Despite economic positivity inflation remains too high

Article by our Chair Professor Graeme Roy, first published in The Herald on 12 June 2023

Last month, at the Scottish Fiscal Commission, we published our latest forecasts covering the Scottish economy, devolved tax revenues and social security spending.

While the outlook is largely unchanged since our last forecasts in December, we now have some interesting data points that give new insights into the relative health of the Scottish economy as we navigate through this “cost of living” crisis.

On a positive note, new data means that we now forecast that the Scottish economy will avoid a “technical” recession this year. Unemployment continues to remain low, and earnings have picked up. The overall environment, however, remains one of relatively slow and fragile growth. As expected, inflation has started to fall from its peak of around 11%. The good news is that it should fall sharply this summer.

The bad news is that within certain key items, most notably food, inflation remains very high, at almost 20%. As a result, living standards are on track to fall once again this year. The average Scottish household is projected to be over 4% worse off by the end of 2023/24, compared with 2021/22.

High inflation does, of course, have implications for the public finances too.

Higher wage growth, as employers are pushed to compensate employees for the rising cost of living, feeds through to growth in tax revenues. With the government choosing, once again, to freeze the thresholds at which taxpayers move into higher rate tax brackets, this “fiscal drag” will boost revenues.

This effect is more pronounced in Scotland. In recent years, the Scottish Government has largely kept the higher rate threshold frozen at just over £43,500. In contrast, in the rest of the UK, the higher rate threshold now stands at over £50,000. Taxpayers in Scotland start paying the more expensive higher rate of tax much earlier than elsewhere in the UK. Since 2016/17, we estimate that the number of Scottish higher rate taxpayers has grown by over 70%, compared to growth of just over 25% in the UK as a whole.

This, of course, raises additional funds for the Scottish Government relative to setting the same policy as elsewhere in the UK. Unfortunately, not all of the benefit from this increase in taxes on higher earners is flowing through to a net uplift in the Scottish Budget. This is because increasing tax revenue is not just a question of setting rates and bands, it also depends on the performance of the tax base. In recent years, Scotland’s tax base has grown more slowly than in the rest of the UK and has worked to offset in part the government’s tax-raising measures.

Inflation also erodes the effectiveness of the government’s borrowing powers. The Scottish Government’s borrowing limits are fixed in cash terms and have not changed since 2016. We estimate that the financial power of borrowinghas been eroded by almost 20% from the effects of inflation.

Most significantly, higher inflation also erodes the day-to-day spending power of government. More of its own money is having to go on rising energy costs for public buildings, schools and hospitals. It too faces a higher wage bill as it responds to pressures to increase pay. And social security payments tied to inflation go up more quickly than otherwise would have been the case.

The Scottish Government estimates that, without a change in funding, it will face a shortfall in its spending commitments of £1 billion in 2024/25 rising to £1.9 billion in 2027/28.

Debate has once again started on options for tax reform.

However, as we pointed out in our long-term fiscal sustainability report in March, pressures on public spending will only grow in the years to come, as our population ages and as the costs of delivering key public services continue to rise. As other countries are finding out, year-on-year increases in tax cannot be the only option in the face of such profound shifts in our public finances.

Sooner or later (preferably sooner), we are going to have to build a more sustainable fiscal model that guarantees the future of the vital public services that we depend upon. Tax is, of course, crucial, but so is economic growth, demographics, migration and ultimately difficult choices over what elements of spending to prioritise over others.