the £297 million deficit, that is not the only factor. As we say, there are other elements, the main one of which is the resultant policy choice that the Government makes about the scale of the distributable amount. In addition, as Mr Beattie rightly said, there are timing differences, which means that the account is never likely to be exactly in balance in any one year.

Is there any way of factoring out those timing differences in order to get a real figure?

We think that that is unlikely, given the scale of the account, which £2.8 billion or so goes through. Because it is likely that any appeals process will straddle more than one financial year, it is reasonable to say that timing differences will be an inherent factor in the preparation and management of the account.

Given the timing factors and so on, would you say that the current deficit is reasonable? Could we anticipate its being at about that level? I see that it fluctuates quite a bit from year to year.

As we say in the report, we would expect fluctuations from one year to the next. We also note in the report that 2016-17 was the fourth year in a row in which there was a deficit in the account, which has been growing. We thought that that was an important factor to capture in the annual audit report and the Auditor General’s section 22 report.

Put simplistically, the councils make a projection of what moneys they will receive and, on the basis of that projection, the Government decides what to pay the councils. Therefore, I presume that there must be some negotiations about the deficit. Do those negotiations take place with individual councils or with the Convention of Scottish Local Authorities?

The distributable amount that the Scottish Government will set is part of the Scottish budget, so it is part of the overall local government funding settlement. When fluctuations occur during the year, the Scottish Government will adjust the general revenue grant component of that. The overall funding element of the local government funding settlement is guaranteed for that year, so the issue will form part of the negotiations on the overall funding settlement for that year.

That would be the subject of negotiation with COSLA.

That would form part of the normal process of negotiations on the draft budget.

Do we know how that is broken down in terms of who receives what?

I will take us back a step. The decision on the overall distributable amount that the Scottish Government puts into the budget is a policy decision for the Scottish Government and is subject to the normal budget process; it is not the subject of a negotiation with COSLA or with individual councils. However, there is an element of negotiation on the overall local government settlement and, during the budget process, the estimate of the distributable amount might be subject to change. Members may recall that, during last year’s budget negotiation process, the Scottish Government revisited its assumptions about non-domestic rates receipts and increased the distributable amount for 2017-18 by £60 million. That had the effect of delaying the point at which the account was likely to come back into balance.

That was an appropriate approach to take, but it was not transparent to the Parliament or more widely because of the way in which the information was broken down between different budget documents and different financial reporting documents. Transparency is one of the reasons for our report.

I presume that the figure of £60 million was based on projections of how much non-domestic rates income was going to be received.

One of the underlying reasons for our report is that the basis for the estimates of the distributable amount is not clear. I think that Stephen Boyle would like to add to that.

As we mention in the report, the additional £60 million was subject to further provisional collectable amounts that were provided by local authorities, so there is an element of connection there.

Is it the case that the only way in which the account can be put back into balance is by reducing the allocation to councils for non-domestic rates? Is that the only mechanism for doing that?

That could also be done by reducing the amount of non-domestic rates collected because of increases in the tax base or increases in the tax poundage. Due to the way in which the Scottish budget is becoming more complex—it has more moving parts—there is more room for transparency around the Government’s assumptions of that in each individual budget year and, as part of the Government’s commitment to longer-term financial planning, over time.

09:15  

You have already addressed this question, Auditor General, but perhaps you could say a little more about why you decided to wait until now to report on the deficit. The table on page 8 of your report shows that the biggest deficit was in 2014-15 and that there was a similarly significant deficit in the following year. Why did you wait?

As Stephen Boyle said, we would expect there always to be either a surplus or a deficit in the account in any one year, which you can see in the second line from the bottom in exhibit 2 and, in more detail, in the appendix to the report. That is partly about timing differences and partly about forecasting differences.

The fact that there is a deficit balance is, in itself, not a matter of concern to me. The bigger concern is the extent to which the deficit is continuing to grow and the fact that it is quite hard for that to be made transparent to the Parliament in the budget process at a time when there are other elements of uncertainty and volatility because of the devolution of income tax and other new taxation powers.

The budget process happens annually. If I understood your answer to Mr Beattie’s previous question, you are saying that, as part of the budget process, the Government can vary its estimate and, in essence, borrow from local government’s future budgets to balance the current year’s budget. Should that not be reported on annually so that we understand exactly how the budget has been arrived at? The Government can change the estimate in order to balance the budget—is that a fair way of describing what you have just said?

That is one of the possibilities. The challenge at the moment is that it is not clear what is driving changes in the Government’s assumptions about the amounts that will be raised and its decisions about the amount that will be distributed to local government in each budget process. What has actually happened becomes clear over time in the account, but there is a risk, which we see now, that that can lead to an accumulation of a deficit balance that is increasingly significant. The recommendations that I make in the report about publishing the underlying assumptions and a longer-term look ahead at what will happen in each year and to the cumulative balance would be the answer to your question, rather than the individual decisions being made annually.

Can you help me out with something? Is the deficit an actual financial deficit in the sense of its being a minus figure in a bank account somewhere that is accruing interest and that is being serviced by a different budget?

The non-domestic rating account does not reflect a fund; it reflects an account that aims to show the amounts that are collected and paid out by the Government over time. Stephen Boyle can talk you through the process in more detail.

The requirement to prepare the non-domestic rating account dates back to the Local Government Finance Act 1992. Its purpose is to demonstrate that the non-domestic rates amounts that have been collected have been paid out. The account is referred to as an extract account of the Scottish consolidated fund, and the flow of funds through the consolidated fund is part of the overall arrangements.

As the Auditor General said, there is no deficit sitting in a fund per se; the non-domestic rating account exists to illustrate that the non-domestic rates that have been collected have been distributed. As we mentioned in earlier answers, the account will always balance to zero, and there have been fluctuations over many years into surplus and into deficit.

That makes sense up to a point. A cash sum is paid out before receipts have come in, hence there is a minus figure, but where does that money come from?

As we have noted in previous years, the distributable amount that is set and that has resulted in the deficit arising has, in effect, been a result of the Government paying more to councils than has been received. The amount is set as part of the overall Scottish budget, so the money comes from the Scottish consolidated fund and, if the money that comes back in does not quite match the distributable amount because of lower-than-expected collections, the Scottish Government balances that out across its overall budget.

The Government intends to get rid of the deficit over time. What will be the practical impact of that on local authority funding and on local authorities’ ability to deliver services?

You are right in saying that the Government has signalled its intention to bring the account back into balance. Ultimately, the overall funding that is allocated to local government in general is a policy decision. If that intention is followed through and the non-domestic rating account returns to balance, the distributable amount will, over time, be lower than the collectable amount that is recorded for the purposes of the account.

In some of the key messages in the report, we touch on the relativity of non-domestic rates compared to the overall funding arrangements for local government, which capture the revenue support grant and other elements. We note that non-domestic rates income accounts for 29 per cent of the total allocation to local government from the Scottish Government.

We are using a lot of terms that people will find challenging—I find them challenging. Is it fair to say that, in order to get rid of the deficit, there might be a cut in the amount that is distributed to local authorities?

Ultimately, it depends. That would not necessarily be connected to the reduction in the deficit in the non-domestic rating account. It remains a policy decision for the Scottish Government how much it chooses to allocate to local authorities. However, it has signalled its intention to bring the account back into balance and, if doing so means that the distributable amount that relates to the account is lower, the Government might choose to offset that reduction through other funding mechanisms.

You make an important point, Mr Boyle. The Scottish Government has chosen to bring the account back into balance. I will say this as a statement but I ask you to take it as a question. There is, I presume, no legal or formal accounting requirement for the Government to bring the account into balance—it is a choice that is being made. If I am right about that, I presume that there is nothing to prevent the Scottish Government from running a deficit or a surplus in the future.

That is correct. The legislation that set up the account does not require it to operate in surplus or in deficit. The only obligation is that an account be prepared and that it demonstrate that the amounts that have been collected have been distributed. There is nothing to prevent any Scottish Government from operating the account in deficit.

I am grateful.

Good morning. When the cash that goes out is more than the cash that comes in, somebody somewhere has to fund that. Therefore, there is a funding requirement in that situation. We can talk about funds, parts of funds and an account, but there is a cash deficit.

I think that your question relates to the transactions and the money that goes into and out of the Scottish consolidated fund. The local authorities pay money in during the year as rates are collected, and they receive money through the distributable amount from the Scottish Government and general revenue funding. Those amounts are all netted off, so the transactions are just net payments between Governments and councils.

But the Scottish Government is still out of pocket until that is resolved.

There will be a deficit that will be recovered from future—

But the Scottish Government is out of pocket. There is a cash deficit.

That deficit will require to be recovered from future years.

The term “signalled” is a very good one. It means nothing, really, does it? There is no legal obligation on anyone to do something if they have just “signalled” that they are going to do something.

You say that there is always a deficit or a surplus. That is acceptable if the amounts are small, but those amounts build up. Does the hole in the accounts affect the amount that the finance secretary can distribute this year? Does he take that into account when he decides how much he has available to give to local authorities and how much he must raise in tax?

That affects the overall amount that is available in the Scottish Government budget in the year to come and, depending on the policy decisions that the Government makes about the amount that it intends to distribute to local government as part of the settlement, it affects the amount that is available to local government. At both levels, it is clearly not possible to keep distributing more in non-domestic rates than is collected. As you say, that has happened—

If local authorities had paid this sum, Derek Mackay would have £300 million more in his budget to distribute this year.

It not so much to do with local government not paying the sum; it is more to do with what the situation would be if the Scottish Government had paid out less than the distributable amount in each of the past four years.

Whichever way you look at it, if there was a surplus, Derek Mackay would have £300 million more in his budget this year.

Yes.

Liam Kerr asked about accounting. You gave a clean audit opinion, which means that you have no doubt that the sum is recoverable. The Government has only “signalled” that it is going to get it, but you are happy that the sum will be collected.

We are required every year, as auditors, to consider the going-concern principle, as well as whether there is a deficit in an account. It is for management to determine whether an organisation can continue in any respect. Our obligations as auditors require us to make a judgment on that; we would consult auditing standards and the “Government Financial Reporting Manual”, which sets out the criteria, were that judgment to be in doubt. We considered the position and concluded our audit opinion and decided that there was nothing further to be done and no need to make any reference to the situation in the audit opinion. Nevertheless, we think that it is an important matter that ought to be brought to the committee’s attention, which is why we captured it in the annual audit report and the section 22 report.

So, you relied on the signalling.

Ultimately, its being an account that is required to demonstrate the amounts that are collected and receivable—an extract account—and the presence of the consolidated fund reassure us sufficiently that the situation will not evolve into an issue with regard to the going-concern principle, for the purposes of the account.

I find it interesting that you need to bring the issue to us in a special report but would not mention the issue in your own report. However, that is your judgment.

The other thing that we can take from the discussion is that the Government can decide to either collect the sum or write it off in the future.

I would not say that the Government could decide to write the sum off, but it could certainly decide to collect it. However, for as long as there is a deficit, there is—

I think that you said that the Government could adjust the amounts that it could distribute.

The deficit will either remain or it will be recovered, depending on the extent of the distributable amount or the amounts that local authorities decide to collect. There is no provision for writing off a deficit balance on the account.

I do not see that there is a particularly big issue here: it is just about financial transactions that are affected mainly by timing changes. In one year the local authorities might be the beneficiary and in another it might be the Scottish Government. Until the point at which the account is completely balanced, there will be winners and losers each year, but at the end of the process, when the account is balanced, there are no winners or losers, because the money that is sent to the Scottish Government is fully returned to local authorities. That is how I see it.

How does the reconciliation process work? Does the Scottish Government return to local authorities amounts that they have overpaid? Does that happen per local authority, or is a compound amount distributed to councils? Are there local authorities that lose out in that process, or does each local authority get back what it overpaid?

I will pick up your first point and then ask Stephen Boyle and Michael Oliphant to follow up on the second point.

I entirely agree that if we were seeing a surplus in one year and a deficit in another, there would not be an issue. However, as table 2 shows, in recent years there have been deficits one year after another, and there was a rapidly increasing deficit until the end of 2016-17. That leaves £300 million that will need to be recovered at some point through the account, in the context of the overall Scottish budget. That is why I decided to bring the report to the committee. Stephen Boyle or Michael Oliphant will pick up on the reconciliation process.

09:30  

I will pick that up. As the question outlined, the issue is about timing differences. At the start of the year, a council estimates what it will collect, and during the course of the year it pays that amount to the Scottish Government. It is only when we get to the end of the year that we know by how much the figure was out.

There are two scenarios in which reconciliation is required: when a council has collected more than it expected—it then pays the additional amount into the NDR pool or NDR account—and when a council has received less than it expected, in which case the Scottish Government reimburses the amount. The key point is that, where there are fluctuations, the Scottish Government alters the level of the general revenue grant so that each individual council gets what was intended as part of the local government financial settlement, and that smooths out any fluctuations for councils.

That is kind of what I meant: at the end of the process, when the account is in balance, there are no winners and losers. I imagine that that is the way that it should turn out, ultimately.

When the account is in balance, that is the case. The process of getting it back into balance means that that £300 million is not available for spending as it would have been if the account had remained closer to balance over the past three years.

Auditor General, the Scottish Government has said that it intends to bring the account into balance by 2020. How achievable is that?

It is difficult to answer that question in the absence of the other information that I have recommended should be available. Towards the end of my report, in paragraph 28, I set out a range of things that would improve the available information and would allow us and, more important, Parliament to understand the underlying assumptions and the ways in which they affect the budget as a whole and local government. Until we have that information, it is difficult to see what the impact will be of bringing the account back into balance, which is why “signalling” the intention is not sufficient. We need a plan, and the underlying information that makes that plan testable by Parliament, as part of the budget process.

Does the plan need to incorporate that and will the information that you are looking for improve on the unpredictability of the account as it stands?

As we have said in response to previous questions, there will always be differences that are due, straightforwardly, to timing, and there will be differences because a forecast is only ever a forecast and will never be right. However, it should be possible for the forecasts to be better understood and better tested and, therefore, to be clearer over time. That would also allow Parliament to understand the policy decisions that are being made and proposed by the Government about the amount that it intends to distribute in the local government settlement.

During last year’s budget process, as we touched on earlier, the Government’s estimate of the distributable amount was increased by £60 million. That was based on information that was available to the Government but not to Parliament about where differences were arising. We do not yet know what the outcome was, but in a budget that has more moving parts, volatility and uncertainty, it is important that there is more clarity about how that particular strand of revenue is being managed over the long term, in line with the Government’s wider commitment to more transparency and longer-term financial planning.

Thank you. That is useful. For the committee’s information, are there any other areas of policy in which there is a similar lack of information or transparency and with which you could draw parallels?

It is difficult to talk about individual streams, although the committee will be aware that the overall thrust of the budget process review group’s report was to try to present the overall picture, rather than individual streams of revenue and expenditure, and how the strands interact with one another. It is difficult to overstate how much more complex the Scottish Government’s budget is now than it was even a couple of years ago. That complexity will increase further up to 2020, at least, so having the big picture is increasingly important.

Thank you very much for your evidence. I suspend the meeting for a couple of minutes to change witnesses.

09:34 Meeting suspended.  

09:36 On resuming—