Part 1: The ‘fiscal gap’ and the Welsh economy

This is the first in a three-part series of blog posts examining Wales’ current fiscal position, exploring the prospects for improving Wales’ fiscal position as part of the UK, and outlining some of the implications for the Welsh independence debate. The full report – Wales’ Fiscal Future – can be downloaded here.

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Last July, the Wales Fiscal Analysis team published the latest edition of Government Expenditure and Revenue Wales (GERW) – a report estimating the contribution of revenue raised in Wales towards the goods and services provided for the benefit of Wales.

The ONS has since released updated data on Wales’ public sector finances covering the 2018–19 financial year and new estimates of Welsh GDP.

This blog post analyses what the latest data tells us about Wales’ current fiscal position as part of the UK.

The ‘fiscal gap’

In 2018–19, the difference between total expenditure for Wales (including an allocated share of UK government spending) and total revenues raised in Wales was around £13.5 billion, or 18.0% of GDP. This is the notional ‘fiscal deficit’, or the ‘fiscal gap’ as it’s sometimes known.

It is not unusual for sovereign countries – and much less unusual for constituent parts of nation-states – to spend more than they generate in revenue in any given year. In some cases, a deficit can be sustained over a prolonged period – the UK has been in the red since 2000–01.

At a UK level, this deficit reflects government borrowing. At a Welsh level, it represents a combination of UK government borrowing and implicit fiscal transfers from the rest of the UK.

Unlike many European countries that have explicit equalisation arrangements between regions, fiscal transfers in the UK are largely made through the tax-and-benefit system. Revenues raised from income taxes in Wales tend to be lower than the UK average; at the same time, residents receive higher levels of social protection spending per head, reflecting greater levels of relative need.

Although the UK has high levels of regional inequality as measured by output (GDP), the implicit transfers through the tax-and-benefit system have a slight dampening effect on this inequality. While primary income in Wales (income from employment, profits and property) is around 74% of the UK average, after accounting for direct taxes and transfers, disposable income is around 81% of the UK average.

This is one of the reasons why comparisons with Ireland are not always illuminating. Although Ireland’s GDP per person is around 2.3 times higher than Wales, disposable income is only around 8% higher. Much of the profits from multinational company activities, which contribute to Ireland’s GDP, flow out of the country.

But Wales’ fiscal deficit does not reflect healthy or optimal economic conditions. The First Minister has acknowledged that closing the fiscal gap would be “a proper ambition for any Welsh Government”. For advocates of independence, this is an even more pressing task.

Why is the fiscal deficit so large?

In 2018–19, Wales’ fiscal deficit amounted to £4,305 per person, compared with £622 across the UK.

Total spending is somewhat higher in Wales, with £690 more being spent per person on social protection (pensions and benefits). But by far the largest contributor to the country’s weaker fiscal position is lower revenues. Revenues from Income Tax and National Insurance contributions are around £1,750 lower per person. If revenues from these taxes alone matched the UK per person average, total revenue would be £5.5 billion higher, nearly halving the fiscal deficit.

Wales’ fiscal deficit and the UK economy

The ‘fiscal gap’ has been a long-standing feature of the Welsh economy. However, the first estimates of the public and private flows into and out of the Welsh economy, produced by the economist Ted Nevin in 1957, showed a rather different picture.

In the immediate aftermath of the second world war, Welsh economic growth outpaced the UK average; in part due to UK government policy that compelled manufacturing to locate there. Estimates suggest that Wales ran a fiscal surplus of around 1% of GDP on average between 1948 and 1956.

The worsening of Wales’ fiscal position over time is a symptom of decades of Welsh economic underperformance and an increasingly imbalanced UK economy.

Wales is not unique in having a fiscal deficit – of the UK’s three devolved countries and the nine English regions, only in three of the twelve did revenues exceed government spending in 2018–19, and only London has consistently been in this position over the last twenty years.

Fiscal transfers across the UK allow a higher level of consumption of goods and services in nations and regions like Wales. Although no official data exists, our rough estimate suggests the difference between the value of Wales’ imports exceed exports by some £13.1 billion. This is financed mostly by fiscal transfers from the rest of the UK, a share of UK government borrowing and by some private sector financial flows.

However, fiscal transfers are not currently paying for investments – such as in our infrastructure and our education – that would allow a turn-around in the relative performance of the Welsh economy and our fiscal position.

It is becoming increasingly clear that improving Wales’ current fiscal position will require a fundamental change in the nature of the UK economy – or indeed, Wales’ constitutional settlement.