Chapter 7 - Borrowing
Introduction
7.1. The chief advantage of having the capacity to borrow is to have the ability to shift expenditures between time periods; and to be released from making expenditures only at the time and on the scale allowed when matching revenues arise.
7.2. Governments therefore borrow in order to achieve greater flexibility, and greater effect, in when they can make their expenditures. This enables them to adjust their expenditures quickly in the face of unexpected or predicted events; or to smooth their expenditures over time when revenues are uncertain; or to make capital expenditures on infrastructure or development projects at the pace and priorities they choose, before the additional revenues are earned.
7.3. The Council has stressed the need to change the structure of the Scottish economy in order to make it more competitive and to increase long-term growth. This means a significant amount of new investment. Borrowing would allow such projects to be undertaken by spreading the costs over time. Many, particularly those involving investments in infrastructure, have large costs upfront but generate extra revenues over a long period of time. In the absence of borrowing, these investments may not be undertaken; or would have to take place at a much slower pace and might have a lower priority if the financing has to be agreed with the UK Government first. Moreover, borrowing and paying back through future tax revenues ensures that future tax payers will pay for a share of the benefits generated by earlier borrowing. Borrowing to repay is also a useful discipline that increases the responsibility and accountability of Scottish policy makers.
7.4. The same applies to investments that create new facilities and incentives for investors, or training for employees in new high productivity, high value added industries or industry clusters. An example would be North Carolina's programme for establishing a biotech industry. The state invested $1.2 billion over ten years in new facilities to create 54,000 jobs in 500 newly-arrived companies. 45 A quick calculation suggests that the payoff in terms of state income and sales taxes, assuming that half of the jobs created are new, is an extra $250 million each year. This investment will pay off in five years. However, under the current arrangements, the new revenues would all go to the UK Treasury if Scotland were to do the same. More generally, the Scottish Government has calculated that borrowing an additional £100 million each year, over 25 years each time, would eventually create a debt of 1 percent of GDP and annual servicing costs of £165 million. An addition of 0.13 percent to the annual growth rate would cover the cost of that borrowing. 46
7.5. For the Scottish Government, two distinctions are important:
- between the very small amount of borrowing that could be exploited under current arrangements, and the amount of borrowing that would be helpful and useful for running the economy efficiently and raising its potential growth; and
- between borrowing for capital expenditures, whether for infrastructure, human capital, environmental protection, or industrial development; and borrowing for the purposes of macroeconomic stabilisation (smoothing taxes and expenditures over time). Government neither can, nor should, turn expenditure on public services such as healthcare and education on and off as revenues fluctuate over the economic cycle.
7.6. As things stand, macroeconomic policy is a matter for the UK Government and it is therefore appropriate that borrowing to reduce macroeconomic fluctuations should be a UK reserved matter. The management of public expenditure in respect of devolved functions, however, is a matter for the Scottish Government. Government should be able to determine the appropriate timing of capital expenditures; should be able to plan current public expenditure over a period of years; and should be able to review the balance between current and capital expenditure in respect of devolved functions. 47 All of these purposes require the capacity to borrow on the part of the Scottish Government.
7.7. Over the last decade, there has been wide variation in the surplus or deficits run by the UK Government as a percentage of GDP. It does not appear to us that, at least until 2008-09, these fluctuations were primarily or even substantially caused by macroeconomic stabilisation policies of the UK Government. Even in 2008-09 the explosive growth of the deficit was mostly caused by unplanned increases in expenditure and reductions in tax revenues arising from the recession - the effect of 'built-in' automatic stabilisers rather than discretionary fiscal policy. In practice, the main source of fluctuations on surplus and deficit has been gyrations in the tightness of control of public expenditure by the UK Government, particularly in health and education. The UK Government maintained a restrictive stance until 2000, which was then followed by exceptional laxity.
7.8. Borrowing is often advocated as a means to finance active stabilisation policies. But, even in the absence of active stabilisation, borrowing may be necessary to cover passive (involuntary) changes in the budget balance - for example, when the economy enters recession, expenditures cannot be cut, and revenues raised in the short time needed to counteract an emerging deficit.
7.9. Through the Barnett formula, the instability of UK Government spending on health and education led directly to similar instability in the funding of the Scottish Government even though these are devolved functions. From 2000 to 2006, the revenues of the Scottish Government increased very rapidly - probably too rapidly - and in 2006 the tap was turned off. The Scottish Government did not, in fact, spend all the revenues it received during the earlier period, and has been permitted to use these balances for subsequent expenditure smoothing. This arrangement, although obviously sensible, is outside the spirit and letter of the current arrangements. It reflects a welcome flexibility in the stance of the UK Treasury, but such flexibility cannot be assumed and may not have any effect if tight budgets going forward do not enable unspent balances to be accumulated in advance. Moreover, the same flexibility does not appear to be present in respect of the funding of the projected Forth Crossing.
7.10. Currently approximately 11 percent of Scottish Government spending is funded from 'own source' revenues (e.g. non-domestic rates and Council tax) that can vary according to economic conditions. Under the proposals of the Commission on Scottish Devolution, almost 30 percent of the Scottish budget would be funded in that way, with no protection from sudden losses in own source revenues. 48 The future uncertainty over flexibility and the proposals of the Commission reinforce the pressure for the Scottish Government to have the capacity to borrow.
7.11. The primary cause of recent fluctuations in the UK Government surplus or deficit has not been the UK Government's counter cyclical macroeconomic policies, but its poor management of UK public finances. Such mismanagement at the UK level has led to worse management of Scottish public finances than we believe is desirable, or would otherwise be the case. We therefore consider there is a strong case for developing borrowing powers for the Scottish Government. We do not consider that such powers would create significant problems for the UK Government's macroeconomic policies, provided there were measures in place to ensure responsible management of Scottish public finances. In fact, we take the view that the UK as a whole would benefit as a result of the better management of Scottish public finances which borrowing powers would permit. We also take the view that UK public finances have been badly managed and that Scotland would likewise benefit from improvements in the UK fiscal framework.
Experiences Elsewhere
7.12. All national governments and most regional governments have the ability to borrow. Only Denmark and Korea among OECD economies forbid their local governments from borrowing; and none forbid their regional governments. On the other hand, local and regional governments are subject to a variety of limits. Some are required to obtain official approval before borrowing and many have their borrowing restricted to certain purposes (usually capital spending). But several (France, Netherlands, Austria, Germany, Canada) are unrestricted altogether, while some are restricted by limits on new borrowing (Spain, Belgium, the US) or on the level of debt (Japan). Very few, however, have any formal guarantees from higher tiers of government attached to their borrowing.
7.13. It is therefore interesting that few, if any, regional governments in these systems have gone bankrupt. The last major defaults among US states were in the 1820s, there have been no defaults in Canada and none in Western Europe since the Second World War. 49 This has been achieved by a combination of market and self-imposed discipline.
7.14. On the other hand, mispricing a loan or a guarantee - or presuming a guarantee when it cannot or will not be honoured - can cause big problems. It is generally agreed that the Argentine default in 2001 was, in large part, due to excessive spending by the provinces guaranteed by the Federal Government against a background of falling national income and falling prices. This was mispricing on a grand scale, deficits having exceeded sustainable levels for nine years, even though Federal loans had to carry risk premia of 2 to 3 percent for several years, rising to 15 to 20 percent or more in the final two years. 50
United States
7.15. The US States raise their own revenues to supply the majority of public services in their jurisdiction (social security, Medicare, defence and some capital spending excepted). That covers about 40 percent of public spending; central and local governments cover the rest. They typically have debt ratios of 15 to 20 percent of state GDP. The majority have balanced budget restrictions, but that refers to the formulated budget only (much goes 'off budget'). Tennessee has had deficits of $0.5 billion year on year, Massachusetts had debt of $68 billion in 2007, and Rhode Island recently borrowed 12.6 percent of its annual budget without difficulties. 51 This has had little effect on the ability to borrow, the cost of borrowing or the perceived likelihood of financial difficulties. Market risk premia have varied between 0.7 percent and 1.4 percent above US Treasury rates, even in the hard times of 2009.
Canada
7.16. Canadian provinces are responsible for most social and development programmes. Using direct and indirect taxation, business taxes and resource taxes, they raise 50 percent of their spending directly. In addition, there are various equalisation transfers imposed by the Federal Government to offset differences in fiscal capacity in the poorer areas. Transfers limit the burden placed on revenue raising in the provinces with the weakest tax base, and send a signal that the Federal Government or other provinces will support the weaker provinces to the extent of providing a common level of public services. In that way the Canadian system overcomes the inherent conflict between achieving equity between provinces and equity within provinces - in contrast to the UK whose current system is designed to produce equity between regions but not within them; and to the US which provides (up to a point) equity within States but not between them.
7.17. Canadian provinces can, and do, borrow abroad or domestically, without limit. This is remarkable since it means provincial borrowing runs the risk of attracting both foreign exchange and default risk premia, and hence substantially higher borrowing costs. In practice this has not happened. Risk premia have been 0.7 percent or less above the Federal borrowing rate, even for the poorest provinces.
What the Scottish Government can do with Existing Powers
7.18. At present the Scottish Government is unable to borrow for any of the purposes noted above. A very limited amount of borrowing is allowed under the Scotland Act (s66/67) to cover temporary shortfalls of cash: formally "a temporary excess of sums paid out of the Scottish Consolidated Fund over sums paid into that Fund"; or to "provide a working balance in the Fund". Any such borrowing must be from the UK Treasury, on terms set by the Treasury, and not from alternative sources even if cheaper; and any such borrowing must be less than £500 million (0.4 percent of GDP in 2007) in total. "Temporary" is not defined in the Act, but it is evident from the wording and the small sums involved that the provision is intended to ensure solvency for day-to-day government spending, but no more. Since each grant is calculated for one year and cannot be cumulated, this solvency support would have been of no use in the current recession.
7.19. Although the Scottish Government cannot borrow, except to this limited extent, local authorities within Scotland can. The Local Authority Prudential Scheme allows local authorities and statutory bodies to borrow to invest in capital works, assets, infrastructure or capital improvements. In 2007/08 some 18 percent of local authority capital spending was financed in this way. These loans are intended to be self-regulating. They are administered through the Public Works Loan Board ( PWLB) and the Debt Management Office ( DMO), subject to the prudential code under which the local authorities may determine for themselves what they can afford in terms of future revenues and sustainability. Formally the PWLB makes the loans and collects the interest and repayments, but the DMO sets the terms as part of its lending on policy for government money. There are no formal borrowing limits. 52 The local authorities are free to borrow as much as they wish either at the prices they can obtain from the DMO, or from the capital markets, whichever is cheaper. The latter might involve a premium on the borrowing rate, but local authorities may still prefer to go to the markets to get a loan tailored to meet their specific needs and requirements.
7.20. Local authorities claim this scheme is advantageous because it enables them to secure efficiency savings, to decide how and when to do the borrowing, and to operate better procurement policies. It also allows them to exploit partnerships with other bodies, to obtain cheaper funding (possibly because of the prudential code and implicit guarantees involved), and to operate better asset management and capital programming procedures over a longer period.
7.21. Transport for London, like Network Rail and many of the special purpose vehicles established under PFI contracts, has engaged in 'off balance sheet' borrowing, and the Scottish Government has in the past made considerable use of PFI. These transactions have been deemed not to represent government borrowing even though repayment of the debts incurred will be undertaken from funds partly or, in many cases, wholly provided by the UK or Scottish Governments. In addition, the borrowings would not be possible in the absence of an implicit (or in some cases explicit) commitment by government to provide such funds.
7.22. The accounting treatment of such transactions is governed by International Financial Reporting Standards ( IFRS). These have been revised since Enron and similar fiascos associated with off balance sheet financing, and such provisions are intended to restrict substantially the scope for taking borrowing transactions off balance sheet. The UK Government has delayed implementation of these standards and has now chosen to distinguish IFRS treatment from the treatment adopted in public accounts.
7.23. We are strongly of the view that the Scottish Government should pursue a policy of openness and transparency in its financial accounts. We regret that the UK Government has not adopted such a policy, and observe that one result has been the higher costs associated with off balance sheet financing. We hope that in future the UK Government will choose a more transparent procedure, but if it does not then its policies provide an additional argument for greater fiscal autonomy for Scotland within the UK. In the short-term, however, we recognise the Scottish Government may be obliged to operate within the constraints and practices of the UK Treasury.
7.24. The key restriction on borrowing by the Scottish Government is the prohibition on borrowing within the Scotland Act. The force of this prohibition depends on the meaning of borrowing. The legal definition of borrowing might follow IFRS, but it is more likely that a court would look to legal form rather than seek to interpret economic substance. Most forms of off balance financing by the Scottish Government are therefore likely to escape the Scotland Act prohibition, and we note the suggestion by the Chancellor of the Exchequer that the Scottish Government should use this route for the financing of the Forth Crossing.
7.25. In the absence of authority to borrow explicitly, we recommend that the Scottish Government and Scottish Futures Trust should continue to explore the use of special purpose vehicles and other semi-autonomous bodies - modelled on Network Rail and including Network Rail itself - to enable them to manage Scottish public expenditure more effectively. Considerations of both transparency and cost, however, make it strongly preferable to create explicit borrowing authority.
Borrowing by the Scottish Government
7.26. The management of any public debt will depend on the institutions chosen to guarantee and/or manage it. If the Scottish Government were to have borrowing authority, there would be a need for that authority to be constrained. While the level of borrowing will ultimately be limited by the debt markets, the point at which this constraint becomes effective entails debt levels far higher than those that would be prudent. The policy framework set out by the UK Government in 1998, based on the principles that borrowing should on average over a cycle be matched by productive investment and a target ratio of debt to national income represents a sensible set of principles. However, this framework has proved ineffective in practice because of off balance sheet financing and the Treasury's role as monitor of its own targets. We believe it is essential that the borrowing activities of the Scottish Government should be subject to the scrutiny that comes from fully transparent accounting and independent evaluation of the consistency of practice with the stated policy framework. We do not consider that the UK Treasury is an appropriate body to provide such scrutiny for Scotland.
7.27. A standard result from the literature is that any given debt burden (ratio of debt to GDP) is sustainable, under balanced budgets, if the rate of growth of output is greater than or equal to the interest rate payable on that debt. This result is independent of the level of debt: if the rate of growth is higher than the interest rate, the debt burden will be falling (or a limited deficit may be allowed); if the rate of growth is lower, the debt burden will rise (or a surplus must be run). It is also important to ensure that the interest and capital repayments remain affordable.
7.28. The danger is that a shock to growth (an economic downturn, a loss of competitiveness, an ageing population), or a shock to the financial markets (monetary policy, a risk premium, a credit crunch), will push the growth rate below the interest rate and turn a sustainable debt burden into an unsustainable one. Public finances would then be at risk. To guard against that and ensure that the interest and capital repayments remain feasible, some countries impose borrowing limits. An easy way to do that, and more effective than a deficit limit, is to impose a debt target. This is because the moving average element in the stock of debt provides a measure of persistence that forces policy makers to plan with a longer horizon, and prevents them from revising their plans without constraints from the past or expected revenues in the future.
Debt Management
7.29. The Scottish Government would have the option of managing its own debt via a separate Treasury function set up for the purpose; or of subcontracting to the UK Debt Management Office. 53 The DMO could, in turn, either issue debt as agent for the Scottish Government or borrow in the name of the UK Government and make the funds available to Scotland.
7.30. Under current practice, the Treasury - or the Scottish Government in this case - sets the amount to be borrowed; but the DMO decides on the maturities and type of bond to be used - specifically how much debt should be put into short- (one to seven years), medium- (seven to fifteen years), or long-term (more than fifteen years) maturities. However the DMO does not adjust the debt structure thereafter so as to minimise the cost of servicing the debt burden as interest rates change. Refinancing could therefore be used to reduce the cost of borrowing - an option the Scottish Government might wish to pursue, being a small player in the debt market. This is standard practice in many countries, but not in the UK.
7.31. The DMO typically charges a small mark-up for its services - in effect a price to cover the cost of the implicit guarantee. But, it is not clear that the DMO prices its guarantees very effectively. If it prices the loan too high, or offers the wrong maturity for the purpose of the loan (because of its practice of pricing loans uniformly across wide maturity bands), then the borrower could do better by going directly to the markets - with the temptation to borrow too much since it is not clear who really bears the risk. But, if the DMO prices the loan too low, the borrower will again be tempted to borrow too much compared to the resources being offered to back the guarantee. IMF advice, with which we concur, is that the true cost of the guarantee should be reflected in the price of the loan. If that is done correctly, then there is no reason to limit borrowing since the price will reflect the quality of debt and the tax raising powers of the borrower.
Fiscal Discipline
7.32. The Council believes that the Scottish Government should establish a Scottish Fiscal Policy Commission. The responsibility of such a commission would be to review the fiscal outlook for Scotland, examining the revenues likely to be available to the Scottish Government from the UK Government, any other revenue sources, and the future expenditure implications of current policies, including such items as PFI commitments, changing demography, and pension costs. Its work would inform both Ministerial decisions and the work of the Scottish Parliament and its committees. The proposed Fiscal Policy Commission should work closely with Audit Scotland, and it is important that it should be seen as similarly objective and non-political. We believe such a body would have an important role in monitoring and advising the Government on fiscal policy, and would make the case for borrowing more credible both with the public and in the markets.
7.33. The Council recognises (paragraph 7.6) that the exercise of borrowing powers by the Scottish Government needs to be coordinated to be consistent with UK macroeconomic policy. This might be done through a partnership agreement, or inter-governmental committee of UK and Scottish Governments. This is important because there is a natural concern that Scottish economic policies should be consistent with UK economic planning, just as there is concern that UK policies should take Scottish economic conditions into account. Such an agreement would provide the means for coordination and control.
7.34. There are models for this. The coordination of Scottish borrowing, spending and taxes with UK macroeconomic policy, with a view to influencing UK policy on the extent of borrowing, the stance of fiscal policy, tax competition, or a race to the bottom in social or business taxes, could be managed by a Fiscal Policy Commission working through a partnership agreement as Canada, Sweden, Germany, Chile and Hungary do now; or as the Australian grants commission or Belgian finance council do for regional funding. So this is a well tested idea. 54
7.35. Alternatively, borrowing could be made subject to limits on the deficit or debt as a proportion of GDP. There are advantages to an 'internal stability pact', applied as a debt rule. The problem would be enforcement. Monitoring and advice to ensure prudential fiscal policies and the debt limits were followed could therefore be added to the Fiscal Policy Commission's tasks.
7.36. The golden rule is another discipline device, designed to limit fiscal deficits without damaging public investment at the same time. It recognises that firms would naturally borrow to make capital expenditures, and one would not want to restrict them in that, if additional revenues and growth may be obtained from the investment. The same should apply to governments. The golden rule therefore states that current spending should be balanced by revenues, while capital spending may be financed by borrowing. The budget's current spending must be balanced over the cycle (paragraph 7.25), but the capital account may be in deficit to the extent of public investment (assuming a firm and agreed definition of public investment can be reached). This is the budgetary rule followed in Germany and the one foreseen for Scotland under the Calman proposals.
7.37. The Council believes that the Scottish Government could borrow at rates little different from the UK Government so long as the scale of borrowing was modest and there was proper prudential supervision of that borrowing. That is the role of an independent Fiscal Policy Commission. Given such a framework, there might be some appetite for Scottish bonds for reasons of sentiment and diversification.
Recommendations for the Scottish Government
7.38. The Council recommends the Scottish Government continues to use its ability to bring forward capital spending within a spending review period, and should also have the ability to deploy accumulated year-end funds without discussion with the UK Treasury. The Council also recommends that the Scottish Government:
Recommendation 15: makes the maximum use of special purpose vehicles and other devices to exploit borrowing opportunities within the present framework of legislation and expenditure control;
Recommendation 16: seeks powers to engage in simple, clear and transparent borrowing, with access to the Local Authority Prudential Scheme, but with the ability to borrow from capital markets where advantageous, and seeks to have the current £500 million short-term limit lifted or revised to a more realistic figure; and
Recommendation 17: emphasises the need for public accounts to present a clear and fair view, and should establish a Fiscal Policy Commission to review the presentation of public finances and the future fiscal position and outlook.