Jim Gallagher and Jeremy Peat : Spending: It's all a question of balance

Public spending can go down as well as up. Every year since we've had a Scottish Parliament, the problem has been where and how to spend more. Now big reductions have to be managed - exactly how big, we'll learn later this month. Scotland's politicians face their biggest challenge since devolution, especially hard when an election looms.

That's why the David Hume Institute and the Scottish Policy Innovation Forum have brought together a group of experts to look at and publish the options. Their analysis makes sobering reading.

There's no simple, single solution to rebalancing Scotland's public finances. The objective must be the right package - silver buckshot rather than silver bullet: a mixture of efficiency gains, service reductions, revenue and charging increases and, for the long term, structural changes. Each will be unpopular with someone and there's a temptation to rule some out - but the more are ruled out, the bigger the pressure on what's left.

Our experts, some of whom will be expanding on their ideas in these pages over the next three days, make this clear. Professor Anton Muscatelli puts this in the context of the worldwide recession, which accentuated the heavy borrowing problems already building in the UK. As he and Professor David Bell say, there's argument about the precise cause, and pace of retrenchment. But there is no disagreement: major reductions are needed.

The problems are not short term. The public finances have been running on unrealistic assumptions about the productive capacity of the economy. We've been spending fairy gold, and it's caught up with us. Deficit reduction is a long-term issue, and will continue for years. Some serious people have already been looking at this. Andrew Goudie, Chief Economic Adviser at the Scottish Government, set out starkly how much spending might go down. The Scottish Government-commissioned Independent Budget Review (IBR) has opened up the options. Our authors agree with much of this analysis and build on this work.

Prominent in this debate is Bob Black, the Auditor General. He estimates spending has grown at 5 per cent in real terms annually since devolution. We've entered into binding commitments of more than 3 billion a year, and increased free universal services, some available only in Scotland, costing nearly 1bn a year. And all at a time when an ageing population and other pressures drive costs up.

Several of our experts criticise the record of efficiency gains in Scottish public services.There's not the right data for meaningful targets, and cost reduction through improved efficiency has, with notable exceptions, been poor. Recently the David Hume Institute looked closely at efficiency gains based upon positive experience in Scottish Water. This might offer a starting point for real progress elsewhere in the public sector.

An early and rigorous programme of efficiency that releases real cash savings is clearly essential, and our authors - especially Professor Eddie Frizzell and David Hume of Borders Council - have interesting thing say about how to make them.

Better measures of efficiency are clearly needed, but so are positive plans for change. That's a job for public-sector managers -our politicians need to give them the space to do so.

It will be important to learn from others. Scottish companies have been through highly painful cost reductions since recession struck. They can teach positive - and negative - lessons. Our work includes a valuable paper from IBM on their experience, and what it can offer the Scottish public sector.

But efficiency alone will not be enough: as the Independent Budget Review emphasised, the full range of options has to be examined. What are they ?

Scotland has scope to raise revenues. John Aldridge, however, points out that politicians all but rule out using the Scottish Variable Rate of income tax. The council tax is much debated, though revenue from lifting the freeze on it would not necessarily benefit council services.

Like the IBR, our work looks at raising revenue by charging for services presently free. David Bell rigorously examines the universality versus selectivity debate. Many "free" services are seen as entitlements, and opening up means-testing would provoke highly-charged debate. Nevertheless we have to look at what makes sense in tough times. And, as Professor Richard Kerley says, why not look more widely? What about road charging, or even components of NHS spend?

There will be particular pressures in higher education. Our existing regime now looks unsustainable. Universities and government are beginning to look at this. At this stage the important thing is not to be rushed by political imperatives into ruling options out.

Cuts cannot be avoided, and that means painful choices. Should health be protected? Is that a rational rather than purely emotional approach? The health budget faces heavy pressures from demand, especially ageing, and cost increases. But there are options: care for the elderly out of hospital - perhaps with personal budgets - would fall to council, not NHS, spending. How should the balance of cuts reflect this and other factors?

Pay and pensions dominate spend on public services. Governments have restrained pay, and changes to pensions are now proposed, although neither as sharply as in Ireland.What happens next? Should Scotland stay within UK deals or stand alone in some areas? The present pattern displays no logic, and we have no evidence of which is better, though few pay deals have delivered efficiency or cost reductions.

In the package of measures needed some will yield benefits more quickly than others. Early progress on cost-reducing efficiency gains and revenue-raising could help take the strain at the start. Service cuts may take longer, and so would structural change.

The IBR team suggested looking at the status of Scottish Water. No quick fix is feasible, but given the long-term problem a change in its structure or financing must merit urgent consideration.

Faced with these challenges, the political mind turns to thoughts of reorganisation. The Scottish public sector has grown, not been designed: surely it could be streamlined? But as Richard Kerley reminds us, reorganising is expensive, and most cost is not in oversight and governance but in the services themselves.

Nevertheless, there is scope for change. Present structures have not created the environment for continuing efficiency improvements. The Scottish Parliament itself is funded almost wholly by Westminster grant, so perhaps the emphasis for the last ten years on spending, not cutting cost, is not surprising. That may change as the UK government implements the Calman recommendations.

Structural change in the public sector could simplify the landscape, and face up to the long ignored question of the role of local government in a devolved Scotland. More important for our purposes, it could help change the culture of public bodies, a point made by Eddie Frizzell's work.

This is a different era and that must be reflected across all the public sector, especially in thinking about continuing cost reduction. This is a job for managers, though even strong managers need reliable data and the appropriate incentives. There is a hard message for politicians here. Their job is to set change in motion, and then step back - intervening only when things go seriously off track.

In all these changes, government must watch the economic impact. That may be proportionally greater in a highly public sector-dependent Scottish economy. Capital spend could be hit particularly hard - bad news for the construction sector, and infrastructure cuts risk damaging Scotland's competitive position, critical for economic growth.

There is no easy answer to any of this, but a balanced package will include real efficiency gains, essential from the start; more revenue; planned reductions in service; and, for the long run, structural improvements. Transparency will help in putting this together: analysis cannot all be within government. Being open will help secure consensus around hard choices.

Our authors make no claim to definitive answers, but to add to the debate. Final choices will be for parliament.That's as it should be and it would be better for politicians to concentrate on the decisions and not play political games.

• Jim Gallagher is a Gwylim Gibbon Fellow at Nuffield College Oxford, a former 10 Downing Street adviser and former head of the Scottish Justice Department. Prof Jeremy Peat is director of the David Hume Institute and former group chief economist at the Royal Bank of Scotland. The papers are published with support from IBM