Finance and Constitution Committee

Meeting date: Wednesday, September 27, 2017

Official Report 521KB pdf

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Brexit (Impact on Scottish Budget)

Agenda item 2 is a discussion on the impact of Brexit on the Scottish economy, which is part of our focus for budget scrutiny this year. We are joined by Professor David Bell, who is a fellow of the Royal Society of Edinburgh, and Professor David Heald, who is professor of public sector accounting at the University of Glasgow.

Thank you for providing the committee with your written responses. We will move straight to questions. Adam Tomkins will begin with questions on growth.

I should say for the record that I am also a fellow of the Royal Society of Edinburgh, although I had nothing to do with the preparation of these papers. I do not know whether it was relevant to declare that interest.

Professors, you heard our earlier witness, Paul Johnson, say that there is an unprecedented level of uncertainty in the economy. Do you agree with that?

Yes. The striking thing is that we have a coincidence of three major issues at the same time. The first point is that the basis on which the Scottish Parliament is funded has fundamentally changed. We are moving from the position in 1999, when it was essentially funded by block grant but with some tax powers in the form of the tartan tax and local government taxation, to a position in which the funding of the Parliament depends on the performance of the UK economy and on the performance of the Scottish economy relative to the UK economy.

The second point is that we are going through the longest period of fiscal austerity for 100 years. It is not the deepest but, generally speaking, periods of public expenditure cuts and tax increases usually last for a relatively short number of years, whereas it looks as if the whole of the 2010s will be affected.

The third point is obviously Brexit. You heard from the previous witness that the balance of economic opinion is that the effect on the UK economy will be negative. That will lead to the lower affordability of public spending at the UK level, and hence to less money coming down the Barnett pipeline. What deeply concerns me about that is that the whole of the public debate seems to be concentrating on what I regard as a pretty irrelevant issue, which is the divorce bill. The net UK contributions are about 1 per cent of total managed expenditure, so a relatively small item is dominating public debate and creating a pretty toxic atmosphere between the European Union and the United Kingdom, when important things such as trade and future relationships are what actually matter.

I agree with the premise that we are in a period of considerable uncertainty. I would add a couple of points to what David Heald has said, one of which relates to austerity. What also lies behind that is something that Paul Johnson was talking about, which does not have its roots in Scotland. It is the question of whether a secular change is taking place in the UK’s economic performance, and maybe beyond the UK, in terms of the lack of productivity growth and the slowness of recovery from the recession, which, as we have heard, is almost unprecedented historically. I have looked at the great crash and various other recessions that we have experienced during the 20th century—I have experienced more of them than most of you—and the duration of those recessions was much shorter than what we are experiencing now.

Secondly, in relation to Brexit and the way in which Scotland’s finances will now be determined, what will matter a lot is the relative performance effect caused by Brexit on the Scottish economy relative to the rest of the UK. Ultimately, that will have a bearing on the block grant adjustment and therefore on the ability to fund public services.

Given that you both agree that there is an unprecedented level of uncertainty, I would like to ask about some of the figures, particularly those in Professor Bell’s paper. You have given some disturbing, alarming and concerning figures about forecasts of growth, particularly with regard to gross value added and various of Scotland’s economic powerhouses and cities. Given that level of uncertainty, how seriously are we to take those figures? How robust are they?

That is a fair point. That work has been done by Henry Overman and Stephen Machin at the London School of Economics. It is based on an overall model of trade effects on the UK, so it is looking at the long-term impacts of changing trade patterns in the first instance, and then bringing those down to a spatial level and looking at the effect on areas and cities. I would say that the figures are indicative; I would not go further than that.

Is there any evidence to support those figures? They are forecasts, and we all know that forecasts can be wrong and can sometimes be wildly wrong. Is there any evidence at all that those forecasts are correct, or are they just guesswork?

They are forecasts, so we cannot know whether they are correct until the time point by which they are predicted to occur.

One of the big difficulties that has not yet been mentioned is that the dynamics are really uncertain. You may remember that there were some who forecast the almost complete demise of the British economy the day after the referendum as a result of the Brexit vote. It seems to me that that was obviously wrong and those forecasts also failed to make it clear that one of the particular uncertainties is around when things will happen. If trading patterns change, how long does it take for businesses to decide to change their investment plans and for new contracts to be made and so on?

I would see the forecasts as indicative. Quite an important message that underlies a lot of them is that areas or cities that are particularly exposed are those that have high concentrations of private sector service workers. As we heard earlier, trade agreements that have much by way of agreements around trade and services are pretty thin on the ground, therefore those services may find post-Brexit life most difficult.

I saw Gordon Brewer interviewing you about this on the television on Sunday. He put to you a question that I think it will be useful to get on the record at the committee. If those indications, as you call them, are the sorts of numbers upon which we should place any weight at all, would you not already expect to see business confidence beginning to diminish and business investment plans beginning to change, given that the plans are made in anticipation of the way in which the economy is developing? There is no evidence to support the idea that, for example, Glasgow’s growth will be cut by the numbers that you have put in your submission.

It is difficult to disentangle the effects of Brexit when we live in an economy where other things are also going on. We have already heard a discussion about the potential effects of the depreciation of the pound, which in some cities may have had beneficial effects. In trying to isolate the effects of Brexit, which is what Overman and Machin have done, they are being placed in a counterfactual where nothing else is going on, but other stuff is always going on.

So we should not place too much weight on those figures.

I think that they are useful indications and they make the basic point about trade that we are currently in a single market, in which we have extremely advantageous trading relationships, and are moving to a situation in which there is great uncertainty and there are all kinds of issues that trade economists would say would make life more difficult. I think that those are the general lessons that are worth placing some weight on.

The relative performance of the Scottish economy seems to be a very important issue for the committee, because of the way that the fiscal framework works. One of the things that concerns me is the ramifications of the decline of the oil sector. I spent much of my working life working in north-east Scotland and the effects across the north-east economy of what is happening in oil can be seen very clearly. I suspect that the linkages are also affecting the rest of the Scottish economy.

10:45  

If we are looking for reasons why this period has the coincidence of the factors that I mentioned, when the Scottish economy might perform worse than the UK economy, the ramifications of oil are important, as is the question of what kind of deals will be done to protect important parts of the UK economy. For example, if the UK Government makes trade-offs that protect the financial sector, there might well be benefits to the non-Scottish parts of the UK, particularly in the south-east and London. The relative performance has become very important, because how much the Scottish Parliament will be able to spend will depend in part on the relative performance and its effect on the block grant adjustment.

The impact of Brexit on cities in Scotland will not be uniform; it will be felt differently in different areas. I understand that the figures on gross value added that have been quoted are forecasts, but it would be wrong of us to ignore warnings about their impact. It was stated:

“Aberdeen’s GVA is forecast to fall more than any other city in the UK”

and

“Edinburgh’s GVA is forecast to fall by 3%”.

There will be an impact not just on Aberdeen and Edinburgh, but on Dundee and Glasgow.

What Professor Bell said about the areas that will be worst affected having the highest level of private sector service workers was interesting. The evidence that we just heard suggested that they are also the lowest-paid workers. What will be the impact of the hit from Brexit on the poorest members of society?

You said that

“The Scottish Government and the City Partnerships might wish to consider how”

best to mitigate the impact on the cities. What is your suggestion for how the Scottish Government, councils and city partnerships can best mitigate the impact?

It is true that there are more private sector workers than public sector workers at the lower end of the pay distribution. However, it is also true that what we are talking about are effects that are largely to do with trade and which parts of the economy will be most affected by a different trading environment. The higher-paid private sector workers are the most likely to be affected. In Edinburgh, for example, if it becomes more difficult for life sciences to penetrate markets or for high-tech computing firms to break into new markets, those are the effects that are most likely to impact on the overall GVA in that city.

We should remember that, as far as the relative performance of Scotland is concerned, it is the higher earners that matter more, in a sense, because they are the bigger contributors to income tax revenues. Relative performance in relation to income tax per head will determine how the block grant adjustment evolves. That is not to say that there will not be trickle-down effects that will affect poorer workers, but the lesson that I took from Overman and Machin’s research was not necessarily that that will particularly affect poorer people. Rather, it will affect cities as a whole, because it will have a negative effect on their trading relationships with those that they currently trade with, or could trade with in the future.

What about your call for the Scottish Government and city partnerships to look at ways in which they can mitigate the potential impact on cities?

I could launch into an explanation of that, which the committee might find interesting, or it might not.

The issue of what will happen to the structural funds post-Brexit is important. One possibility is that that money will move into the city partnerships. That would change UK regional policy in the sense that, at present, we have some policies that are place neutral. That means that, to get that support, places have to qualify in terms of income per head, a measure of relative poverty or whatever. The standard measure that the European Union has applied in the latest budget is that regions that fall below 70 per cent of EU average per capita income are eligible for direct support. That now applies only to Cornwall and west Wales. If that money is taken and put into city partnerships, it will be allocated to places where deals are being done through engagement with other stakeholders. For example, the University of Edinburgh is a big stakeholder in the city deal, and so is the local authority. Deals such as that are done in places where there are actors that are willing to engage with them. If a similar place-neutral regional policy is not introduced, places that currently qualify for some EU-type support may lose it. All the money will end up concentrated in the cities and there will be left-behind towns, rural areas and so on.

This has to be thought through very carefully. It is not clear what the UK Government’s thinking is about setting up some kind of fund. It is important to know where the social fund and the structural funds that currently come from Europe are going to end up. A decision has to be made about whether they will come to the Scottish Government or be retained and distributed at the UK level.

My question is on that very issue. God forbid that the structural funds cash will end up only in cities in Scotland. North Ayrshire and East Ayrshire would throw their hands up in horror at that prospect.

You touched on the fact that there needs to be a strategic approach. North Ayrshire Council’s submission tells us that up to 25 per cent of Scottish councils’ spend on economic development comes from the European Union and that it supports a wide range of things such as infrastructure, business investment and youth employment in areas such as North and East Ayrshire. I suggest to my colleagues round the table that the impact of Brexit will not be felt only in the cities and that there is a case to be made for having a regional policy in Scotland that continues to provide support. Is any work being done on what the impact might be in areas outwith the cities and on their councils?

Some parts of Scotland and indeed large swathes of England qualify for transitional funding because their income per head is between 70 and 90 per cent of the EU average. There is also European social fund money, which I think is what you are referring to. No work is being done on that, as far as I know, because of the uncertainty about what is going to happen to those funds. Are they even going to be allocated to regional development? Are they going to be allocated at a Westminster level or will they go to the devolved assemblies?

A lot of this goes back to Keynes’s comment that the things that practical men do are things that were thought through by some economist long ago. Ultimately, the argument is based on different views about where money should be allocated. This is not going to be good news for MSPs from rural areas because, basically, the argument is that concentrating resources in cities generates more returns. That is what lies behind the initiatives that have been taken at UK level in relation to cities in the past 10 years or so. That clearly goes against equity, but the argument is that concentrating resources in cities is more efficient. All that I say is that that kind of thinking lies behind decisions about the allocation of resources to different parts of the country. We currently have a mixed economic development set-up, in which the EU does not really care about where money goes as long as it goes to places that qualify, and the UK Government and the Scottish Government try to get people together to agree on policies to promote the growth of cities.

We have gone on to the question of what happens with functions that are repatriated. There is much talk in the media of a power grab by the UK Government, which has upset the devolved Administrations. There is a crucial question about whether there will be UK common frameworks—in the context of agricultural subsidies, for example—and how they will be financed. Obviously, the UK Government could keep everything and just run it all from the Treasury. Alternatively, the existing Scottish spend on presently EU-financed functions could be transferred into the Scottish block, with future changes going through the Barnett formula.

I make the point in my memorandum that that will introduce a new set of controversies into the budget process, because there will be a direct conflict between spending money on nurses and spending money on sheep. Because it is done within a European framework, the budget is actually segmented—those two budgets are not fungible. As soon as we put it into the block, questions will arise about whether future changes that come through Barnett will be sufficient to pay for agricultural subsidies, and about what relative priority should be given. That is a very important issue for the committee to think about when it turns its focus to the specifics of the budget process.

I can almost see my colleagues in east Ayrshire, North Ayrshire and South Ayrshire reaching for their email in horror at the prospect of a city-only regional policy. We will get the spin-off benefit from that, of course, as we always have, but I do not think that they will really follow that. Is there a need to develop a more regional policy in Scotland around these types of frameworks so that we do not get left out and it is not just the cities that get the attention, through regional policy and otherwise?

You could certainly argue that the kind of policy that I described—I do not necessarily subscribe to it—does not take account of the associated externalities. One of the externalities that we have seen in Scotland for a long time is the effect of young people being attracted to cities, and other parts of the country being left with much more challenging age structures than the average in Scotland as a whole. A lot of the consequences of that have to be borne by public services, which results in higher costs for hospitals, care and so on.

There is a good case for looking at economic development in the round—which I do not believe that the UK Government has done—and taking into account those externalities and equity considerations. Driving up GDP is not just about efficiency; it is also about maintaining a balance between different parts of the country.

11:00  

Earlier, David Bell spoke about the impact on higher-rate tax payers and the potential for greater attrition in terms of jobs and so on. I compare that with David Heald’s paper, which talks about the numbers from the HM Revenue and Customs work in 2017 being “striking”. It says:

“Of 2,601,000 Scottish income taxpayers in 2014-15 paying £1.68 billion, the 4.38% with incomes greater than £50,000 accounted for 38.39% of that total.”

Those figures are worthy of a bit more discussion. If I understand them correctly, the impact on that sector of Brexit and leaving the single market could have quite serious consequences for the income tax take in Scotland.

About seven or eight years ago when I originally saw those figures in the HMRC survey of personal incomes, I was sufficiently shocked that I thought that I had calculated them wrongly. However, the figures are broadly consistent from year to year: roughly speaking, 5 per cent of income tax payers produce 40 per cent of Scottish income tax revenues. That shows the importance of thinking carefully about the effect on that group when the Scottish Parliament sets tax bands and rates.

There are two issues here. The first is the one that you have directly raised, which is the fact that people in the private services and oil sector have had very high incomes. Because of Brexit and other things that are happening, we have got to think very carefully about the relationship between the tax regimes of Scotland and the UK. I was one of the people behind the tartan tax proposal 30 years ago. It atrophied because so much money was coming down the Barnett pipeline. It is very important that the Scottish Parliament and the Scottish Government do not allow the Smith commission tax powers to atrophy. The point that I am making is that they have to be used carefully. A broader political point is that it is wrong to think that you can protect or fund increases in public services solely by taxing the well-off, such as additional-rate tax payers. In the context of continuing austerity and pressure on public services, if Scotland wishes to spend more, relative to what the Scottish block grant will fund, it has to face the fact that income tax powers will have to be used across the spectrum and across a broad base.

The other issue is that the Scottish Parliament does not have control over the personal allowance. Trying to use a zero per cent band would create complications with some social security benefits. However, Parliament has control over the bands. For a long time, my view has been that the higher-rate threshold is too low. From the 1980s, the UK has moved to a two-rate system: a basic rate and a higher rate. You need to think about what those bands should be, so that people on an income of £43,000 do not go from 20 per cent to 40 per cent.

The practical difficulty that we have is that the Scottish Parliament does not control national insurance. As a result, when one talks about the effect on individuals and households, one has to think very carefully about the relationship between marginal rates of combined income tax and national insurance.

That was very useful. The position regarding Scottish taxation might or might not shift, but from what I took David Bell to say, even if all things are equal and nothing in the Scottish tax system changes, there might still be a negative effect on higher-rate taxpayers as a result of Brexit. In other words, even doing nothing might have an impact on the Scottish budget with regard to the amount of income we get from income tax. I wonder whether David Bell might like to say a bit more about that broader point, taking into account what David Heald has said about the impact of the choices that we make.

As far as the Scottish budget is concerned, there is a level effect and a relative effect. The level effect is that, other things being equal, Brexit is more likely to induce falls in income among higher earners or, indeed, induce the emigration of higher earners, particularly EU nationals who currently live in Scotland, in both the public and private sectors. That is because those people have easier access to markets, countries or polities outside the UK where they might prosper relative to the UK, and they consider such options more of the time than low-paid workers do.

The relative effect comes through the block grant adjustment. The question in that regard is: who is doing worse with regard to high earners—the rest of the UK or Scotland? Notwithstanding the forecasts of the difficulties that particular cities might face, the expectation overall is that Scotland will be less affected than the rest of the UK. At the moment, it is difficult to predict how that will come through as far as those at different earnings levels are concerned, but clearly that sort of thing can affect the block grant adjustment.

So—incredibly—the bottom line is that what happens to the City of London will have a huge impact on what happens to the Scottish block grant and what happens in Scotland.

Yes, and although we have no direct evidence of investment intentions, I should say that I was at my daughter’s primary school in Wimbledon yesterday and found that over the past year her class had been depleted by six kids, all of whom have European parents. There is already evidence of some changes taking place, but of course it is just hearsay until it enters the official statistics.

This might get me into trouble, but it probably means that in order to further Scottish interests we in Scotland will have to stand up for the City of London.

Can I tweet that?

I said “probably”. I did say that it would get me in trouble.

Because it is such an important technical point, we have tended to stress the question of the importance of the Scottish economy relative to that of the rest of the UK. However, I think that, with regard to Brexit, the biggest effect on the Scottish economy and the Scottish budget will be if the UK economy does badly, because if that happens, we are likely to get an even longer period of austerity. Everybody must understand the significance of the block grant adjustment and the fact that the relative performance matters, but my major concern is the overall effect on the UK economy at a time when there are other reasons—such as the decline of oil—to be worried about the Scottish economy.

Okay. It is all complicated stuff. I call Murdo Fraser.

Professor Heald, I have to say that I do not understand your use of the term “atrophy” in relation to the Scotland Act 2016 tax powers. The Scottish Parliament now has to set tax rates on an annual basis; we have to have a positive vote in Parliament to set rates, and some of us might argue to keep them in line with those of the rest of the UK while others might argue for a different choice. How is it atrophy if the Scottish Parliament is taking a positive vote to set tax rates?

I take your point. I was thinking very much about the 1999 tartan tax powers. I was around when those powers were being discussed, and at the time, people did not appreciate the significance of the Parliament not having to have a positive vote—I certainly did not. However, we found that one of the consequences of the Parliament not having to have a positive vote was that, over time, it became much more difficult to use the powers, partly because they had never been used. Furthermore, after a period of time, the administrative machinery collapsed without the Parliament being told that it had.

My concern about the present powers in the 2016 act is that, although I take the point—and welcome the fact—that a positive decision has to be made, the longer that those powers go without being used or are used in only a minor way, the greater the danger that, for example, HMRC’s preparedness will decline. When I talk about things atrophying in this context, I am thinking about the two things that will happen if you do not use the powers: first, the administrative machinery will disintegrate over time, because it is costly to maintain; and secondly, the difficulty of making a decision becomes more severe.

I hope that the discussion paper that the Scottish Government has committed to producing on income tax will give us an opportunity to avoid the atrophy that you are talking about.

Professor Heald, your written submission uses a phrase that I found interesting. It says:

“for each tax within the Scottish Parliament’s portfolio of taxes, there will be those who advance plausible or specious arguments about the economic benefits of tax reduction.”

You mention a number of examples in relation to that, such as aviation tax. Is there a danger that income tax will be seen in the same way, and that that will lead to the kind of tax competition that leaves the revenue of all parts of the UK worse off?

Yes. One of the things that filled me with a certain amount of disquiet during the Smith commission discussions was that loads of people in Scotland seemed to think that having more tax powers would mean that you would be able to spend more. It seemed that Scotland wanted more tax powers so that it could spend more and have a more generous welfare state and better public services. However, there has always been a different strand of argument, which is that a national Government that has to raise its own taxes will spend less. It is possibly why there was a move from a position at the time of the 1997 referendum in which there was substantial opposition to the tartan tax to a position at the time of the Smith commission in which it was almost as if everyone was competing to give Scotland more tax powers.

Of course, one of the difficulties is that, although Scotland now has substantial tax powers, they interact with other taxes. Essentially, the UK has two forms of income tax; in my view and in the view of most economists, national insurance is basically a second income tax, and the interaction of those taxes is extremely important. Committee members will probably remember that, under the Labour Government, Tony Blair and Gordon Brown promised not to increase income tax, so they increased national insurance contributions instead. The political relationship between those two taxes is important, but what is called income tax is probably far better understood than the operation of the national insurance system.

11:15  

The other issue is that the Scottish Parliament does not set the tax base for income tax; the powers relate to only non-savings and dividend income. Therefore, there will be issues about the relationship between personal income tax and possible avoidance strategies such as incorporation into companies. There are also questions about the move towards self-employment and relative enforcement.

Not for the first time, Adam Tomkins and I have apologies to make to the country on behalf of the Smith commission—for the complexity of the process, if nothing else.

I want to park some of what we have talked about, because it is not directly relevant to the discussions about the Brexit context, although it is obviously of huge importance generally. The political will to take a different tax policy is far more important than the debate on powers. Scotland has had very broad taxation powers with regard to local services, and there can be no greater example of atrophy than the failure to do anything serious with them over the years.

The potential changes with regard to Brexit that you have both touched on and which relate to whether people move, leave or organise their affairs in a different way in response to what is happening with Brexit and the economy bring me to a question about the potential impacts of tax changes at the additional and higher rates. The argument has been made repeatedly that increasing the additional tax rate might not generate additional revenue, because there will be behavioural changes. That situation might be exacerbated in the context of Brexit, given that people might already be thinking about relocating or arranging their affairs differently.

I have repeatedly asked a number of people, including the Government, whether there is any evidence that the same argument that is being advanced for the additional rate applies to the higher rate. Can either of you answer the question whether the higher rate of tax—or potential increases at the higher rate—is equally as vulnerable to such behavioural effects as the additional rate, and is there any way in which we can estimate the size of the effect?

I cannot help on the question of estimating the size. I would make the point, though, that there are very few additional-rate taxpayers in Scotland. The number that we see widely quoted is 17,000, which is very small. There are a lot more higher-rate taxpayers.

My more general point about the higher-rate threshold is that when higher rates operated in the past, it was not expected that they would catch people on moderate incomes in the way that they do now. My argument about the higher-rate threshold being too low and there being insufficient graduation in the system is based more on equity. There is also a very important question about how much attention HMRC pays to the enforcement of residence rules.

Going back to the question of additional-rate taxpayers, I suspect that a lot of those in Scotland might have other residences, so the extent to which HMRC actually polices residence and makes sure that the system operates as the legislation intended is important.

That is also less likely to be the case with regard to the higher rate.

It applies generally about enforcement, but because so much money comes from the additional rate, the potential gains from avoidance behaviour become greater.

The greater concerns with regard to the higher rate are about incorporation. As you might well remember, Gordon Brown as chancellor provoked an enormous increase in incorporation with the introduction of a zero-rate band of corporation tax, so there is past evidence that taxpayer behaviour can actually be quite sensitive. The UK is an unusually fiscally centralised state. In Canada or the United States, the idea that a different province or state might have a different income tax—or no income tax at all—would create no surprise whatsoever.

The same is true in plenty of other European countries.

Yes, and in a geographically compact country such as the United Kingdom with no tradition of income taxes being differentiated geographically, one has to ensure that the administrative system works properly. In my view, there needs to be caution in the way that those powers are operated. On a more political level, I repeat the point that, if the Parliament wishes to protect public services from future austerity, the use of the income tax powers should be across the board and should certainly not concentrate solely on the additional or higher rate.

So you are calling for caution but not atrophy.

Yes. Caution but not atrophy.

I know that Professor Bell wants to say something about that, but I presume, Professor Heald, that you would agree that changing the higher-rate threshold is not the only—or perhaps not the most effective—way of achieving better graduation. We do not need to assume that one basic rate for an entire swathe of income needs to stay for ever.

I absolutely agree.

I agree pretty much with what David Heald has just said. Paul Johnson might have different views, but I know of no evidence on the higher rate per se. I do know that it is quite difficult to work out the effects.

Adding to what has already been said, I would suggest that another option that people might take in relation to Brexit is not to come here at all, which is something that the higher education sector is aware of at the moment. As for income tax in general, Brexit might make the option to move something that certain classes of worker will consider more than has been the case in the past.

David Heald has talked about the redefinition option, which relates to incorporation for higher-rate taxpayers. There are two classic reactions that people might have to higher tax rates: one is to work fewer hours, which is probably important for married women and for older workers in general; and the other is to decide that life holds other challenges than working and to drop out completely. You might think that that does not really happen very much among working-age people, but one of the big changes over the past 10 years—and in this respect, I would reference what Paul Johnson said about intergenerational equity—is that the fastest-growing group of workers are those aged 50-plus; indeed, HMRC has said that it is surprised by the increase in income tax revenues from those aged 65-plus. People are staying on longer, and that is helping to boost income tax revenues. There is a huge opportunity to do some work on that to try to understand it better, but in thinking about bands and rates, you have to think about all the different options that people might have when confronted by either a fall or a rise.

I want to ask about the Brexit divorce bill. I know that Professor Heald said that it is pretty irrelevant in the wider scheme of things, but it seems to have caught people’s imagination somewhat.

The RSE paper suggests that the bill might be around the £36 billion mark and says:

“If, however, additional payments form part of the final divorce bill, then there are likely to be consequences for the Scottish budget”.

Can you explain that for us?

I will need to remember why that was the case in the paper.

If the UK is paying more to the EU than expected, there will be no consequentials because the other things that it might have spent its money on, such as health and education, will not be available as options. The higher the bill to exit the EU, the less money will be available for UK domestic services, and that will affect the Scottish budget with regard to the extent to which those services have Barnett consequentials. We have heard that some parts of the public services budget are under huge pressure at the moment—health is the obvious one—and that will immediately have Barnett consequentials. That was the thinking behind the wording in the paper.

One of the aspects of the devolved funding system, even after the fiscal framework, is how much discretion is in the Treasury’s hands. If the UK paid a £50 billion divorce bill, what would happen would depend on whether the Treasury said that that had to be fitted into one year or over several years against the current envelope of total managed expenditure. If the Treasury said that it was going to be a one-off, there would be no Barnett consequences, because it would not displace expenditure that would generate such consequentials. That is a good example of how, even with the fiscal framework, so much depends on the discretion of the Treasury.

At this point, is there any way of putting numbers on what the impact on the Scottish budget might be, or is it too early to say?

There are two big choices. The first choice is whether it is a lump-sum payment made in one year or a payment spread over a number of years. The second choice is whether it scores against current expenditure totals or whether it is a one-off. If it scores against current expenditure totals, it will depend on what gets displaced and whether what is displaced is Barnett relevant.

As a representative of the Highlands and Islands, I am, as you can imagine, hearing a great deal of concern about the potential uncertainty around common agricultural policy funding. Can either of you give me an idea of how significant a contributor that is to the economy compared with other forms of EU funding?

I have forgotten what the current Scottish spend on CAP is.

It is about £500 million.

I was going to guess about £470 million.

The role that CAP spend will play in relation to the general Brexit debate will be much larger than its size in the economy, because there will be conflict around which powers are retained at Westminster and which are handed on to the Scottish Government. The agenda here relates to free trade. Currently, there is a group in government that is very keen on free trade, which means no tariff barriers on goods traded. The highest tariffs by some distance are those on agricultural goods; on beef, for example, we are talking about a rate of around 80 per cent. If the UK Government wanted to enter into a free-trade deal with another country, its ability to continue to subsidise agriculture would be in question.

11:30  

Interestingly, the EU’s deal with Canada has not resulted in changes to the CAP in Europe. Relative strength matters in this area. If you are doing a deal with someone, a key question is: who has more at stake? If the UK wants to be in a position in which it is willing to put everything on the table—because it might, for example, want concessions for another sector—its ability to continue to protect agriculture might come under threat.

It comes back to my point about whether there will be common frameworks in the areas where the UK has previously not needed its own common framework because an EU common framework has been in place. A subsidiary question is: who actually makes the decisions about that? Will it be negotiated with the devolved Administrations, whose agriculture sectors are more dependent than England on subsidies, or will the UK Government impose a framework, because it wishes either to assert itself or to keep its hands free in the context of the free-trade agreements that David Bell spoke about?

Interestingly, the part of the UK that is most dependent on agriculture subsidy—much more so than Scotland—is Northern Ireland.

When we talk about efficiency versus equity in the Highlands, the argument that I have heard regularly is that CAP funding is actually one of the most efficient ways of injecting money into the local economy. In the Highlands and Islands, the money goes directly from the farmer’s pocket to pay vets’ bills or purchase feed. Do you have any thoughts on that? If such an option is not available to the UK—presuming, of course, that those powers go to the UK Government—is there another more efficient way that you can suggest of subsidising a rural economy?

Over the years, the EU has gradually moved away from the idea of subsidising output—for example, the production of wine or sheep—towards encouraging farmers to produce the kind of goods that it wants, which might include, say, a better environment rather than sheep. The EU also wants to protect rural communities. Different streams of funding go through the CAP, some of which may end up in vets’ bills.

Standing back from that, the question is: what do we want the agriculture sector to produce? Is it vibrant rural communities, an outstanding environment or greater output? The way in which we design the agricultural payment system will provide the incentive for farmers to do one thing rather than another.

All of that is up for grabs. If we are going to redesign our agricultural support system—indeed, if we are to have one at all—those kinds of issues will have to be thought through. It is an issue for the Scottish Parliament and the Scottish Government.

I imagine that there might be significant policy differences between the Scottish Government and the UK Government in the areas that you have just mentioned.

There are bound to be, because the structure of agricultural production is quite different in England and indeed in Wales. What happens in Scotland is not the same.

Does Ivan McKee have a supplementary on that?

No, but I have a couple of other points.

I will take Murdo Fraser’s question on structural fund issues first.

I have a couple of points to raise, one of which is on structural funds. I listened to all that you had to say and it was very interesting. We all understand that Scotland does relatively better from structural funds than many other parts of the UK. You can tell me whether you agree or disagree. Are you really saying that we should replace structural funds with some other source of funding that needs to come not through the Barnett formula process, which might disadvantage Scotland, but through some new system of regional policy funding?

When the Scottish Parliament has got new functions in the past—rail franchising being the obvious important example—the spend in the year before it happens gets transferred into the block and the formula is used subsequently. It is not a question of getting a population share of UK spend.

I agree with David Heald on that.

I did not really bring out the other point that lies behind this. Another thing that will be up for grabs is the ability of different parts of the UK to provide direct support to industry. For many years, Scotland has, under certain conditions—such as when the EU agreed that it did not significantly jeopardise the internal market—been able to spend money on regional selective assistance for particular companies coming in.

Regional selective assistance died a long time ago in England; it is not one of the options that is allowed to be applied in England. We have to think through the size of the structural funds as well as all the rules around when support can and cannot be given. It appears that the EU was content for Scotland to have a slightly different set of rules than was applied in England. Therefore, when those rules come up for discussion, it will be interesting to see whether the UK Government is willing to negotiate a continuation of that kind of difference between different parts of the UK.

If you look at the Treasury’s annual public expenditure statistical analyses, you will see that the index of public expenditure on economic developments in Scotland is vastly higher than the UK average. Within the umbrella of EU funding, Scotland has maintained a system of industrial support, which, as David Bell said, has tended to wither in England. In terms of the internal UK market framework, that will be one of the issues up for discussion.

One of the things that concerns me about the expenditure side and the tax side is that, freed from EU constraints, which everyone has blamed for lots of things, there is a danger of competitive subsidy bidding within the UK, and also a danger of competitive bidding on the tax side, as with proposals to reduce air passenger duty.

We can only lose in Scotland if that happens.

My view is that Scotland, Wales and Northern Ireland should avoid that kind of competitive bidding with England.

Although it does happen to an extent already.

Yes.

I have one other question, on a different topic. It follows from Ash Denham’s questions about the impact on the budget. What seems to be missing from your papers is any recognition that there will be a net benefit to UK finances from leaving the EU. It might not be £350 million a week, but Paul Johnson said earlier that it would be £8 billion a year net. Even factoring in the prospect of a divorce bill, in the longer term, could that not mean that would be more money to spend rather than less?

I was at the back listening to Paul Johnson’s evidence. What he said was that the overall fiscal effect would be negative because of the effect on the forecast growth of the UK economy.

I have seen various figures on the UK contribution to the EU in different years, and it is a net contribution of about £8 billion to £10 billion per year, but one must not just look at the budget numbers; one must think about the affordability of future plans in relation to the growth of the economy. On one level it is right to say that £8 billion will be freed up, but the overall economic context will be more difficult.

That is the forecast.

Sure.

As we know, forecasts might or might not turn out to be true. I am just surprised that none of that is recognised in either of your submissions to the committee.

I want to touch briefly on two or three points. The first goes back to Neil Bibby’s earlier question about the best thing that Government can do to mitigate the impact of Brexit on the cities. I agree that the best thing would be to find a way to stay in the single market.

My personal view is that the UK should not leave the single market or the customs union. I accept that the direction of travel is that both will happen.

My view is that it is likely to happen irrespective of whether I think it is a good idea or not.

I mentioned scenario planning in our paper for the committee. There is an argument for thinking through what the implications of different types of Brexit are and, indeed, a hard Brexit would pose particular challenges to industry. I guess that the Scottish Government might have a role in trying to mitigate the effects of the challenges that industry could face.

For example, what issues might our financial sector face in accessing markets that it currently accesses if there is no agreement and we fall back on World Trade Organization rules? We know that the Royal Bank of Scotland is thinking about setting up an office in Amsterdam.

There might be real issues for even quite small businesses in Scotland, such as food exporters. What kinds of things do they need to be thinking about if they want to get through a hard Brexit?

Yes. However, a soft Brexit, by my definition, would be staying in the single market, whether in a UK context or a Scottish context through a differentiated solution.

My second point—and I cannot let this go—is that I am surprised that people are surprised that only 4 per cent of the tax base raises 40 per cent of the revenue. That is classic Pareto, and nobody should really be surprised at that.

My substantive question is on immigration, which is raised in David Bell’s submission. You will have heard me ask Paul Johnson about this earlier, but what do you think will be the medium to long-term impact of a significant reduction in net immigration into Scotland or net migration from Scotland on growth rates, public sector finances and, given the age profile of those concerned, tax take and pension rates? Secondly, if Scotland were able to achieve a differentiated immigration solution similar to that in Canada and Australia, what opportunities would that present to the Scottish Government and the Scottish economy?

11:45  

The fact is that Scotland attracts a relatively small proportion of UK migrants. It is surprising that Scotland is such an outlier, given its income per head; you would expect it to attract quite a lot more, but it does not and we do not know exactly why.

As a result, if the UK reduced net immigration to the tens of thousands, it would be difficult to see net immigration to Scotland being anything more than 10,000, and even that might be pushing it. Over the long term, that will have demographic implications, because it will effectively mean that the population will be bound by a lack of net inflow; deaths and births will be more or less equalised; and the population will more or less stabilise at 5.4 million or whatever it is at the moment.

As for the effect of that on the economy, I go back to Paul Johnson and the fact that it is important to differentiate overall GDP and GDP per head. If the population is not increasing, GDP itself can be stable while GDP per head—

But growth rates are always based on total GDP, so let us just stick with that.

That is true, but as far as living standards are concerned, what actually matters is GDP per head. In any case, a slowdown in migration will certainly result in slower GDP growth.

It is more difficult to say what would affect GDP per head, but we also have to take into account the other on-going effect that you have mentioned—the ageing population. That is already affecting Scotland more than it is the rest of the UK, and it means that a relatively larger proportion of people in Scotland will be outside the labour market than will be the case in the rest of the UK, unless, of course, more people continue to work into their 60s and 70s. That would result in a less optimistic view of the Scottish economy in the medium to long term than would be the case if net immigration remained roughly at the levels that we have experienced over the past 10 years or so.

What about the question of whether a differentiated solution could offer any opportunities?

It is almost like the situation with taxation. There are countries where immigration is set centrally; in other places, it is set by subnational Governments and national Governments in consultation; and there are places where the subnational Government plays a leading role. There is a very good paper by Christina Boswell that explores the possibilities for a differentiated migration policy in Scotland.

One could conceive of policies—I can go into detail if you like—that do not necessarily threaten the overall target for the UK but nevertheless allow for some differentiation in Scotland.

Alexander Burnett has been very patient but two members have indicated that they have supplementaries on what Ivan McKee asked. Can we make these tight, please?

I just want to make sure that I have understood two points properly. The first relates to Murdo Fraser’s questions about potential longer-term opportunities and the fact that your submissions and all the other written submissions, as far as I can see, talk about the economic harm of this process and not about potential benefits. Is it fair to say that even a hard-right, fully signed-up Brexiteer with a vision of the sunlit uplands of empire 2.0 can make a rational argument only about the scale of the damage that the process of leaving will cause, even if they think that there might be further opportunities in the long term? Is there any plausible scenario in which the taking of this country out of the European Union will not cause economic harm?

There has been some discussion in the newspapers about Singapore-on-Thames and the logic of leaving if the UK was going to go into a low tax, low regulation, low public spend environment. I would not support that policy but I understand the logic.

One of the things that I find striking is that we seem to be delaying the date of exit from the European Union by two years because of the transition period. That will create its own difficulties because decisions will be taken by, and the UK will be making contributions to, a body on which it has no representation. I can imagine a new wave of difficulty there.

I do not understand the argument that we leave the European Union and then bind ourselves to basically the same regulations and financial contributions similar to those that we already make. If I wanted to construct an argument in favour of Brexit, it would be a question of making a complete break with the European social model and the heavily regulated European economies. I do not see the point of mirroring those regulatory regimes to secure access to markets.

It is difficult to predict what effect that kind of transformation would have. It would require huge structural change in the UK economy. People would be doing things quite differently and different things from what they have done before. I do not think that the benefits of that can come through in the short to medium term.

All the recent research on trade patterns shows that geography still matters. Value chains are centred in the world around China on the one hand, Germany on the other, and the United States on the other. The countries around them trade with them extensively. We are moving out of the ambit of one of the three key trading partnerships in the world.

In response to Ash Denham, you talked about the divorce bill. Have I understood you correctly? Did you say that if the UK Government wants to avoid adding another dose of something toxic to the relationship between itself and the Scottish Government, it has complete freedom to decide to pay that divorce bill in a way that avoids a knock-on consequence to the devolved Administrations’ budgets?

Yes.

Thank you.

How realistic is it to suggest that leaving the single market and paying the divorce bill means the end of everything and that we will not pay a further penny, when you consider that we are inextricably linked to the digital single market in Europe? There is a huge range of services that we currently share and will continue to share beyond Brexit, and it is ridiculous to suggest that we will get that for nothing. Roaming charges have been flattened out, online content will be available right across Europe from next summer, and there are general data protection regulations coming in that the UK is signing up to. There are huge amounts of digital infrastructure already in place, so is it not ridiculous to say that we will pay a one-off bill to say, “Cheerio”, but continue to use all that? Is it not a bit like saying that we will be off the bus and on it at the same time, when it comes to the digital market?

To the extent that you are picking up on what I said, my personal view is that it would be sensible if the UK completed the discharge of its financial obligations to the European Union, so that there could be a clean break. At that point, you discuss what future collaborations you will have.

And pay for.

Almost certainly the European Union will expect the UK to pay for them. However, I want to make it quite clear what the divorce bill is. On the day that divorce takes place, there is a clean break. If you want future relationships, such as contributing to the Erasmus programme or horizon 2020, which are important for Scottish universities, you will have to pay for that. It is quite transparent in terms of presenting to the public that the divorce is over and that our future relationship is something that we will conduct on a transactional basis.

Could we be out of the single market but in the digital single market at the same time?

I confess that I do not know much about the digital single market.

I am sure that David Bell will enlighten us.

Not really. I think that all those things—whether we are in horizon 2020 or the digital market—will be determined by negotiation. A lot will depend on European politics and whether they particularly want to engage with us or not. It is unlikely that it will be a free lunch for us.

Given the noise of Brexit, one of the most incisive points that I have seen put on paper to date is one of Professor Heald’s conclusions, which states:

“Conflicting forecasts of prosperity or doom ... align with the individual ... view of the desirability of Brexit”.

Where do you put yourselves in relation to that statement?

As I said at the beginning of my contribution, we live in an age of remarkable uncertainty. Economic models tend to be calibrated on the basis of past experience. There is much rhetoric, but people are talking about Brexit being the biggest change in Britain’s relationship to the outside world since 1945. To some extent, existing data will not tell you what is going to happen.

One point that I forgot to make earlier is that I am surprised that we have not talked more about the cost pressures on the Scottish budget, which are partly Brexit related in terms of exchange rate depreciation, but also related to the issue that I raised at the beginning about the long period of austerity. One of the reasons why the public sector pay cap may be coming to an end is that, apart from the political difficulties that the Government experienced at the most recent election, recruitment difficulties are beginning to appear that might be accentuated by Brexit through losing access to the European Union workforce, as working in Britain will become less attractive to European Union workers.

One has to think through those issues. If there was a sudden release of the public sector pay cap, because the Scottish public sector employees are a higher proportion of the total workforce than the UK average, Barnett is not necessarily going to pay for that. A 3 per cent increase across the board on a UK national agreement will cost Scotland more.

There will definitely be budget pressures on public spending in the UK, but they will also affect Scotland, Wales and Northern Ireland to the extent that they have larger public sector workforces. The context of public sector pay will be a very significant issue.

12:00  

I would like to think that I am driven by the evidence. I do not claim to be a trade economist, but all the examinations of patterns of trade show that geography matters—being close to something matters in terms of who you trade with and if you cut yourself off that will be an issue.

On migration, it is important to realise that, for the foreseeable future, the Migration Advisory Committee will play a key role in determining whether we get more anaesthetists, for example, from outside the UK in the future. If Scotland has differentiated needs in respect of particular occupations, it is incumbent on the Scottish Government to make the case to the Migration Advisory Committee that those occupations be placed on its list so that it is easier to get people from outside the UK to fill vacancies. The Migration Advisory Committee currently deals with work for non-EU migrants, but there is a big debate to be had about the change in its role to cover EU migrants after Brexit.

We have had a significant session with our two professors this morning. Thank you for helping us to delve deeper into the details of the issues that we will face. That was extremely useful.

12:02 Meeting continued in private until 12:16.