Forecasts for Scottish income tax, block grant adjustments and reconciliations

Since April 2017, the Scottish Government has received full non-savings non-dividends (NSND) income tax liabilities from Scottish resident taxpayers. To reflect these Scottish income tax (SIT) revenues, a deduction is made to the block grant funding that the Scottish Government receives from the UK Government. This deduction is called the block grant adjustment (BGA), which is based on the income tax revenue in England and Northern Ireland (ENI).¹

The gap between Scottish income tax revenues and the amount deducted from the block grant through the BGA is called the income tax net position. The net position summarises the net effect on funding for the Scottish Budget of income tax devolution.

Ahead of each financial year, the Scottish Government must set its budget based on the money it expects to receive from income tax and the expected size of the BGA. The gap between these two forecasts is known as the budget-setting net position. When outturn data becomes available, the difference between the budget-setting forecast and outturn net positions is settled through a process called a reconciliation where the Scottish Government receives or pays back this difference.

The Scottish Government can borrow money to offset the impact of negative reconciliations, but the 2027-28 limit is currently forecast to be capped at £670 million. If the reconciliation exceeds the Scottish Government’s borrowing limit then it reduces the Scottish Government’s funding in that year.

Reconciliations are the result of the differences between forecasts and outturn data, known as the forecast difference.² The income tax forecasts used for the Scottish Government’s budget are based on the Scottish Fiscal Commission’s (SFC) forecast for Scottish income tax and the Office for Budget Responsibility’s (OBR) forecast for ENI NSND income tax which forms the basis of the BGA.³ Therefore, the size of the reconciliation depends on the relative differences between forecast and outturn of the OBR's ENI income tax forecast, which is used to calculate the BGA, and of the SFC's Scottish income tax forecast.

When SIT outturn exceeds the SFC forecast made at the time the Scottish Budget was set, the Scottish Budget receives more SIT funding than was originally forecast. This contributes positively to the subsequent reconciliation. There is the opposite effect for the BGA, if BGA outturn is higher than forecast then this leads to a reduction in funding to the Scottish Budget and contributes to a negative reconciliation.

The overall size and direction of the final reconciliation depends on the interaction of these two effects. SIT and BGA differences in opposite directions will offset each other, while differences in the same direction will add together to create a larger reconciliation.

Reconciliations therefore depend on how correlated SIT and ENI income tax forecasting differences are. This depends in part on the degree of correlation between Scottish and ENI income tax revenues. To date, NSND income tax outturn data suggests a high degree of correlation of Scottish and ENI revenue growth.⁴ That is, when revenues in ENI grow strongly, revenues in Scotland tend to do so as well, and vice versa.

A high degree of correlation in revenue growth suggests that if the Scottish and ENI forecasts are similar this would tend to reduce reconciliations. However, Scottish and ENI revenues are not perfectly correlated, and so including some Scottish and ENI specific factors in the respective forecasts should also help reduce reconciliations.

In practice, this is how SFC and OBR forecasts operate. The OBR primarily focuses on forecasting the whole of the UK in our economy forecasts, and this will be the primary driver of income tax revenue growth in ENI. The SFC makes an assessment of Scottish tax revenues, which is informed by forecasts of economic conditions in Scotland and the UK. For the UK outlook, the SFC tends to draw upon OBR assumptions on economic factors such as productivity growth and inflation. For its Scottish forecasts, the SFC then look at Scottish specific factors in areas such as nominal earnings and employment. This should mean a high degree of correlation in our forecasts, but also allows for some regional variation.

Chart 1 shows that over recent years the differences between our forecasts and outturn have generally been correlated. In five of the last six years, our forecast differences have offset each other to reduce the size of the reconciliation. From 2021-22 to 2023-24 both the SFC and OBR significantly under-forecast SIT and ENI income tax revenues as nominal earnings were higher than anticipated due to the inflation shock caused by the Russian invasion of Ukraine and recovery from the pandemic. This meant that the positive SIT difference and the negative BGA difference largely offset.⁵ As Scotland and ENI are generally subject to the same shocks, this pattern of offsetting differences has been common over the last few years, with SIT and BGA forecast differences since 2019-20 having a correlation of -0.86.⁶

However, there is always a risk that the two forecast differences reinforce each other to form a larger reconciliation. This risk has crystallised for the 2024-25 reconciliation. The deduction to the Scottish Government’s funding from the BGA is £512 million larger than was projected, based on outturn for ENI compared to the OBR’s November 2023 forecast. Revenues from SIT are £209 million lower than was forecast at the SFC’s December 2023 forecast. Although these differences are relatively small, they compound to form a projected reconciliation of -£720 million which exceeds the Scottish Government’s borrowing limit.

Differences between forecast and outturn are inevitable in any forecast. The data we have to date show that the degree of correlation in SFC and OBR forecast differences has generally helped to limit the size of reconciliations. However, given the volatility and uncertainty in income tax revenue growth in Scotland and ENI, some reconciliations will always occur, and occasionally they will be large. This is an inevitable outcome of the fiscal framework.

Previous analysis by the SFC estimated that, if there is an 80 per cent correlation between SFC and OBR forecasts, there is a 24 per cent probability that a negative reconciliation would exceed £600 million. Higher correlations, as we have seen in outturn, will lower the expected size of reconciliations. However, the likelihood that the reconciliation exceeds this is not insignificant, so the negative reconciliation of £720 million should not be unexpected. The Scottish Government must continue to expect and have a plan to manage large reconciliations, both positive and negative.

In addition, the likelihood of reconciliations exceeding the borrowing limit is likely to grow over the coming years. This is because the borrowing limit is uprated by inflation, whereas the forecast differences and therefore the reconciliations are likely to grow with the size of income tax. Income tax is likely to grow faster than inflation due to average earnings growing faster than inflation and policies, such as threshold freezes, which have increased the size of income tax in both Scotland and ENI.

The OBR and SFC will continue to work closely together over the coming forecasts to understand the differences between our forecasts and the impact on the Scottish Government’s budget. We comment on our projections for the net tax position in the OBR’s devolved forecasts and the SFC’s economic and fiscal forecasts.

Acknowledgements

We are grateful to colleagues across the Scottish Fiscal Commission and the OBR for their expertise and support in the preparation of this article.

Downloads

Forecasts for Scottish income tax, block grant adjustments and reconciliations (article PDF)