Scotland's Budget hit by £851m tax gap and welfare bill

The Herald Scotland

4 days ago

Total funding for 2025–26 is forecast at £59.6 billion, up almost £800 million on the SFC's previous projection in December 2024, largely due to increased UK Government funding. Of that, £52.2 billion is allocated for resource funding — the part of the Budget that covers day-to-day spending such as health, education and benefits — rising to £61.6 billion by 2030–31.
However, after accounting for inflation, the real-terms growth in resource funding is just 7% over the next five years. Once rising social security spending is included, real-terms growth for all other areas of the Budget drops to just 5%.
The Commission noted that Scotland is forecast to spend £1.3 billion more on devolved social security than it receives in UK funding in 2025–26, with that gap widening to around £2.2 billion by the end of the forecast period. This structural pressure is driven by both Scottish Government policies and UK Government welfare reforms.
A key factor is the Scottish Government's decision to mitigate the two-child limit in Universal Credit, a policy expected to cost £156 million in 2026–27 and rise to £199 million by 2029–30. Meanwhile, UK Government plans to reduce spending on Personal Independence Payment in England and Wales will reduce the block grant to Scotland, cutting £400 million from Scottish social security funding by 2029–30.
Spending on devolved social security benefits is expected to increase from £6.9 billion in 2025–26 to £9.4 billion in 2030–31. Of that £2.5 billion rise, £1.0 billion is attributed to annual inflation-linked uprating of payments and £1.3 billion to increasing caseloads, particularly for disability and carers' benefits.
Beyond welfare, the SFC warns of 'major and immediate pressures' on the Budget from public sector pay and workforce costs. Many 2025–26 pay deals — including a 4.25% increase for NHS staff and 3.6% for ScotRail workers — exceed the Scottish Government's public sector pay policy cap of 3%. Additional pressure is being created by increased employer National Insurance contributions, which the UK Treasury is only partially funding. The cost to Scotland's devolved workforce is estimated at £535–725 million, while only £339 million in compensation has been provided through the block grant.
The Commission also highlighted risks from unfunded political commitments, such as the permanent removal of peak-time ScotRail fares. Due to take effect from September 2025, the policy was not costed in the 2025–26 Budget but is expected to cost around £40 million a year, with at least £20 million needed this year. Ministers have yet to set out how they will pay for it.
Meanwhile, capital funding — used for infrastructure and investment — is forecast to decline in real terms over the final three years of the outlook. Although it rises to £7.4 billion in 2025–26, partly due to £341 million from ScotWind revenues, real-terms reductions are expected from 2027–28 onwards, with the government's borrowing for capital projects assumed to remain fixed at £300 million a year.
Perhaps the most serious risk identified in the report is a projected reconciliation shortfall of £851 million in 2027–28, related to income tax revenues for 2024–25.
When the Scottish Government sets its Budget, it uses forecasts to estimate income tax revenues. The actual figures are not confirmed until HMRC completes its processing of returns around two years later. If the actual tax collected is lower than forecast, the Budget must be adjusted downward — a process known as a reconciliation adjustment.
The shortfall for 2024–25 has ballooned to £851 million, up from a £701 million estimate in December. The Commission attributes this to the Office for Budget Responsibility revising up its forecasts for earnings growth in the rest of the UK — which increases the Block Grant Adjustment used to calculate Scotland's net tax position — while Scottish income tax revenue projections have remained broadly unchanged.
That mismatch is expected to exceed the Scottish Government's borrowing capacity in 2027–28, meaning even if ministers borrow the maximum permitted, they may still face a funding gap. While Scotland's tax position is forecast to improve again from 2026–27, that depends on Scottish earnings growing faster than in the UK — a scenario the SFC describes as a 'downside risk'.
The report also notes an 'economic performance gap' in the Income Tax net position — the difference between what Scotland actually raises and what it could theoretically raise if earnings and employment matched the UK average. For 2025–26, this gap is £1.06 billion and has widened since the December 2024 forecast.
Total devolved tax revenues are expected to reach £24.7 billion in 2025–26, up slightly from previous projections. The net Income Tax position — the amount added to the Budget once the Block Grant Adjustment is subtracted — remains positive, but has been revised down by around £180 million a year.
The Fiscal Commission cautioned that many of its forecasts may shift again following the UK Government's Spending Review on 11 June, which will set departmental budgets in devolved areas. If more funding is directed towards defence and other reserved matters, Scotland's share of future UK spending may be reduced.
The SFC will publish an update to its forecasts alongside the Scottish Government's delayed Medium-Term Financial Strategy in late June, followed by a full fiscal update in August.