By Anton Muscatelli

There has been considerable focus on the Scotland Bill, which will transfer substantial new powers to Scotland, including over social security and taxation. Policy makers in Edinburgh will soon be responsible for a far larger share of their budget with revenues directly linked to Scottish policy choices and economic performance.

There has been less focus on the financial arrangements that underpin the Bill: the so-called fiscal framework. While the Smith Commission set out general principles for the design of the framework, there was little detail on how it would operate. But the framework is arguably even more important than the Bill as it will determine future budgets for public services and the degree to which Scottish administrations can manage economic and financial risks.

The commission set out three key principles for a successful framework. First, the block grant to Holyrood should continue to be determined by the Barnett Formula. Secondly, the Scottish budget should be no larger or smaller simply as a result of new powers being devolved: the "no detriment" principle. Thirdly, Holyrood should be granted greater economic responsibility with the Scottish budget benefitting from measures that raised revenues and incurring the cost of those that reduced revenues.

Of critical importance is how the Barnett block grant is adjusted each year to reflect the new tax powers. The method used will have huge implications for future Scottish budgets. The most sensible option is to relate the block grant adjustment to changes in the corresponding tax receipts being devolved (for example income tax) in the rest of the UK. If Scotland performs better than the UK it would benefit; if it grew more slowly it would lose out. That’s the nature of economic responsibility.

In the first year the new tax powers are transferred, it is easy to simply deduct from the block grant the amount of revenues raised from Scotland’s new taxes. This would ensure that, at the point of transfer, Scotland’s budget was no larger or smaller.

In future years, calculating the amount to be deducted becomes more complicated. This initial deduction will have to be indexed (that is, increased) to ensure its value is not eroded by inflation.

There are two main ways an indexation mechanism could work. One option is to increase the block grant adjustment each year by a population share of the change in income tax receipts in the rest of the UK. Whilst straightforward, this would impose a significant cost on Scotland. Like most other parts of the UK, Scotland’s share of UK-wide income tax receipts (7.3 per cent) is smaller than a UK population share (8.3 per cent). This reflects in-built structural imbalances within the UK economy, in particular, London’s dominance as a hub of corporate activity.

This means that, even if Scotland matched UK economic performance and grew its tax revenues by the same rate as the rest of the UK, the amount deducted from the block grant would always be larger than revenues collected from tax.

Even within three or four years, the Scottish Budget could be hundreds of millions of pounds lower as a result, and this loss would grow over time. The funding available for public services would be reduced, not as a result of changes in economic performance or policy but simply as a result of the new funding formula, which no-one in the Smith process intended. Scotland would be penalised even though it grew its economy in line with the rest of the UK.

A much better alternative would be to index the block grant adjustment to the growth in income tax receipts per person in the rest of the UK. This would mean that, if the amount of tax paid by people in Scotland grew at the same rate as in the rest of the UK, the adjustment to the block grant would almost exactly match the growth in tax receipts. The Scottish budget would be no better or worse off. It would also ensure that future Scottish administrations retained the benefits and incurred the costs of policy decisions. The Smith principles of no detriment and economic responsibility would be satisfied.

It is crucial that policymakers recognise these basic principles enshrined in the Smith Commission report. Discussions around the fiscal framework are necessarily complex. However, it is important that the correct decisions are taken as the risks to Scotland’s budget are potentially significant. The demand for more powers cannot come at any price.

Professor Muscatelli is Principal of the University of Glasgow.