Current criticisms of the Barnett formula revolve around the way the funding is distributed to the home nations. In particular, that Scotland receives around 20% more per person than in England, while politicians in Wales complain that they are being short changed. While there is a need for change to the formula and the way distribution is calculated, it would be prudent for the right changes to be made by observing what has worked elsewhere and what has failed or delivered undesirable outcomes. It is most important to avoid policy shortcomings, as even temporary government policies and measures have a bad habit of sticking around much longer than initially planned. The Barnett formula itself was never intended to last for the 39 years it has been in use. Originally intended as a short-term solution to minor Cabinet disputes in 1978, it has outlived its purpose.
The main critique of the Barnett formula is that it is not based on fiscal need of each of the home nations or the amount of tax raised in each home nation. The problem immediately becomes that each has a different, extremely complex fiscal need, based on a myriad of factors including sparsity of the population, health, age, cost of travel, crime rates, etc. In parallel with the different fiscal needs, each home nation also has different tax revenues.
Before we look at how a new system could distribute tax revenue or what sort of system would be put in place it is necessary to investigate why fiscal transfers have become necessary and what sort of perverse incentives they may yield.
Fiscal transfers are a product of vertical fiscal imbalance. This is where one level of government - generally the central government– raises more tax than it consumes, and other levels of government – generally state and local – raise less than they require for their legislated operations. In the UK, the Treasury uses the Barnett formula to determine how much funding should be sent to Northern Ireland, Scotland or Wales based on funding in England. In order to determine the change in the block grant, the increase or decrease in spending for England is multiplied by the population proportional to England and multiplied by the extent to which powers have been devolved from the UK Parliament to the relevant legislative branch.
With fiscal transfers, special care needs to be taken to avoid perverse incentives, especially when the term ‘needs-based’ is applied, and the formula used takes into account income and expenditure. An OECD report into Fiscal Equalisation in OECD Countries warned of these incentives and what effect they can have on recipients. Revenue equalisation can reduce tax and development efforts, as it significantly increases a recipient’s income with no need for improved efficiency or encouragement of industry in its jurisdiction. Cost equalisation is prone to rent seeking and can entrench inefficiency. For a recipient of funds, there is every incentive to spend more money on services. This is because in the next year you will be awarded more funding due to the high expenditure requirements for you to supply comparable services. There is no incentive to supply more efficient services as this will affect the next equalisation payment. Equalisation can also pose a problem for budget stability as revenues are not certain.
Under the system that operates in Australia, the Commonwealth Grants Commission distributes the Goods and Services Tax (GST) (VAT equivalent) according to ‘relativities’, which are calculated using a formula to allow states to supply equivalent services to citizens. This formula effectively rewards the inefficiency of the state tax system and prevents improvements in productivity in the supply of government services. It would be prudent for the UK to avoid the pitfalls of the Australian system.
One example of budget instability was seen when a collapse in revenues from mining royalties in the state of Western Australia was not offset through transfer payments, contributing to the worsening fiscal position of the State government. The state was receiving $0.30 for every dollar of GST raised in the state. No state had ever received less than $0.835 on the dollar under the relativity calculations until Western Australia crashed through this barrier. The Northern Territory currently receives $5.57 in 2016-17 for every dollar of GST raised in the state. The biggest problem with the distribution is the zero-sum game nature of GST distribution. In order for one state to gain revenue, another must lose revenue. The nature of the distribution severely hampers any reform efforts, with states in receipt of higher funding uninterested in changing the formula.
It is necessary to be aware of how these incentives and uncertainty can influence governmental operations. Governments need to have an incentive to use received fiscal transfers efficiently. One option to increase efficiency of operations can be an efficiency dividend. Another option is to give the home nations, or states, more fiscal autonomy by devolving some taxation powers from the central government to the state and local governments. In Britain’s case, this could involve devolving some taxation powers to the home nations, allowing them to fund their commitments responsibly. This will reduce the vertical fiscal imbalance and introduce competition into the operations of government.
Allowing Scotland, Wales and Northern Ireland more fiscal autonomy will encourage them to supply services that deliver value for money to taxpayers. It would also provide an incentive for tax and development efforts, reward the home nation with savings through productivity gains, and reduce fiscal dependency on the central government.