5 regional funding(1)

Dr John Moffat
Richard Price Building, Room F49
Email: J.D.Moffat@swansea.ac.uk
Office Hours: Tuesday & Friday, 1:30-2:30pm

Learning Outcomes
 Students should be able to answer the following
questions:
 What impact will increased levels of expenditure have
on regional income?
 How is funding distributed to the devolved regions of
the UK?
 Explain why many people regard this funding
mechanism as unfair.
Topic 5: UK Regional Funding 2

Readings
 Armstrong & Taylor, chapter 2
 Holtham Commission (2010), Fairness and
accountability: a new funding settlement for
Wales, Available from:
http://wales.gov.uk/docs/icffw/report/100705fundings
ettlementfullen.pdf
 Oxford Economics (2008), Regional Winners and
Losers in UK Public Finances, Available from:
http://www.isitfair.co.uk/Reports/Public/OE%20UKP
ublicFinance.pdf

Keynesian Income-Expenditure
Model
 The importance of regional funding is explained by the
regional multiplier which shows the impact of an increase
in government expenditure (and other types of
expenditure) on regional income
 To provide the intuition behind the multiplier, suppose the
UK government decided to pay workers in Wales to
electrify the railway line between Cardiff and Swansea:
 This increases the income of these workers
 These workers spend a proportion of this income in Wales
 This is income to other workers in Wales
 These workers spend a proportion of this income in Wales
 And so on

Model
 The national income identity is:
(1)
where C=consumption; I=investment; G=government expenditure;
X=exports; M=imports
 Assume for the moment that:
(2)
 And that:
where (3)
(4)
where c=marginal propensity to consume; m=marginal propensity to
import; t=marginal rate of taxation
MXGICY
000 ;; XXGGII
d
cYCC 0 tYYY d
d
mYMM 0

Model
 Substituting (2)-(4) into (1) gives:
(5)
 Or:
where:
(6)
is the regional multiplier
 The impact of changes in autonomous expenditure can be calculated as
follows:
(7)
tmc
MXGIC
Y
11
)( 00000
00000 MXGICkY
tmc
k
11
1
0
0
GkYk
G
Y

Model
 To calculate the regional multiplier, we need estimates
of (c-m) which is the marginal propensity to consume
locally produced good and services
 This will typically be smaller when:
 The regional economy is smaller
 The regional economy is more specialised
 The regional economy is closer to other labour markets
 For Scotland, using information from input-output
tables, Harris (2009) estimates that (c-m)=0.39. If we
assume that t = 0.2, then the simple Keynesian
multiplier equals 1.45

Model
 But treating investment and government
expenditure as exogenous is unrealistic
 More realistic specifications for investment and
government expenditure are as follows:
where i<1 (8)
where we assume that g<0 (9)
d
iYII 0
d
gYGG 0

Model
 Substituting equations (8) and (9) along with (2) – (4)
into (1) gives:
(10)
so:
(11)
 Using this more realistic version of the multiplier, and
having estimated that i=0.17 and assumed that g=-
0.1, Harris (2009) calculates that k=1.58 in Scotland
00000
11
1
MXGIC
tgimc
Y
tgimc
k
11
1

Crowding-out
 The Keynesian income-expenditure model assumes
that increased government expenditure does not cause
an offsetting reduction in consumption or investment
 This assumption will not hold if increased government
expenditure is financed by borrowing which in turn
causes a rise in interest rates
 This is what is referred to as ‘financial crowding-out’

Crowding-out
 The Keynesian income-expenditure model also assumes
that the supply curve is horizontal and that there is
therefore no impact on prices of increased expenditure
 This assumption will not hold if the economy is at or near
full capacity
 In these circumstances an increase in public expenditure
will increase aggregate demand which in turn will increase
wages and prices
 This moves the economy to a new equilibrium with higher
nominal wages and prices but unchanged real wages and
output
 This is referred to as ‘resource crowding-out’

Crowding-out
 But crowding-out is unlikely to be a problem in the
context of regional policy
 In relation to resource crowding-out, the regional
economy is unlikely to be at or near capacity or it
would not be a target for regional policy!
 Financial crowding-out will be a problem for the
region only if the region rather than the central
government has to borrow to fund the increased
expenditure or if the region is a very large part of the
country

Barnett Formula
 The devolved authorities receive their funding for
spending on devolved areas through a block grant
allocation from Westminster
 Increases/decreases in the size of the block grant are
allocated to devolved regions through the Barnett
formula on the basis of:
 the size of the increase/decrease going to England
 population shares

Barnett Formula
 The change in the size of the Welsh block grant is given by:
where ΔG denotes the change in nominal expenditure on
services and W and E refer to Wales and England respectively
 α is given by:
 where POP denotes population
 Using ONS mid-year population estimates for 2010, an increase
in expenditure of £1 billion on a devolved area in England leads
to an increase in expenditure of ((3/52) x 1 billion=) £58 million
in Wales
EW GG
E
W
POP
POP

Barnett Formula
• As spending increases, the Barnett formula should
eventually lead to the following outcome:
• Wales will receive a share of expenditure that is
equal to its share of population
• In other words, spending per head will be the
same in Wales and England
E
W
E
W
P
P
G
G

Barnett Formula
 As spending per head in the devolved regions is
currently greater than in England (see next slide), this
implies that spending per head relative to England will
fall if spending in England increases
 This is the so-called ‘Barnett squeeze’
 But if spending falls, as it is forecast to do over the next
few years, spending per head relative to England will
rise in the devolved regions

Identifiable Expenditure Per
Head, 2006-2010 (£)
2006-7 2007-8 2008-9 2009-10 2010-11
North East 7,833 8,235 8,889 9,459 9,501
North West 7,636 8,093 8,631 9,267 9,386
Yorkshire and the Humber 7,033 7,332 7,867 8,462 8,512
East Midlands 6,527 6,875 7,385 7,950 8,098
West Midlands 7,097 7,502 8,015 8,613 8,679
East 6,241 6,534 7,067 7,690 7,834
London 8,352 8,806 9,355 10,146 10,198
South East 6,208 6,524 7,091 7,513 7,529
South West 6,531 6,896 7,481 7,977 8,096
England 7,042 7,414 7,962 8,553 8,634
Scotland 8,588 9,045 9,424 9,945 10,165
Wales 8,260 8,609 9,144 9,726 9,947
Northern Ireland 8,963 9,540 10,044 10,550 10,668
UK 7,288 7,671 8,203 8,785 8,884
Source: PESA (2011)Topic 5: UK Regional Funding 17

Regional Expenditure
 Considerable anger surrounds current levels of
expenditure per head across the regions of the UK
 Much of this anger is directed at the fact that Scotland
receives higher expenditure per head than Wales (and
many English regions) in spite of having, by most
measures, a stronger economy (see previous lecture)
 But, as shown above, the Barnett formula, if rigorously
applied, should eventually lead to convergence of
spending per head across the devolved regions and
England

 But is convergence of spending per head desirable?
 Many people advocate the distribution of public
expenditure on the basis of a needs-based assessment
(as in, for example, Australia)
 A needs-based assessment would take account of
different levels of demand for public goods and
differences in the cost of providing a minimum
standard of public goods across the country

 The Holtham Commission (2010) undertook a needs-
based assessment and calculated that Wales was
underfunded by £400 million in 2010-11
 This calculation was based on the six measures of need
shown in the next slide
 The weighting attached to each measure of need was
determined by a statistical analysis of their influence
in determining relative levels of expenditure across
areas within the other countries of the United
Kingdom

Holtham Commission (2010)Topic 5: UK Regional Funding 21

 What does Lord Barnett think of the formula that he
devised in 1978? He said the following:
“I do not consider it is successful. I do not think it is
fair… I thought it might last a year or two before the
government would decide to change it. It never occurred
to me for one moment that it would last this long”
(House of Lords Select Committee on the Barnett
Formula, 2009)

Regional Revenue
 It may be argued that, when judging whether the
current distribution of expenditure across the UK is
fair, the amount of revenue raised in each region
should be taken into account
 Information on tax receipts is not collected on a
regional basis by HMRC so the tax revenue from each
region needs to be estimated
 The table in the next slide was calculated by
subtracting (estimated) revenue per head from
(estimated) expenditure per head for each region

Net Regional Fiscal Balance Per
Head, 2006-7
Topic 5: UK Regional Funding 24Oxford Economics (2008)

Expenditure Allocation
 The total amount of money available for expenditure
by the devolved parliaments is determined by the
Barnett Formula
 But the distribution of expenditure across those areas
for which they have responsibility is determined by the
devolved parliaments
 In other words, the ‘Barnett consequentials’ from an
increase in expenditure on, for example, health in
England do not have to be spent on health in Wales

Summary
 The Barnett formula determines the size of the budget
for the devolved parliaments of the UK
 Many people regard the Barnett formula as unfair and
argue for a needs-based assessment to determine the
distribution of expenditure throughout the regions of
the UK
 The devolved parliaments are free to spend their
allocations in whatever way they like across those areas
for which they have responsibility

5 regional funding(1)

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