The Biggest Questions Facing Post-referendum Scotland

Knowledge@Wharton

Republished with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

The Queen of the British Commonwealth wasn’t the only who “purred” — in Prime Minister David Cameron’s words — when Scotland voted “no” to independence last month. Many who worried what the region’s economic future might look like breathed a sigh of relief for the status quo. The outcome of the referendum vote carried significant implications not just for Scotland and the rest of the United Kingdom, but also for the whole of Europe.

The world witnessed one of the most extraordinary democratic processes in modern history when 55% of Scottish residents voted a resounding “no” to becoming an independent nation. The result has also assured the stability of the United Kingdom, which affects Europe and global markets, at least for the short term, say Wharton experts.

Big questions about currency and Scottish businesses have been resolved. The British pound stays intact and banks and corporations have “no fear that the rules of the game are changing,” says Mauro Guillén, a Wharton management professor and director of The Lauder Institute. “I think the Scottish economy will continue as it has been Twitter . It will do fine and it will stay on par with the U.K.,” agrees Franklin Allen, a Wharton finance professor and director of the Brevan Howard Centre for Financial Analysis at Imperial College in London.

After the referendum, the British pound rallied to a two-year high against the euro and market shares experienced a slight rise as confidence in the U.K. was restored.

However, the economic and political landscape of Scotland and the rest of the United Kingdom have been indelibly altered forever. “The Scottish referendum issue is settled now, but it’s opened up other questions,” Guillén notes.

What’s on the Table for Devolution?

Change is inevitable now. Scotland will get further devolution, meaning the United Kingdom will transfer fiscal and political powers away from Westminster in London to the Scottish Parliament in Edinburgh. The Scots will also have more say about what happens in Scotland, even if they’re not independent.

“The Scottish referendum issue is settled now, but it’s opened up other questions.” –Mauro Guillén

In the week before the referendum, leaders from all of the major political parties — the Tories, Labour and the Liberal Democrats — descended into Scotland to rally for a “no” vote, or rather to keep the United Kingdom together. The “no” campaign was bolstered by last-minute promises for more Scottish power, which would be worked out in finer detail if Scotland voted to stay with the rest of Britain.

Hence now, the real work begins on a relatively tight timetable. Prime Minister Cameron has commissioned Lord Smith of Kelvin, a Scottish businessman who oversaw the recent Commonwealth Games in Scotland, to convene a group consisting of representatives from all political parties, including the Scottish National Party (SNP), to come up with the best proposal for devolution. “I suspect it will be the Labour and Conservative parties that will dominate the proposals, and the SNP will be consulted,” says David Bell, professor of economics at the University of Stirling in Scotland. Devolution plans will have to be approved by the British Parliament where Labour and Conservative members dominant the seats.

Taxes are at the crux of the devolution debate. How much will the Scots and Scottish businesses pay? And what proportion of the budget does the Scottish government get to decide how to spend? Personal income taxes are the easiest issue to tackle because it will be less challenging to reach consensus among all the parties, Bell notes. Personal income tax brings in strong revenues for the Scottish government with fewer regulatory complications from the U.K. and the European Union.

The Scotland Act of 2012, which should go into effect in April 2016, gives the Scottish government the power to set the Scotland Rate of Income Tax (SRIT). Currently, the British tax system works like this: If someone makes under £31,865 annually, he or she pays 20% in taxes. If a person’s income is over that amount, he or she pays 40%. For incomes over £150,000, 45% goes to the government. Even before the referendum vote, the British government had agreed to reduce the federal income tax by 10% for Scots and let Scotland determine what tax rate it wants to impose to meet its own budget requirements.

What has tied Scotland’s hands, however, is that its government already spends more money than what it can raise in taxes, resulting in a large vertical fiscal imbalance. Under the new legislation, Scotland will be able to borrow up to £2.2 billion annually.

Changing personal taxation won’t be thesalveto cure all evils, though. “I’m concerned [they could] sell this as a mechanism to grow the Scottish economy faster than the rest of the U.K.; I’m really not sure income tax will make that much difference,” warns Bell. “The U.K. is in considerable debt. Income tax is kept at quite a high level as part of the plan to deal with the debt.”

According to Paul Cairney, political and public policy professor at the University of Stirling, “essentially, they will tinker in the margins, doing things slightly differently. There is no party out there saying they’re going to radically change taxes.”

In the past, Scotland’s budget was mostly financed by a block grant from Westminster, which is determined by the Barnett Formula, named after Joel Barnett, chief secretary to the Treasury, who came up with the convention in the 1970s. Critics have said that the monies relegated to Scotland have been generous, resulting in £1,157 per Scottish person, which is 11.5% higher than what is allocated to residents of the rest of the U.K., according to the Institute for Fiscal Studies. Some say the substantial amount was awarded to assuage any independence drum-beating. Under the Scotland Act, the block grant will be reduced as the Scottish government takes more control of how it raises the budget and how it is spent.

Relatively minor taxes, like landfill and stamp fees, will be devolved under the Scotland Act. (Stamp taxes are duties for legal documents.) Business taxes and council taxes, which are like local taxes, have already been devolved to Scotland but they only accounted for less than 6% of the Scottish budget in 2012-2013, according to Bell. (Tax years run from April 1 to March 30 in the United Kingdom.)

“I’m concerned [they could] sell [income tax] as a mechanism to grow the Scottish economy faster than the rest of the U.K.” –David Bell, University of Stirling, Scotland

One of the major platforms for the campaign in favor of independence was more control over welfare spending, adds Bell. It was no coincidence that the two poorest cities in Scotland — Glasgow and Dundee — voted “yes” to separating from the U.K. Bell expects the Scottish government will take a closer look at benefits for older people, disabled people, welfare housing, and programs to help the unemployed and young people enter the labor market.

Still Open for Business

While governments work out their budgets, businesses want to move full steam ahead. “Devolution will not scare corporations, but independence would have,” says Cairney.

Most Scottish companies want to focus on the devolution negotiations ahead. According to Liz Cameron, chief executive of the Scottish Chambers of Commerce, “Understanding the changes in taxation that would help businesses grow is important, as is achieving a flexible mix of taxes, which encourages a pro-business fiscal regime. A reduction in an existing business rate tax would alleviate some cost pressure, as this is among the highest cost for many businesses.” A spokesperson at Scottish Enterprise, a public-private group aimed at developing business opportunities, notes that it, too, has “an interest in delivering additional powers to Scotland.”

Prior to the vote, major players in the financial sector were threatening to relocate their headquarters out of Scotland and into England, sending markets into jitters. The British government estimates that 8% of Scotland’s GDP is tied to financial services. Scottish Financial Enterprise, a trade group, says that 12% of the Scottish workforce is employed by insurers, banks and asset managers.

Lloyds Bank, Clydesdale Bank and the Royal Bank of Scotland (RBS), which owns Citizens Financial Holdings in the U.S., announced outright that, in the event of a successful “yes” vote, they would move to England to access the Bank of England’s bailout services if need be. Standard Life, a savings and investment firm which employs 6,000 people in Edinburgh, also said it was registering companies outside Scotland in the event that it would have to relocate.

Bell notes that Scottish banks would have had to move out because “most of the customer base is outside the Scottish border. In those circumstances, they would not wish part of their customer base to be subject to different regulations than customers in Scotland.” He adds that now that the vote is over, financial companies have stayed put and are operating business as usual. If there had been a “yes” vote, there would have been an interim period before the companies would have had to relocate. “Moving a large company is not without cost. Finding a suitable workforce on very short notice is quite hard to do,” Bell says.

On the other hand, the oil and gas industry “would have been less affected,” Bell states, because the industry is used to dealing with various tax regimes in several countries. Oil reserves became a serious bone of contention between independence campaigners, who believed Scotland could become more prosperous if it kept oil revenues in the country, versus energy companies, which maintained that the oil didn’t necessarily belong to Scotland, and it would run out in 50 years.

“People constantly develop new technologies to extract more oil. Even 50 years ago, they were saying there would only be 50 years of oil left,” Cairney points out.

However, there was no debate about the value of Scotch whiskey. The largest drink export, whiskey is worth £4.3 billion in exports annually and accounts for a total of 25% of all British food and drink sent out of its borders. David Williamson of the Scotch Whiskey Association says the trade organization “welcomes the stability” the referendum brought. He adds, “There must now be a renewed focus on improving the business environment so that Scotland’s economy can grow to everyone’s benefit,” after the debate over independence showed that the “government and businesses need to collaborate to address long-term economic challenges.”

“Devolution will not scare corporations, but independence would have.” –Paul Cairney

Political Repercussions

Like a domino effect, the Scottish independence vote also set off a slew of events. Soon after, the Catalan government called for, and then suspended, its own independence referendum, which the Spanish government has already declared illegal. Protestors in Barcelona have been waving Saltires, the heraldic symbol depicted on the blue-and-white flag of Scotland.

English members of Parliament are demanding that their Scottish counterparts have no say on laws that affect England since the English MPs will have no say on laws that affect Scotland with the coming of devolution. It’s called the “West Lothian” question because the Scottish political leader who first raised it represented the county of West Lothian outside Edinburgh.

In 2015, the U.K. will have a general election to choose its next prime minister. As a campaign promise, the Tories have already vowed to hold a referendum vote to decide if the U.K. wants to stay in the European Union. “Lots of support for the E.U. is in Scotland,” warns Guillén, adding that he is “skeptical of referendums to settle issues, but very supportive of democratic processes” where the course can be reversed at the next election. Referendums are permanent decisions, he adds, and are sometimes carried out with “emotions and sentimentality.”

According to Bell, “The U.K. as a whole is growing better than mainland Europe, and Scotland is growing at the same rate as the rest of the U.K. Any disruption in the U.K.’s growth path wouldn’t have been good for Europe since the European economy is pretty close to stagnation.”

However, the U.K.’s growth wouldn’t be permanently hindered if it left the E.U., depending on the separation terms, Allen points out. “The U.K. could still be part of the single market” with free labor movement, and the U.K. would have more control of regulations, he says. “In my view, it won’t negatively affect the U.K. in the long run. There are lots of rich countries outside the E.U., like Norway and Switzerland, but it’s quite unclear how it would work out.”

For many people who voted “no” to independence, the question boiled down to the economic future for Scotland, which would have affected the U.K., Europe and arguably, the rest of the world. “Devolution in the U.K. will be interesting,” says Allen. Westminster and the Scottish Parliament will have to work out budgets, taxes and spending powers, which will affect the economic prospects of Scotland and the rest of the U.K. “It will get hammered out, but it might take a while,” Allen adds.

 
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