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Twenty years on from devolution, the UK’s fiscal and economic model is still broken

The ‘deficit’ is unevenly distributed, with investment in R&D, transport and the arts still heavily skewed to the South East. Post-Brexit, is it time for a change?

Image: The Norman Foster-designed Crossrail garden, Canary Wharf, 2016. Credit: Jayflux/Wikimedia, CC 2.0

Anniversaries and major events often give us pause for thought: a time to reflect on the past and to look forward to the future. Next year sees the twentieth anniversary of the people of Scotland and Wales voting in favour of devolution. At the same time the UK is expected to leave the European Union. So, how have Scotland and Wales fared economically over the last twenty years? Have the fiscal arrangements worked? And could the repercussions of Brexit be a catalyst to deliver better economic and fiscal outcomes in the future, not only for the two devolved nations but also to many regions of England?

Brexit is expected to have a major impact on the UK economy with the effect being markedly different in various parts of the UK (1). While there is much debate and disagreement regarding the medium to long term economic impact of Brexit a useful exercise is to look at the current state of the UK economy and how the picture differs across the nations and regions. Such an analysis offers a good starting point for consideration of the fiscal strategy that should be pursued by the UK Government post Brexit.

The UK’s fiscal deficit is unevenly distributed

The Office for National Statistics (ONS) recently published estimates of the fiscal balances for the nations and regions of the UK (2). Within the past few years at the UK level the deficit, the difference between public expenditure and revenue, declined from just over £90bn in 2014-15 to £46bn in 2016-17. The outlook for the current year (2018-19) is a deficit of roughly £30bn or under 2 per cent of GDP. Thus, after years of austerity progress continues to be made, albeit slowly, to achieving a ‘balanced budget’ where public expenditure and revenue are in balance. If it were not for the uncertainties associated with Brexit a balanced budget could well be achieved within the next few years - some twelve years or so after the onset of the financial crisis in 2007-08. These figures are for the UK as a whole and are the ones most often quoted in the media. What is the picture at a more localised level?

The ONS analyses public expenditure by geography with the majority (~85 per cent of total expenditure) being identifiable (defined as expenditure that can be recognised as having been incurred for the benefit of individuals, enterprises or communities within a particular country or region) and the balance being central government expenditure which, being deemed as on behalf of and for the benefit of the UK as a whole (e.g. defence, international aid, debt interest), is allocated geographically on either a population or GDP basis. The ONS report also covers the income side of the public accounts and draws on detailed geographical analysis of tax and other revenues undertaken by HMRC (3).

One of the most striking but not surprising elements of the ONS report is that of the twelve nations and regions of the UK only three are in budget surplus. These are London, South East England and East of England or, in other words, London and its hinterland, often tellingly referred to as the ‘Home Counties’. In 2016-17 these three regions had a surplus of £52bn while the remainder of the UK had a deficit of £98bn. England as a whole had a deficit of £8.5bn compared with deficits of almost £15bn for Scotland and just over £13bn for Wales.

In Wales the key factor driving the deficit is not higher public expenditure but lower revenues. Total public expenditure per capita in Wales is almost 8 per cent higher than the UK average - but revenue per head is 25 per cent lower. Compared to the UK average, Wales is spending and extra £881 per head but taking £2,675 less in tax. Scotland, by comparison, is in the enviable position of having both higher tax revenue than Wales (only £508 less per head than the UK average) and higher public spending (spending £1,495 per person more).

What are the reasons for revenue in Wales being so low? There is a close correlation between tax generated per head and GVA per head. So why is GVA so low? About 70 per cent of it comes from wages. Higher Welsh unemployment rates (4.3 per cent for Wales and 4.0 per cent for the UK) is a minor factor. Lower average earnings are more significant (median weekly earnings in 2016 of £498 in Wales versus £539 for the UK). But the main cause is the distribution of wage levels, particularly the low number of higher earners. According to estimates by the Wales Governance Centre the mean taxpayer income in Wales in 2014-15 (excluding dividends and interest) was £24,900 compared with £29,900 for the rest of the UK.

Wales with 4.7 per cent of the UK’s population has only 1.4 per cent of additional-rate taxpayers. The sensitivity of income tax yield to income distribution has increased markedly since the policy, introduced in 2010, of raising much more quickly than inflation the threshold at which income tax becomes payable. Low incomes are, in turn, a reflection of low productivity. Productivity per hour in Wales is some 80 per cent of the UK average (4).

The three principal sources of tax revenue are: income tax; national insurance contributions (NIC); and Value Added Tax (VAT). The weak performance of Wales in generating tax revenues is summarised in Table 1. 

Table 1: Principal sources of tax revenue 2016-17 (5). Source: HMRC. October 2017.

 

Population share

Total Tax

Income tax.

 NICs

 VAT

Wales

 4.7%

 3.4%

 2.9%

 3 .5%

 4.1%

Scotland

 8.2%

 7.6%

 7.3%

 8.3%

 8.3%

England

 84.3%

 87.0%

 88.3%

 86.2%

 84.9%

N. Ireland.

 2.8%

 2.0%

 1.6%

 2.1%

 2.7%

The centralised big country model

The geographic pattern of surpluses and deficits has persisted for decades and unless the UK economic model is radically changed there is no reason to believe that it will not continue. This pattern is, in large part, the result of economic policies pursued by successive UK governments over many years. To illustrate this point, consider the following: given that the fiscal strategy of the UK Government is to balance the budget and what will happen if and when the UK as a whole achieves fiscal balance? If the past is any guide to the future, then public spending will then be allowed to grow broadly in line with GDP (over the longer-term expenditure in the UK has been within a percentage point or two of 34 per cent of GDP) and total taxes may be cut a little although individual taxes may be changed more substantially. The Chancellor of the day will be guided by UK aggregate figures with little attention being paid to the regions and nations of the UK beyond London and the ‘Home Counties’ which currently account for 46 per cent of total public sector revenues in the UK and as noted are the source of large budget surpluses. The fact that the wider UK will continue to be in deficit and the recipient of fiscal transfers from the centre will be regarded as a ‘price worth paying’ to support the current economic model. Implicit in such a model is an acceptance that the level of economic wellbeing in most of the nations and regions of the UK will continue substantially to lag London and South East England and be below their potential. As has been noted elsewhere: “the centralised big country model which concentrates too much economic activity in London and the South East region is holding Scotland and the other regions and nations of the UK below their potential.” (5).

It is a tribute to the power and persistence of the current economic model that the majority of people in the UK view such a geographical pattern of surpluses and deficits as the norm although there are the first signs of stirring of discontent beyond Wales and Scotland in parts of the north of England. Perhaps there is a dawning realisation that unlike the laws of physics economic outcomes are principally determined by human behaviour and policies formulated by governments. Modern, advanced economies such as Germany, the Netherlands and the USA have a much more geographically even spread of economic prosperity.

In a modern economy factors which loomed large in earlier times such as quality of agricultural land and proximity to raw materials are of little importance and what counts are: levels of education; skills; R&D led innovation; availability of capital for investment; modern infrastructure; together with legally-respected property rights.

It is no coincidence that in many of the areas which involve public investment UK government policy has disproportionately favoured London and the Home Counties. Consider three areas of public spending: research and development; investment in transport; and the arts.

London gets 10 times more R&D funding than Wales

As the world moves increasingly towards being a knowledge driven economy, expenditure on research and development is important both as a source of new ideas and inventions that can be commercialised to form the basis of the next generation of business and also as a means of equipping people with the requisite skills for the new economy. There are a number of sources for spending on R&D: business; higher education; government and research councils; and private non-profit. Business is by far the biggest source of R&D expenditure and this tends to be concentrated in certain sectors (defence and pharmaceuticals) and geographically. Of the £6.5bn spent on R&D by the higher education sector 59 per cent, or £274 per person was spent in London and the Home Counties. This compares with £83 per person in the rest of England, £86 in Wales and £196 in Scotland. The differences are even more marked in the case of R&D spending by the UK Government and the research councils: of the £2.2bn spent in 2016: £54 per person was spent in London and the Home Counties; £5 per person in Wales and £30 per person in Scotland.

Recent analysis by Guto Ifan of the Wales Governance Centre at Cardiff University (6) has shown how London has been the recipient of a disproportionate share of public investment in transport over decades. Cumulative spend per person in real terms since 1999-00 has been £7,500 in London compared with £4,100 in Scotland, a mere £3,000 in Wales and £3,700 across the UK as a whole. This distorted pattern of public expenditure in favour of London has persisted for many decades. Examples of the much higher spending in London over the past fifty years include: the Victoria and Jubilee underground lines; the M25 orbital motorway; HS1 which is soon to be followed by HS2 (a report by KPMG (7) shows that London will benefit far more than Birmingham and points north on the proposed HS2 route); the Docklands Light Railway; and Crossrail 1 which is due to open in 2019 and is expected to be followed by Crossrail 2.  

London gets 5 times more arts spending (per head) than Yorkshire

A common response to cold, financial analysis is to claim that other factors such as ‘quality of life’ are important and this is undoubtedly true. Indeed, it is increasingly recognised that a vibrant cultural life can be a powerful factor in attracting and retaining well educated and skilled people who are increasingly needed in the knowledge-based economy. However, despite the fact that private sponsorship of the arts is overwhelmingly concentrated in London here again public spending is heavily weighted in favour of London as well. Arts Council England spent £24 per person in London compared with £5 in Yorkshire and £6 in the North East of England in 2012-13 (8). The comparable figure in Wales is £9 per person.

The way the Treasury allocates funding is part of the problem

To a large extent the spending patterns across the countries of the UK are locked into the way the Treasury allocates funding. In the case of Scotland and Wales changes to approximately half of total public expenditure are linked arithmetically to changes to public expenditure in England (the Barnett formula). Little or no attempt is therefore made to respond to changing needs or to the need to ‘pump prime’ the economies of those countries by additional investment aimed at stimulating faster economic growth which in the longer term would not only result in healthier economies but would also reduce the need for fiscal transfers from the centre. Similar considerations apply to most of the regions of England where funding is distributed by Whitehall using a range of formulae.

Table 2 sets out relative GVA per head and relative identifiable expenditure per head for some of the regions of England and the countries of the UK.  

Table 2: Relative GVA per head and relative public spending 2016-17. Source: Public Expenditure Statistical Analyses 2018. HM Treasury. July 2018.

 

Relative GVA

per head

 Relative Identifiable

 Expenditure per head 

UK

 100%

 100%

England

 103%

 97%

 North East

 73%

 106%

 North West

 88%

 103%

 Yorkshire & Humber

 79%

 96%

 East Midlands

 80%

 90%

 West Midlands

 83%

 97%

 South West

 88%

 93%

 London

 176%

 111%

 South East

 109%

 89%

 East of England

 91%

 89%

Wales

 73%

 110%

Scotland

 94%

 116%

Northern Ireland

 76%

 121%

Clearly, there is little relationship between public spending levels and GVA per capita. London stands out like a sore thumb with much higher GVA per head allied to high public spending. The East Midlands and South West of England are at the other end of the spectrum with low GVA and low public spending. When reviewing how public funding is allocated attention is usually paid to relative need (see for example the reports of the Holtham Commission (10)) but little attention has been paid to the need for supplementary investment funding in order to raise the economic performance of poorer countries and regions of the UK over the medium to long term.

It is noteworthy that in those regions where public expenditure per head is relatively high the most common reason is higher spending on ‘Social Protection’ which principally comprises spending on old age pensions and sickness and disability payments. In the case of Wales, of the £917 per person of above UK average public expenditure in 2016-17, £650 went on social protection. Welcome as such payments are they contribute little to preparing the next generation for a more prosperous future within their own nations or regions.

What can Welsh and other national governments do?

The principal economic levers that affect Wales are, to the extent that any level of government controls them, in the hands of the UK Government. Such levers include: target inflation rates (set by the UK Government and implemented by the Bank of England); the structure and levels of taxation; and public expenditure including capital investment. However, this is not to absolve the Welsh Government from its responsibilities in areas such as: education including university funding; skills development; public procurement; facilitating the provision of funding for Welsh business; and supplementing capital investment in infrastructure by means of fund raising in the capital markets although such spending is severely constrained by the UK Government.

Another role for the Welsh Government is working in close collaboration with the Wales Office to ensure that Wales receives a proportionate share of spending in those areas not devolved to Wales but allocated to the countries and regions of the UK by the central UK Government. As has been shown the evidence suggests that both the Welsh Government and the Wales Office are falling short in this vital task.  

Post Brexit: threats and opportunities

The lack of ‘pump priming’ funds may well become even more pronounced after Brexit given that in recent decades regional policy and funding has largely been ignored by the UK Government and left to the European Union. In theory repatriation to the UK of regional policy and funds (~£370 million a year in the case of Wales) could enable the UK Government to step into the breach. The repercussions of Brexit could be used as catalyst for change. If those favouring Brexit really believe that the UK will be better off as a free standing, united state free from the shackles of the European Union then the challenge to them is to demonstrate this by formulating and implementing an economic strategy that ensures much greater economic equity across the nations and regions of the UK. However, many of us fear that the repercussions of Brexit are likely to push regional policy even further down the list of priorities of the post-Brexit UK Government no matter which political party is in office.

Without a fundamental change in the UK political and economic models we can expect little improvement in the relative performance of national and regional economies outside London and its immediate hinterland. While Brexiteers may proclaim their aim of stopping the UK becoming a ‘vassal state’ of the EU are they content for much of the UK, including Scotland and Wales, to remain in such a position within the UK?

About the author

Eurfyl ap Gwilym is economic adviser to Plaid Cymru, a member of the Silk Commission and a former Deputy Chairman of the Principality Building Society.

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