GERS and Tax Volatility

The latest Government Expenditure and Revenues Scotland (GERS) report shows that the fiscal deficit relative to output increased to 8.3% from 5.8% in 2012-13. This includes the favourable geographic share of tax revenues from North Sea oil and gas. The onshore deficit fell slightly but remains a staggering 14% of GDP. There is no denying that these are very large deficits. While most of the commentary has been comparing the data to the whole of the UK, the real news in these figures is the volatility of tax revenues. Using the currency of another country combined with volatile tax revenues, a large fiscal deficit and high debt burden carries significant financial risks.

The first point to make about the GERS data is that they, of course, do not equate to an independent Scotland.  The best that can be said is that they measure differences in the fiscal position of a hypothetical ‘separate’ Scotland on the basis of the taxation and spending policies within the existing fiscal union with the UK. The revenues and spending figures are identified items in Scotland or apportionments, but they occur within a fiscal union. For example, job seekers allowance happens through a single welfare state, some revenue is shared by formula across regions and there is a single cost of borrowing. That is, the fiscal union with the United Kingdom implies some amount of smoothing in the public finances that would disappear if Scotland became an independent country.

The volatility of tax revenues is important for the optimal choice of currency, especially at high levels of government debt.  The data from GERS showed the tax revenues from North Sea oil and gas fell by almost 3 percentage points of GDP.[1] This is the second time this has occurred in five years. These are huge swings. If an independent Scotland were hit by the same nearly 3 percentage points of GDP drop in tax revenues from North Sea oil, and Scotland were using Sterling, then the response would have to be purely fiscal. That is, to plug the nearly 3 percentage points of GDP hole in its finances, an independent Scotland would either have to impose austerity policies (reduce spending and/or increase taxes) or it would have to increase borrowing.

The message we highlight in our research is that the optimal choice of currency for an independent Scotland must take into account the amount of debt it would inherit. We know from recent experience in Europe that there are tipping-points for countries in currency unions where investors doubt that countries with too much debt can make the sacrifices necessary for eventual repayment. Governments may find that they suddenly cannot borrow at reasonable interest rates and capital markets effectively become closed. For a given level of debt and deficit, the greater the volatility of tax revenues the more likely that this tipping-point will be crossed. Put another way, countries with volatile tax revenues generally require lower debt levels and better fiscal balances to prosper in a currency union. Any assessment of Scotland’s currency options which does not consider its likely debt burden is incomplete.

So how does the hypothetical ‘separate’ Scotland compare in terms of tax volatility and debt?[2] In Table 1 above we compare the tax revenue volatility and debt burdens of countries in our Euro zone dataset with the Scottish Government experimental data between 2000and 2012.[3] We assume an independent Scotland would inherit a share of existing UK public debt equal to 80% of GDP, as explained in Armstrong & Ebell (2014). We then divide the countries into four groups based on high and low debt burdens on the basis of the Maastricht Treaty debt ratio of 60%, and by high and low volatility. On volatility alone, ‘separate’ Scotland is about middle of the pack. Based on our cut-offs, Slovenia is the only country with both low tax volatility and a low debt burden. A second group of countries have high debt burdens but low tax volatility, including Belgium, France, the Netherlands, Germany and Austria. A third group of countries such as Estonia, Latvia, Lithuania, Luxembourg and Slovakia all have tax revenues that are at least as volatile as Scotland, but they also have much smaller debt burdens. The final group of countries are those which, like Scotland, combine relatively volatile tax revenues with high debt-to-GDP ratios. These are mainly the countries which have struggled in the Eurozone: Greece, Ireland, Italy, Portugal, Spain and Cyprus.

In the table we have simply presented the data. It is very difficult to know the relative importance of tax volatility and debt burdens. They almost certainly interact together and a country’s credit risk is likely to be a non-linear and increasing function of both volatility and debt levels. In other words, the consequences of say a ten percentage point increase in the debt burden at high debt and high volatility levels is likely to be far greater than at low debt and low volatility levels.

All of which brings us back to the first point. The volatility of tax revenues in the GERS data are for a hypothetical ‘separate’ Scotland within the existing UK which includes risk sharing within its fiscal union. We cannot know in advance with any precision what the volatility of tax revenues would be in an independent Scotland. But independence would mean ending or at least reducing the fiscal union, which would limit the scope for risk sharing. This is likely to make the economy and tax revenues more rather than less volatile. The GERS data give a further illustration of why an independent Scotland with the sort of debt burden presented in Armstrong & Ebell (2014) would be vulnerable in a currency union.