Scottish budget 'should close economic growth gap with UK'

It said the economy north of the Border, while making a return to growth, “continues to lag behind the rest of the UK” in the first six months of 2016.

Read more: Herald View - Brexit’s effect on Scottish economy

The institute publishes a new report on the country’s economic prospects as Mr Mackay is preparing to unveil his Budget on Thursday.

The UK is also gearing up to invoke Article 50 that would begin the two year timetable for Britain’s exit from the European Union.

The think tank, which is based at Strathclyde University, says that Mr Mackay should focus on closing the gap economically with the rest of the UK, although it conceded the SNP government has “little room to manoeuvre”.

To help balance the books, Fraser of Allander predicts that Mr Mackay will stick to current plans not to pass on a rise in the 40p tax threshold for higher earners in Scotland and a council tax increase for top bands.

But he is “likely to resist going much further”, they say. It says that new tax powers recently devolved to Scotland could exacerbate Scottish ministers’ short-term problems.

The Budget will increasingly depend upon the performance of the Scottish economy. But it will be unveiled against a challenging financial backdrop, including a struggling oil industry and the fallout from the Brexit vote.

Scotland’s economy is currently growing only a third as fast as the UK’s, the report warns.

Under the new fiscal framework agreed between Edinburgh and London, the size of the Scottish budget depends on how much Scottish devolved taxes bring in per head compared to their equivalent in the rest of the UK.

Read more: Herald View - Brexit’s effect on Scottish economy

If they grow at the same rate, the Scottish budget will be no better or worse off.

But even small differences in relative tax growth could prove costly for Scottish ministers. For instance, if Scottish tax revenues grow just a third of a percentage point slower per head than in the rest of the UK that would create a £250 million black hole in the Holyrood budget by 2020, the institute calculates.

Graeme Roy, the institute’s director, said: “The Scottish economy has remained relatively resilient in the face of challenging headwinds with growth returning in the second quarter of 2016. Most indicators point to this growth having continued through the remainder of the year.

“But growth in the Scottish economy continues to lag behind the rest of the UK, driven in part but not entirely, by the ongoing challenges in the oil and gas sector. The Finance Secretary will be thinking hard about how best to use his Budget on Thursday to narrow this gap and crucially whether or not to follow the UK Chancellor’s lead with a support to help business and boost productivity.

“But he has little room to manoeuvre. Whilst the Scottish Budget is forecast to rise slightly in real terms next year, as a result of ongoing efforts by the UK Government to tackle ever higher levels of public sector debt, it is still on track to be cut by over 3 per cent in real terms by the end of the Parliament.”

He pointed to manifesto promises on the NHS, childcare and police funding, plus pressures in education that would imply average real-terms cuts of more than 10 per cent by 2020-21 in unprotected areas.

Read more: Herald View - Brexit’s effect on Scottish economy

He added: “He is likely to announce a modest increase in income tax for higher earnings in Scotland next year."

A Scottish Government spokesman said the economy had shown "resilience" despite UK austerity measures and the UK Government's "determination to pursue a hard Brexit."

Meanwhile, Chancellor Philip Hammond has said a transition period will be needed after the UK formally leaves the EU in spring 2019 to avoid economic instability.