Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Mr Carl Emmerson, Institute for Fiscal Studies

  This note draws on the analysis presented by Tom Clark, Christine Frayne and Julian McCrae at the IFS post-Budget briefing on Thursday 18 April 2002. Copies of the slides from these presentations are available at


  1.  The effect of the Budget measures is to increase taxes by £8 billion a year by 2005-06, even if the full cost of the new tax credits for families with and without children are counted as reductions in tax rather than increases in spending. Many of the measures introduced had been pre-announced. The Chancellor's intention to introduce a research and development tax credit for larger firms, reform the taxation of intangible assets and an exemption for gains arising on the sale of substantial shareholdings were confirmed in a press release on 26 March. The proposals for the Child Tax Credit and the Working Tax Credit were originally mooted in the late 1990s. The effect of the measures that were previously announced will cost the Chancellor around £3.5 billion by 2005-06. The measures that were announced in the Budget which had not previously been consulted on were to increase taxes by around £11.5 billion by 2005-06.

  2.  The net increase in taxes from the Budget measures is not being used to reduce public borrowing. Instead it is being used to increase public spending. This is in contrast to the large tax raising Budgets of Summer 1997 and Spring 1993 which had the stated aim of reducing borrowing. By 2005-06 public spending will be £17 billion a year higher as a result of the Budget.

  3.  The net effect of the Budget is to loosen the fiscal stance by £9 billion by 2005-06 relative to what it would have been had the Chancellor not introduced any of the measures contained in the FSBR. This arises from a £8 billion increase in taxes (net of new tax credits) and a £17 billion increase in spending. The Budget has a negligible impact on the fiscal stance in 2003-04 and 2004-05.

  4.  It might seem surprising that this fiscal loosening is possible given the Chancellor's desire to meet his fiscal rules with a particular degree of caution. In part this has been made possible by an increase in projected tax revenues flowing from more optimistic assumptions about economic growth.

  5.  The Budget forecast is that borrowing in 2005-06 will be £5 billion higher than that forecast in the Pre-Budget Report. This is the £9 billion fiscal loosening outlined above, less £5 billion strengthening due to changes in the forecasts for tax revenues and public spending (numbers do not sum perfectly due to rounding). The outstanding increase in borrowing in 2005-06 is consistent with the Chancellor's golden rules since it is being used to pay for an increase in investment spending in that year.

  6.  Of the £5 billion fall in borrowing from changes to the underlying forecasts, £4 billion comes from the fact that the public finances forecasts now assume that the economy will exhibit real economic growth of 2½ per cent a year, rather than the 2¼ per cent previously assumed. At the time of the Pre-Budget Report the Treasury assumed that the economy would grow at 2½ per cent a year but used 2¼ per cent a year for the purposes of its fiscal projections. It now believes there is sufficient evidence that the economy will grow at 2¾ per cent a year but is using a more cautious 2½ per cent a year for its fiscal projections. This means that while the fiscal projections contained in the Budget are based on cautious rather than central assumptions, there has been a reduction in caution in what the Treasury judges as "cautious" and "central" scenarios. Even if the Chancellor had assumed 2¼ per cent trend growth the Treasury forecasts would still suggest that the fiscal rules were going to be met, but that they would be hit far less comfortably on the central case.

  7.  Figure 1 contrasts the projections for Government receipts and spending with that seen since 1991-92. The difference between the two lines is public sector net borrowing. Both taxes and spending are set to rise as a share of national income between 2002-03 and 2005-06. If the forecasts turn-out to be correct then in 2005-06 taxes will be at their highest level since 1988-89 while spending will be at its highest level since 1995-96. Public Sector Net Borrowing will remain historically low, as is required given the planned levels of investment and the Chancellor's stated aim to meet his "golden rule".

  Source: HM Treasury (2002), Financial Statement and Budget Report, April 2002; HM Treasury (2002), Public Finances Databank, February 2002.

  8.  Looking internationally, OECD data for 2000 shows that the UK spent 37.0 per cent of GDP publicly compared to United States 29.9 per cent, Japan 36.6 per cent, Canada 37.7 per cent, Germany 43.3 per cent, Italy 44.4 per cent and France 51 per cent. The unweighted EU average was 43.9 per cent. The increase in public spending between 1999-2000 and 2005-06 is set to be 4 percentage points of GDP. This will leave UK public spending still lower than the 2000 EU unweighted average, and below that spent publicly by France, Germany or Italy.


  1.  As mentioned above the increases in tax announced in the Budget are being used to increase public spending. In particular NHS spending is set to receive real increases in spending averaging 7.4 per cent a year for the next five years. Taken together with the increases seen since April 1999 this will represent the largest sustained period of growth in spending that the NHS has received since its inception.

  2.  Over the next three years total managed expenditure is set to grow by an average 4.3 per cent a year in real terms (6.0 per cent in 2003-04, 3.2 per cent in 2004-05 and 3.6 per cent in 2005-06). This comprises real average annual growth in current spending of 3.8 per cent a year and 15.7 per cent real growth in capital spending. These large increases in capital spending are from a relatively low base and will result in net investment spending in 2005-06 reaching 2.0 per cent of national income. This is the level of investment spending seen in 1992-93, but is higher than all of the rest of the 1980s and 1990s.

  3.  The increase in public spending, excluding the NHS, over the next three years is set to be 3.7 per cent a year on average (5.7 per cent in 2003-04, 2.5 per cent in 2004-05 and 2.9 per cent in 2005-06). This implies that public spending on areas other than the NHS will increase as a share of national income. This overall increase in non-NHS expenditure would allow the Chancellor, if he wanted, to continue increasing education and social security spending at the rate seen since April 1999 and still allow the rest of Government spending to grow at 3.1 per cent a year in real terms over the next three years. This is faster than expected real growth in the economy. The fact that the increase in overall spending in 2003-04 is larger than the increase forecast for 2004-05 and 2005-06 will mean that some departments will find that their settlements will imply greater real growth in spending next year than in the following two years. While the Chancellor may continue to assert that the spending plans are fixed in practice he has tended to add to them in Budgets and Pre-Budget Reports. If this pattern continues then some departments may subsequently receive additional funds in 2004-05 and 2005-06. In any case spending in the latter year may be re-assessed by the 2004 Spending Review. Of course the fact that the Chancellor has previously added to his spending plans may, in part, have been a result of consistently more favourable outcome for receipts than expected—a trend which may not persist into the future.

  4.  The Chancellor has also pledged to continue increasing NHS spending in 2006-07 and 2007-08. These increases will cost an additional 0.7 per cent of GDP, which in current terms is approximately £7 billion. Spending more on any area of public spending will always require either less public spending elsewhere, higher borrowing or higher taxes. This does not mean that the Chancellor will necessarily have to announce future increases in, for example, National Insurance rates, to pay for these NHS increases since it is possible that the existing tax system might simply deliver sufficient funds. For example as long as the economy grows there may be sufficient fiscal drag, and it is quite plausible that some areas of public spending will fall as a share of national income. In any case the errors on planning government revenues and expenditures over such long periods are extremely large.


  1.  The main measures announced by the Budget having a direct effect on personal finances are: increases in national insurance rates, freezing of the personal allowance and the national insurance primary earnings threshold, introduction of the Working Tax Credit and the Child Tax Credit, Increases in the pension tax allowance and a freezing of petrol and alcohol duties.

  2.  The increase in the employees and self-employed national insurance rates by one percentage point is for somebody whose sole source of income is from paid employment exactly like increasing the starting, basic and higher rates of income tax by 1 percentage point. The Chancellor also decided to increase the rate of employer national insurance by 1 percentage point. Given that income tax, employee national insurance and employer national insurance are all taxes on wages, economic theory suggests that in the long run their effect will be the same. This means that the long run effect of the overall increases in national insurance are, for someone whose sole source of income is from paid employment, like increasing the starting, basic and higher rates of income tax by 2 percentage points.

  3.  The Budget also confirmed the structure of the new tax credits. The new tax credits for families with children will cost £2.5 billion from April 2003 and will be indexed in line with earnings. They represent a further extension of means-testing. As a result of these changes the majority of couples with kids will face joint assessment. The Working Tax Credit for childless families costs just £¼ billion since it is a relatively tightly focussed benefit. Many low earners will not be eligible since they either have a more highly paid partner (which applies to many married women), they work part-time (you need to work at least 30 hours a week to qualify), or they are aged under 25. A single person working 30 hours a week on the minimum wage will receive a maximum £29.50 a week, while a single person working 40 hours a week on £5 per hour will have exhausted their entitlement.

  4.  Figure 2 shows the proportional gains and losses from these reforms across the income distribution. The lighter bars assume that the changes to income tax and employees national insurance result in lower take home pay, but that employers national insurance has no effect. The darker bars assume that employers national insurance is fully incident on wages. Both bars show that the effect of the measures is redistribution from the top half of the income distribution to the bottom half of the income distribution. Lower-income individuals gain from the new tax credits and either do not lose, or lose a smaller proportion of their income, from the national insurance changes.

  5.  The bars in figure 2 are shown as a percentage of income. This means that bars at the lower end of the income distribution represent a smaller cash change than those towards the top end of the income distribution. In cash terms, losses outstrip gains since the Budget raised money to pay for increases in public spending.


  1.  The Budget contained several measures which had already been confirmed in the statement on 26 March: a research and development tax credit for large firms; reform the taxation of intangible assets; and an exemption from corporation tax on gains arising from the sale of substantial shareholdings. These measures reduced taxes on businesses by £¾ billion a year by 2004-05.

  2.  The Budget also contained a number of measures that had not been mentioned in any previous consultation document or Pre-Budget Statement. These measures raised taxes on businesses by more than £2 billion a year by 2004-05.

  3.  Several of these measures are related to the introduction of new anti-avoidance measures. It is often sensible for the Government not to consult on these types of measures.

  4.  However, many of the measures were not anti-avoidance measures, for example the £600 million raised by increasing taxes on north-sea oil. Consultation on policies such as the research and development tax credit has allowed the Government to consider the views of various groups. As a result the policy changed substantially between the initial consultation and the final policy design. It is possible that the policies implemented in the Budget could have been improved with a full consultation process.

  5.  The Government has decided to cut the corporation tax rate on companies with profits of less than £10,000 from 10 per cent to 0 per cent. This dramatically increases the incentive that self-employed individuals have to start up their own business with themselves as the sole employee. There is no economic rationale for the tax system to provide such an incentive. The clear risks to the income tax base do not appear to be reflected in the Governments costings.

  6.  The new surcharge on north-sea profits is based on economic theory for taxing a highly profitable sector of the economy. It does however add another layer to an already complex system that includes oil royalties and petroleum revenue duty. This system creates many problems including an odd distinction in the tax treatment of oil fields opened prior to 1982, those opened between 1982 and 1993 and those opened after 1993. The Government should use its consultation on the abolition of royalties to examine more widely the taxation of north sea profits.

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