This is the first part of an FT series asking whether the UK is heading for break-up. Follow UK politics & policy with myFT to be alerted when new parts are published.
An independent Scotland would inherit a large hole in its public finances because lower than expected tax revenues, Brexit and the coronavirus crisis have increased the country’s budget deficit, according to a Financial Times analysis.
A significant deterioration in Scotland’s fiscal position since the country’s independence referendum in 2014 suggests it will face a persistent deficit of almost 10 per cent of gross domestic product — well ahead of international norms — if the country is to leave the UK by the middle of this decade.
Based on the pro-independence Scottish National party’s previous assumptions, this would mean Scotland needed to raise taxes or cut public spending annually by the equivalent of £1,765 per person in the period after exiting the UK so as to narrow the deficit to sustainable levels.
This in turn highlights how Scotland’s transition to a stable, advanced economy would be more difficult compared with when the 2014 referendum was held.
Nicola Sturgeon, Scotland’s first minister and SNP leader, is aiming to secure an outright majority in the Scottish parliament election on May 6, and then demand that UK prime minister Boris Johnson authorises another independence vote. Scots rejected independence by 55 per cent to 45 per cent in 2014, but opinion polls suggest the public is now evenly divided.
The FT’s estimate that Scotland’s deficit would be almost 10 per cent of GDP means that the size of the tax increases or spending cuts needed to bring public borrowing down to manageable levels has doubled compared with the tight expenditure limits proposed by an SNP economic commission in 2018. At the time of the 2014 plebiscite, the SNP said there was no need for any deficit reduction because the country could rely on North Sea oil revenues.
Scotland’s now much weaker fiscal position would present a newly independent nation with a difficult set of choices. It could impose many years of spending restraint or higher taxes — or bet that financial markets would be willing to lend at very low interest rates to a new sovereign borrower with a large and persistent deficit.
Neil Shearing, economist at Capital Economics, a consultancy, said an independent Scotland would need “a large fiscal adjustment and its government would have to communicate its intentions in a clear and credible way to markets”.
Few economists thought an advanced economy of Scotland’s size would be unviable on a standalone basis, but they cautioned there would be a difficult transition to stable public finances, as well as major challenges around currency and trading arrangements.
Thomas Sampson, associate professor at the London School of Economics, said Ireland showed that prosperity and independence from the UK was possible in the long term for Scotland, “but in the short to medium term, there would be a whole host of problems”.
The public finances stand out as a much greater challenge for Scotland now than in 2014 mainly because of the fall in the oil price.
Scotland received £1,633 per person more in public spending than the UK average in 2019-20, according to the latest Scottish government figures. The country also generated £308 less in tax revenue per person than the UK average if a geographic share of North Sea oil revenues is included.
This leaves a large funding shortfall for an independent Scotland that was not there in 2014. Then, the SNP said that with North Sea oil revenues split geographically the data showed a deficit that was set to fall to 1.6 per cent of GDP by 2016-17.
But shortly after the 2014 referendum, the oil price plummeted and tax revenues have never recovered. The Scottish government subsequently estimated Scotland’s deficit to be 8.3 per cent of GDP in 2016-17, at the same time as UK borrowing fell.
The end of the possibility that oil would finance an independent Scotland’s ambitions led to the SNP setting up a commission in 2018 to devise a new economic strategy.
Led by Andrew Wilson, an economist and former SNP member of the Scottish parliament, the sustainable growth commission said there needed to be a plan to cut the country’s deficit to 3 per cent of GDP for it to be manageable.
This is equivalent to what the UK government thinks is consistent with stable debt levels as a share of the economy in the medium term, and would meet most international norms for a manageable deficit.
The Wilson commission proposed savings from lower defence and other shared UK-wide expenditures, a “solidarity payment” to cover Scotland’s share of UK debt, and said there was an expectation of further improvement in the UK public finances from 2016-17 onwards. This meant the Scottish deficit would fall to 5.9 per cent of GDP.
But with Wilson seeking to reduce the deficit to 3 per cent of GDP, it meant closing a fiscal gap of 2.9 per cent, so he advocated a five to six-year plan of spending control to hit the target.
Although there were many assumptions made by Wilson that would likely be questioned by the UK government, his report was described as “not implausible” by the Institute for Fiscal Studies, an influential think-tank.
Since the Wilson commission, however, Scotland’s revenues from income tax, national insurance and value added tax have been lower than expected, according to the Scottish government.
And amid Brexit and the Covid-19 pandemic, the UK government has abandoned plans to balance the books, so an independent Scotland could no longer assume it would inherit an improved fiscal position.
Using the same assumptions as the Wilson commission, and once the UK economy has fully recovered from the pandemic, the FT estimates an independent Scotland will have a deficit of 9.9 per cent of GDP in the middle of this decade. It would reduce to 8.7 per cent of GDP with lower defence and other shared UK-wide expenditures.
But to reduce the deficit to 3 per cent of GDP necessitates closing a fiscal gap of 5.7 per cent: this would involve annual tax rises or spending cuts equivalent to £1,765 per person.
Wilson said the fiscal and economic starting point for an independent Scotland had become more challenging since his commission reported, but that like other small advanced economies, it would be able to achieve sustainable public finances.
“The starting point will reflect the way the UK is and has been run, its economy and its very substantial regional inequalities — it’s a reason to change, not stay the same,” added Wilson. “There’s no doubt that Brexit has made the starting point more difficult. Again that’s a reason to change, not stay the same.”
The SNP, which currently lacks a detailed economic prospectus for an independent Scotland, did not respond in detail to the FT’s estimates and reiterated calculations from the Wilson commission.
“Pre-Covid, Scotland’s tax revenues were estimated to cover all devolved spending on day-to-day public services — such as the NHS and schools — as well as all spending on pensions and all social security.
“The whole point of independence is to give the Scottish parliament all the economic levers it needs to grow our economy and to make the public spending choices best suited to Scotland’s interests.”
With interest rates globally at historic lows, an alternative to spending cuts or higher taxes could be to seek external finance to maintain borrowing at close to 10 per cent of GDP.
But sovereign bond investors have warned against relying too much on access to cheap credit.
David Riley, chief investment strategist at BlueBay Asset Management, a bond investor, said that “an independent Scotland would be given the benefit of doubt by investors looking for diversification and yield . . . but investors would want assurances that the government has a credible macroeconomic policy framework, including critically a plan to reduce its budget deficit”.
A further complication around borrowing relates to Scotland’s future currency arrangements.
The Wilson commission recommended an independent Scotland keep using sterling until it was ready to adopt its own currency. But reliance on sterling would heighten the need for trusted fiscal policies because bond investors would want to be sure they would be repaid.
Shearing at Capital Economics said he did not think Scotland’s fiscal position was “necessarily a disaster” but it would need to be managed carefully within a credible economic strategy.
“The nightmare scenario is a fiscal plan that lacks credibility, issued in a currency that lacks credibility, on top of a relatively large stock of existing debt and coming at a time in the future when global yields are much higher,” he added.
With persistently high borrowing unlikely to succeed, an independent Scotland would need greatly improved economic performance to avoid tight spending control or higher taxes.
But Brexit raises questions about the border with England that could pose a new threat to Scotland’s prospects for higher GDP.
The SNP wants an independent Scotland to join the EU, and membership of the bloc’s customs union and single market would raise the possibility of a hard border with England, its largest market.
A research paper by the LSE published in February said border problems stemming from Scotland leaving the UK would compound losses from Brexit, and estimated these were likely to result in Scottish incomes being between 6.3 per cent and 8.7 per cent lower in the long term compared with neither event happening.
Lower oil prices, weaker Scottish tax revenues, Brexit and coronavirus have all increased the costs of independence for Scotland. David Phillips, IFS associate director, noting the hard choices to deal with the deficit, said: “Of course Scotland is a wealthy country, it can afford to be independent. It’s just a question of cutting the cloth to match the size of its purse.”