Why devolution shouldn’t include fiscal powers

The Scots have spoken. A solid majority voted against independence in their historic referendum last month. But the debate left no question that an even larger majority favours the further devolution of economic, social and political power in Britain. And regional movements elsewhere in Europe – and around the world – are making similar demands.

The logic of devolution is clear. Scotland, for example, may not want a bigger or smaller government than it has now, but it wants a different mix of taxes and spending. It wants more local control. The Scotland Act of 2012, scheduled to come into effect in 2016, provides a down payment on this desired autonomy. Prime Minister David Cameron, knowing which way the wind is blowing, has promised more.

But if devolution is good for Scotland, then why not for Wales and Northern Ireland? Why not also for England, for that matter? An equilibrium in which Scots vote on English laws but the English have no vote on Scottish laws will not remain an equilibrium for long.

And why stop there? Why not devolution for Yorkshire, a region with a population equal to Scotland’s and an active separatist movement, and for other English regions?

A not-so-United Kingdom of regions need not be a disaster. The United States is able to function, after a fashion, as a union of 50 states of very different economic size and political complexion. Other federal states like Canada and Australia may be even better role models.

But it is important to draw the right lessons from the experience of these other states.

For starters, the central or federal government should retain significant fiscal powers. It must be responsible not just for defense and foreign policy, but also for key economic policies. And it must have the resources to implement those policies.

Consider, for example, policy toward the banking system. With the defeat of the Scottish referendum, it is clear that the UK will still have a single integrated banking and financial system for the foreseeable future. In the US, which similarly has an integrated banking system, the federal government steps in when banks in a state are in serious trouble. Americans have learned the hard way that bad financial events, even when initially localized, can quickly infect the entire system.

Specifically, the federal government steps in through the agency of the Federal Deposit Insurance Corporation, which has a credit line with the US Treasury. With the federal government raising roughly two-thirds of all tax revenues, there is no question about the Treasury’s ability to provide the financial backstop needed to prevent contagion.

This implies that transferring the majority of revenue-raising capacity to the regions would be a mistake for the UK, because doing so would give the country a banking union without a fiscal backstop. And that, revealingly, is precisely what the Eurozone has. That is not somewhere the UK should want to go.

In the US, control over social policy is delegated to the states, allowing local legislatures to tailor programs to local tastes and use resources efficiently. But those local policies are still subject to federal oversight. The federal government steps in – and has the capacity to do so – when, for example, civil liberties are being violated.

And yet there also is the danger that federal authorities will assign responsibilities to state and local governments but not give them the resources they need to carry them out. And even where revenues are otherwise adequate, states have an incentive to spend more on social programs and, pointing to the resulting deficits, ask for additional federal transfers.

To counter this deficit bias, federations in which states do much of the spending and the central government raises most of the taxes typically impose balanced-budget rules on subnational governments. Forty-nine of the 50 US states, for example, have such rules in one form or another.

The Scotland Act of 2012 caps the region’s deficit at 10% of its budget and limits how much the Scottish government can borrow. These issues are now likely to be reopened with further devolution. But reconsidering debt and deficit limits on regional governments is not the same thing as abandoning them. The experience of other federations shows that the latter would be a mistake.

At the same time, rigid rules limiting deficit spending by regional governments could place the UK in the same fiscal straitjacket as the Eurozone, where member states are prevented from borrowing in recessions. Fiscal policy would then become dangerously procyclical, aggravating business fluctuations.

Simply put, if fiscal policy is to play a stabilizing role in the UK economy, it will have to be conducted at the federal or central level. The central government and its revenue-raising capacity cannot be allowed to wither away.

Devolution is coming, and its appeal is undeniable. But it is important to know where devolution ends and dysfunction begins.

Published in collaboration with Project Syndicate.

Author: Barry Eichengreen is Pitt Professor of American History and Institutions at the University of Cambridge, and a former senior policy adviser at the International Monetary Fund.

Image: A Scottish Saltire flag and British Union flag fly together with the London Eye behind in London September 19, 2014. REUTERS/Luke MacGregor