John McLaren: A question of oiling the wheels of the nation Predictions that North Sea revenue will support Scotland's economy may demand closer examination GEORGE Kerevan raised some interesting and important issues on Scotland's fiscal balance in his article in Friday's edition of The Scotsman. It is worthwhile reflecting on some of these in detail as they are an important element of the newly initiated referendum debate. The article claimed that "in normal times Scotland runs a budget surplus." That means that in an independent Scotland the government would have a slight surplus of revenues over expenditures, so its fiscal balance would be positive. However, in budgetary terms, there would be no "normal" times for an independent Scotland, as its fiscal balance would rely heavily on highly variable revenues from North Sea oil. To illustrate the extent of this dependency, in 2008-9 North Sea revenues accounted for 21 per cent of total Scottish revenues, whereas in 2009-10 this fell to 12 per cent of total revenues. In comparison, and for the same years, the UK dependency was 2 per cent and 1 per cent respectively. Due to this high dependency on oil revenues it is impossible to talk of a "normal" year. Indeed the notion of a "normal" fiscal balance position may be illusory. Having said that, and as the Centre for Public Policy for Regions (CPPR) pointed out in its most recent report on this issue (June 2011), the latest official Government Expenditure and Revenues in Scotland (Gers) publication shows that Scotland's fiscal balance has been as good, or better, than the UK's, in each of the past five years and we estimate that this advantage will continue, though falling, through to 2015-16. Here and throughout this article the fiscal balance discussed is the total balance, which includes both current and capital spending. Any such future estimates of Scotland's fiscal balance are highly dependent both on the level of oil and gas production in the Scottish section of the North Sea, which continues to trend downwards, and the future oil price, which is unknowable, despite Mr Kerevan's assertion that "the average oil price curve is upwards." As a result, the fiscal balance prospects for an economically independent Scotland remain clouded in uncertainty. George Kerevan's article claims that this uncertainty can be overcome by setting up a Scottish Sovereign Wealth Fund (SSWF) which would issue "covered bonds" to capitalise future oil payments and that the capital so raised could be invested in foreign equities, bonds, property etc and so build up a Norwegian-style oil fund. This is an interesting option but there are many uncertainties and risks associated with it. Investors in such bonds are normally attracted by the degree of income certainty. In the Scottish oil case, however, the income is both a derived, tax-related, one, as well as being highly correlated with the erratic price of oil. The Scottish Government has no control over how much private companies will produce in the North Sea, nor over the price to be charged. Furthermore, the corporation tax element associated with the North Sea is, to some degree, mobile, so again certainty of income is undermined. For Norway this would be less of an issue as the state, as a direct investor, has a greater say in the exploitation of its hydrocarbon resources. However, short of nationalising North Sea operations, the situation is not going to change in Scotland. There is also the more basic question of - to what extent would future Scottish North Sea income, whether collected annually or via some form of "covered bond," close the existing and future fiscal gap? According to Gers, Scotland needed to fill a, non-oil, fiscal gap of about £20 billion in 2009-10. This figure is likely to fall over the next few years, but in our recent paper CPPR estimated it would still be over £12bn in 2015-16. As far as likely revenues are concerned, in October the oil economist Professor Alex Kemp estimated that, in relation to North Sea related tax revenues, "over the next decade the annual values could be in the £5-10bn range in real terms." Meanwhile the latest projections by the Office for Budget Responsibility (OBR) show annual North Sea revenues of around £7-11bn for the UK up to 2016-17. In the medium term, therefore, no overall fiscal surplus is likely to emerge. In the longer term, if Scotland were to get back to a position of overall fiscal balance, it would still be running a "structural," non-oil, deficit in the region of £6-10bn. Hence, most, or all, of its share of the anticipated UK oil revenues of £5-11bn a year, would be being used to balance the budget. If instead, some of these North Sea revenues were to be saved in an oil fund, then a resulting deficit would emerge. This deficit could be addressed, either by raising other taxes and/or cutting expenditure, or by additional borrowing, although the latter route could ultimately prove more costly and may prove to be unsustainable anyway. So, while such a "covered bond" option may offer a degree of funding certainty not otherwise associated with Scotland's North Sea tax revenues, it is far from clear whether or not it would fill the underlying, non-oil, "structural" gap. The future price of oil will play a very important role in the degree to which it does, while in relation to the potential role of "covered bonds," as with all such financial engineering arrangements, the devil will be in the detail. Furthermore, if things go well, and price and production exceed current expectations, then Scotland would have a choice - whether to use any such fiscal surplus to reduce its stock of national debt or instead to build up an oil fund. That choice would depend on the relative interest rates associated with the debt versus that associated with the oil fund investments. A further complication arises in relation to the contribution of the North Sea to Scottish GDP (output). As with revenues, much of the output relating to the North Sea would be accounted as belonging to an independent Scotland. However, most of the North Sea operations are overseas-owned and so the profits, excluding taxes, also end up overseas. This leaves open the issue of whether it is Gross Domestic Product or Gross National Product that is the more relevant measure of the size of Scotland's economy and against which the level of debt and borrowing should be measured. The latter measure is much used, for example, by Ireland, due its substantial overseas owned manufacturers presence. There is a lot more analysis that needs to be undertaken to try to better understand the options, and their implications for independence. John McLaren, Centre for Public Policy for Regions (CPPR)