Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by The Institute of Directors

  Thank you for inviting the Institute of Directors (IoD) to submit written evidence on the Pre-Budget Report. If it would be helpful to the Treasury Committee, we would welcome the opportunity to expand on these themes by providing oral evidence.

  The Institute of Directors is a non-political organisation with some 68,000 members world-wide, 55,000 in the UK, whose aim is to help directors fulfil their leadership responsibilities in creating wealth for the benefit of business and society as a whole. To this end the IoD provides an effective voice to represent the interests of its members to government and opinion formers, and to bring the experience of business leaders to bear on the conduct of public affairs.

  We wish to make the following comments.


  The Pre-Budget Report makes the important point that for the first time since 1974, there has been a significant and simultaneous slowdown of growth in the US, Japan and Europe.

  For most of the post war-period, cyclical downturns were driven by excess inflation and a subsequent tightening in monetary and fiscal policy. The origins of the current downturn lie elsewhere. In the US, the downturn clearly pre-dated 11 September and was driven by excess investment and the piercing of an over inflated stock market bubble. In this sense the new economy is very much like the old economy of the 19th century.

  US stock market valuations remain a matter of concern. The market seems fairly valued only on the basis of either a very low risk premium and/or very high future dividend growth. Any reduction in the risk premium as a result of the collapse of communism, is now countered by the possibility of an even greater risk from rogue states and terrorist organisations. Further geo-political shocks could be very damaging to the world economy.

  We would agree with the reduction in G7 GDP growth—as compared with the 2001 FSBR—shown in the Pre-Budget Report (Table A1: The world economy, p 140). However, we would also point out that whilst the balance of probabilities suggests a relatively short and shallow downturn, the risk of a much deeper and longer downturn is greater than at any time since the 1930s.

  The argument for a short and shallow downturn is based on the stimulus from the swift and sharp reductions in interest rates implemented by the Federal Reserve. The argument for a longer and deeper downturn is based on multiple economic problems, listed below, which may result in the world economy being less responsive to a monetary stimulus—pushing on a string.

  Five areas of global weakness can be identified:

    —  Stock market excess in the US

    —  Savings deficiencies in the US

    —  Systemic failure in Japan

    —  Structural weakness the EU

    —  Sectoral concentration—the glom concentration of recession in sectors such as airlines.

  The IoD remains, optimistic about the world economic outlook, but against the background of such uncertainty, does not believe that further large public expenditure commitments should now be set in stone by the Government.


  Further expenditure commitments-over and above the current CSR—would not provide a counter cyclical stimulus, because of the long delay before the money is actually spent. Nonetheless, the risk is that any such increase in expenditure could become embedded as a "sacred cow". This is problematical for two reasons:

    —  Increased expenditure for public sector monopoly provision in health and education is not the best way to deliver improved public services (see below).

    —  The detrimental long-term impact of higher public expenditure on GDP growth may be far greater than generally perceived.

  A recent report from Politeia (Public rags or private riches. High public spending makes us poor, D. Smith, Politeia January 2001) advances a compelling argument that,

    "Public expenditure in the developed world is too high—far too high in most of Europe, much too high in the UK and only a little too high in the US. Even putting aside the philosophical arguments against high public spending, the economic arguments are conclusive. Public spending at the level now reached in the UK damages the British economy, and even those poorer people who are supposed to be the special beneficiaries of high rates of public spending might well be far better off in a few years time in the more prosperous and successful economy which would be brought about by a sharp reduction in public spending".

  The Politeia report takes econometric estimates by Professor Robert Barro (Determinents of Economic Growth: A cross country empirical study, MIT Press, 1997) showing a negative coefficient for the public consumption/GDP ratio. Using the change in the public spending ratio between 1960 and 1998 the Politeia report then estimates the impact on economic growth of the increase in public spending over the period. The results show that over the past 40 years the negative impact of public expenditure on GDP has been immense. If the share of public expenditure in GDP in the UK had been held at its 1960 level, national output would have been 54 per cent higher in 2000.

  This study—as does the Barro research—acknowledges that there are quite high return to increased public spending when it is starting from a low base, without the imposition of the rule of law, or adequate health and education. However, in the advanced economies the situation is entirely different and is more likely to be characterised by diminishing marginal returns. The Politeia report argues that increases in public expenditure produce a smaller rise in GDP ie public expenditure tends to crowd-out private expenditure.

  There are sceptics at the IMF as well. A number of IMF studies have addressed the issue of what is the optimal size for the state. Tanzi and Schuknecht (The Growth of Government and the Reform of the State in Industrial Countries, IMF Working paper 95/130, V Tanzi and L Schuknecht, 1995) argue that the social indicators improved over the 1870-1960 period when the welfare state was in its infancy. Over recent decades they state that,

    "The expansion of public expenditure and of the welfare state during the last three decades has yielded limited gains in terms of social objectives while possibly damaging the countries economic performance. Today, countries with small governments and the newly industrialising countries show similar levels of social indicators but these are achieved with lower expenditure, lower taxes and higher growth than countries with big governments".

  As a result, the IMF paper asserts that drastically lower levels of public spending could be achieved, with the possibility that it need not account for more than 30 per cent of GDP.


  The IoD has consistently argued for the introduction of a Third Fiscal Rule—a medium/long term commitment to reduce the tax burden as a proportion of GDP. The IoD believes that the Chancellor's two fiscal rules are insufficient to restrain growth in public expenditure in the long term. It is possible to argue that satisfaction of the Golden Rule—which requires balance in the current budget over the course of the economic cycle—should alleviate this upward pressure, but the IoD is less confident.

  Satisfying the Golden Rule could still mean that taxation and public expenditure rise significantly. This propensity for tax and spend is a matter of great concern. There needs to be a more binding constraint on expenditure if upward pressures on taxation are to be avoided.

  The Third Fiscal Rule can still be reconciled with improved public services, by providing people with the incentive to make a greater private contribution towards the cost of health & education.

  Over the 1997-2001 period we experienced a significant rise in the tax burden attributable to "covert" increases in taxation. We are now faced with the possibility of "overt" increases further raising the tax burden.


  A rising tax burden will undermine economic incentives and individual effort. Fiscal drag-indexing personal allowances by inflation and not earnings growth, will draw in around 200,000 people into the higher rate tax band this year—is drawing more people into the higher rate tax band.

  This threat to incentives could become even more damaging if the Chancellor were to abolish the upper earnings limit on national insurance contribution. This could lead to a marginal tax rate of 50 per cent on higher earners—hardly an encouragement to enterprise. Half of income tax revenue already comes from the top 10 per cent of earners.


  The central focus of political and economic debate, in the wake of the Pre-Budget Report, has been health expenditure and the interim Wanless Report.

  The IoD disagrees with the "open & shut case" approach taken by the Chancellor in his Pre-Budget Report summary of the Wanless Report to the House of Commons. We are not convinced that the Wanless review has, thus far, considered all possible models of health care.

  In two recent reports (Choice, Choice, Choice, Graeme Leach, IoD Policy Paper, December 1999 and Healthcare in the UK: the need for reform, Ruth Lea, IoD Policy Paper, February 2000) the IoD has examined the funding and provision of health care and education in the UK. The central message of these two reports is that whilst there is a case for spending more of our national (GDP on health and education, any increase would be best funded by the private and not the public sector.

  The IoD argues that the best way to deliver improved health care is to encourage greater private sector involvement—the UK alone is attempting to fund health expenditure solely through taxation.

  The IoD's health passport model would overcome the "all or nothing" choice people face at present. If the Government provided as a credit the equivalent cost of providing these services in the public sector, then people would be for better able to afford the necessary top-up. Importantly, the cost of privately insuring for the top-up would be less than that for meeting the full cost. This could increase the share of health expenditure in GDP, improve the quality of service and cap public expenditure at the same time. Comprehensive health care would remain free at the point of use, for those who wanted to continue to receive treatment through the NHS.

  Whilst the dead-weight cost to the public sector, in the short term of providing the top-up to people already using the private sector, needs to be acknowledged, we feel strongly that such sums would be outweighed in the medium and long term by the dynamic economic benefits attained by liberalising the private health sector.

  There is a risk in focussing on the efficiency of health care as measured by expenditure to GDP ratios alone. Two indicators highlight very serious concerns as to the efficiency of the NHS:

    —  Health outcomes—Since 1960 NHS spending—in real terms—has doubled as a proportion of GDP, over a period when GDP has more than doubled as well. Can we really claim there has been a fourfold improvement in the NHS? The WHO ranks the UK 18th in the world on health system performance. Crude indicators of life expectancy show the UK was ranked 5th and 8th in terms of life expectancy for females and males in 1960, but by 1997 its rank had slipped to 16th and 11th. OECD health outcomes data show the years lost to heart and respiratory disease in the UK are far higher than in other advanced economies. More specific indicators, such as the new NHS Trust league tables highlight huge differences in performance between the best and worst hospitals. The tables explode the myth that social deprivation excused poor performance when hospitals with similar catchment areas produced vastly different scores.

    —  Fraud & mismanagement—Recent press reports (20th November 2001) suggest that up to 20 per cent of the NHS budget could be "wasted" as a result of poor management, fraud, blocked beds, hospital related infections and other areas of mismanagement. This seems an excessive estimate but surely warrants investigation.

5 December 2001

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