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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 389-i House of COMMONS MINUTES OF EVIDENCE TAKEN BEFORE TREASURY COMMITTEE
Monday 26 March 2007 MR ROBERT CHOTE, PROFESSOR DAVID MILES, DR MARTIN WEALE and MS BRIDGE ROSEWELL
MR JOHN WHITING, DR MARTIN WEALE, PROFESSOR COLIN TALBOT and MR ROBERT CHOTE Evidence heard in Public Questions 1 - 109
USE OF THE TRANSCRIPT
Oral Evidence Taken before the Treasury Committee on Monday 26 March 2007 Members present John McFall, in the Chair Mr Colin Breed Angela Eagle Mr Michael Fallon Mr David Gauke Ms Sally Keeble Mr Andrew Love Kerry McCarthy John Thurso Peter Viggers ________________ Examination of Witnesses
Witnesses: Mr Robert Chote, Institute for Fiscal Studies, Professor David Miles, Morgan Stanley, Ms Bridget Rosewell, Volterra Consulting, and Dr Martin Weale, National Institute of Economic & Social Research, gave evidence. Q1 Chairman: Good afternoon and welcome now that we have everyone here and, Dr Weale, you are in your seat with the rest of them. Thank you very much for your attendance. Can I start off by referring to the evidence which Lord George gave us at our Committee last week when he said that the MPC encouraged a consumer boom leading to high house prices and levels of debt, but he did say that was a matter for his successor to sort out. Is that an accurate characterisation of monetary policy over the last ten years? Could the MPC have done more in that area? Professor Miles: I think one part of that statement I would slightly take issue with, which is the notion that there has been a very powerful consumer boom over the last ten years. My reading of the data would suggest that the rate of growth of consumer spending on average over the last ten years is really not very different from the average over the last 30 or 40 years. Q2 Chairman: Can I quote Lord George said that he knew that they had to stimulate consumer spending and that they pushed it up to levels that could not possibly be sustained in the medium and longer term and if they had not done that we would have gone into recession. Professor Miles: Over the whole period and, indeed, over the last five years consumer spending growth has not been unusually strong. The savings rate has come down to some extent and it is slightly beneath the long run average. Clearly where he is right is that house prices have increased enormously and over that ten year period the average price of a house in the UK has gone up three-fold, it is three times higher than it was ten years ago, that bit is certainly right, but it is very difficult for the MPC, who are given the job of trying to keep inflation close to the target, at the same time, using the same single weapon that they have, which is interest rates, to try and control house prices. Ms Rosewell: I would say as well the MPC consistently said over that whole period that they were not targeting asset prices, they were targeting consumer prices, and that is what they succeeded in doing. I would agree with David that although there have been things happening in the housing market, some of that is structural and it has got nothing to do with the management of monetary policy. Dr Weale: I think the United Kingdom has a chronic tendency to hide consumption, at least compared with our neighbours, and that seems to me the reason why interest rates in the UK seem to be higher than those in the euro area. The process that Lord George was describing has to be seen in that context. It is a problem that the UK has had for certainly more than the last ten years, and I would agree completely with David that it is of concern to me, but two policy instruments are needed if you want to achieve two policy targets. If you want to control inflation and you want to have consumption staying at a reasonable level or, to put it another way round, saving at the level you think it ought to be then the Government has to think of using fiscal policy to achieve that in addition to asking the Bank of England to control the inflation rate. Ms Rosewell: Beyond that it is even more complicated, is it not, because it is not as if these things are independent of one another, so you cannot say, "Here is monetary policy, inflation, and here is fiscal policy dealing with the real economy" because there are going to be feedbacks between those two. That old assignment rule that we all used to believe in I think has rather fallen out of favour. Dr Weale: That is why some people had doubts about independence for the Bank of England. Q3 Chairman: That is another inquiry for us. In terms of inflation, do you think that the recent increase in inflation has been due to short-term factors or are there signs of an increase in underlying inflationary pressure in the economy? Ms Rosewell: There are two elements of underlying inflationary pressure, though neither of these are out of control, as it were. One of those is the increased energy costs. They have gone up and they have come down a bit but I do not think we are going back into the $20 barrel a mark any time over the next five years or so because of the increased demand generally across the piece and, indeed, supply constraints. Secondly, and in a way it is related, one of the reasons for lower inflation in the UK has been low import prices and those low import prices are in turn the result of being able to import manufactureds at cheaper rates from newly globalising countries at lower costs but the increase in commodity prices and the increases in their costs will moderate that effect as we go forward, both because there comes a limit to the extension of that effect but also because their own costs start to stabilise as well or, indeed, rise. Both of those suggest to me that there is some underlying pressures but they are not massive as yet. Dr Weale: Chairman, I do think that the Treasury is taking an excessively optimistic view. On page 27 they talk about how what they call core inflation has not picked up in the way that headline inflation did, or at least is still at a respectable level. Had they listened to a speech that Charlie Bean, the Chief Economist at the Bank of England, made, I think it was last year, he observed that what has been keeping core inflation down, the expansion of the Chinese economy, is one of the factors that has been driving up things like the oil price, commodity prices and so on that are excluded from the core measure. If you look at the core measure as the Government is suggesting we would then you are cutting out the areas where the price pressure has come, so I have my concerns about inflation. I would not like to say that it is bound to take off but I do think the Treasury is taking an excessively optimistic view. Q4 Chairman: I think Roger Bootle in his submission to us was talking about inflation and said that he would not be surprised if it was at 1.7% by the end of the year. Would you share that view? Professor Miles: I think it is pretty likely that inflation will come back down quite sharply and maybe even go beneath the Bank of England's target relatively soon now because we are pretty clear that some elements in the price index are going to fall: energy companies, gas companies and electricity companies have announced some price cuts. It does seem to me that inflation is likely to move back down. What we have not seen and what would worry the MPC is wage settlements having moved up quite sharply as the actual inflation rate has moved up and that does not seem to be happening yet. I am fairly optimistic, certainly like Roger Bootle, on the inflation outlook. Q5 Angela Eagle: The growth forecast: the IMF 2.9, the average of independent forecasters up to 2.6, the Bank of 3.1, the Treasury somewhere between 2.75 and 3.75. What is your view of what is likely to be happening with growth? How reasonable is that? It is the largest in the G7. Ms Rosewell: If you look at all the indicators for real performance they are all looking very benign whether you look at employment, the output indicators, consumer indicators or investment. Anything can happen in forecasting, of course, as the Governor of the Bank of England is always reminding us, and I agree with him, but, on the other hand, if you looked at the indicators and said, "Is that a reasonable range to be in?" I think it is very hard to disprove that, which is why there is a very close range on the consensus forecasts. Q6 Angela Eagle: Professor Miles, you seem slightly more pessimistic than the herd. Why? Professor Miles: Slightly more so. There are a few reasons. Firstly, I do not think we have yet seen much of the impact of even the last three interest rate increases last August, November and January. I do not think that has had much of an impact yet on households partly because so many mortgages in recent years have been fixed rate mortgages so it has not fed through to people's mortgage payments as much as it will do over the next year or so. I suspect that will have rather more of an impact than perhaps the Treasury forecast would imply and, therefore, consumer spending will be a bit weaker and the Treasury's forecast to my mind is slightly on the optimistic side, but it clearly is not far away from the consensus at the moment and it is in no sense a ridiculously optimistic forecast. Q7 Angela Eagle: Do you think that the changes in corporation tax and the simplifications on the business tax side are likely to help growth? Dr Weale: I would have thought not very much. They are not very big changes and I would not expect them to be the sort of thing that one could unravel. It is true that business investment, at least measured in volume terms, has been doing well. That may be slightly a casualty from the changes that have taken place to allowances. On the other hand, we may see the lower headline rate stimulating business activity in the country, but all told for small changes you would not expect to be able to say they were going to have much of an impact. Q8 Angela Eagle: Is that everyone's opinion? Ms Rosewell: The other thing you have to bear in mind is that it is a headline reduction for large companies but a headline increase for smaller companies and how that pans out across the willingness to invest or what the investment allowances means to small businesses I do not think any of us, or any of them at any rate, know. It is really hard to call at the moment. Q9 Angela Eagle: In general this move to simplifying thresholds and rates both on the personal taxation side and the business taxation side, is that generally a good thing? Most people would have thought that simplifying tax and threshold rates was a good thing and perhaps over time likely to lead to higher tendencies for growth. Any views on that, or are we all in favour of even more complex systems? Ms Rosewell: Simplification which sticks is generally a good thing, in other words if it makes a system predictable and sure for people then on the whole they know where they stand and if you are investing you know where it is going to pan out and you get used to a particular system. Simplification which goes in different directions every few years does not help at all because nobody knows how to plan on that basis. So you introduce a lower rate of tax, then a higher rate of tax and you change it around, it may look simple at the time when you say it but if people do not believe it is going to stay then I do not think it is simple at all. Dr Weale: I do not think we will see the experimentation with tax rates for small companies that we have had over the last five years or so. I am in favour of tax simplicity rather than having lots of tax allowances. The next question which it is hinted at may be addressed is whether we would be better off having a lower tax rate but ending the deductibility of interest payments. That is a much more substantial issue and it is where a simple arrangement would take you. A major disadvantage of a complicated system is that people devote resources trying to exploit the boundaries and to put themselves on the favourable side of the boundary, so if you have a simple system the resources that are devoted to that can be used productively instead and that ought to be a help. Q10 Angela Eagle: In the labour market, Bridget Rosewell, you said that some indicators, including that one, were benign. What do people think is going on in the labour market? There has obviously been a slight slackening and at the same time employment is going up with unemployment coming down but, again, we have got this situation with a porous labour market of not quite knowing what is going on with migration. Any views about what you think is really going on in the labour market? Professor Miles: As you say it is a difficult one to figure out because one of the most important factors is extremely hard to measure: how many people have come into the country actively looking for work. I think the one thing that we can say is despite inflation having moved up and measured unemployment having moved down in recent months there has been very little acceleration in wage settlements. That would suggest that there remains a degree of slack in the labour market, which is unusual given the relatively low level of unemployment and increases in the number of people employed. Q11 Angela Eagle: Again, this has been a feature of the UK labour market since some of these demand-side issues and the active labour market was introduced. That does not seem to be wearing off, does it? Professor Miles: You are absolutely right. I think it has been surprising over a long period how unemployment on average has gradually moved down in the UK and yet there has been very little increase in wage inflation. Angela Eagle: Everyone has admitted that nobody really quite knows what is going on with migration figures. The ONS has recently started some work to try to scope out better ways of measuring it. Have any of you got any comments on how that is progressing? It has been up on their website. Any thoughts about that? The IMF clearly sees issues with migration as a potential downside in the UK labour market. Q12 Chairman: Can you give us a very short answer to that because I want to move on. Ms Rosewell: It is going to be a very difficult thing to do essentially. No matter how much the ONS puts up on its website actually finding people, surveying them, discovering whether they are staying or not is just fundamentally hard. Q13 Angela Eagle: You are not very optimistic that they will get good measurements? Ms Rosewell: I am not optimistic, no. Q14 Peter Viggers: Turning to the Treasury forecast for Gross Domestic Product, do you think that the Treasury forecast is reasonable for the coming year? Dr Weale: Could I say for the current year I think the forecast is reasonable. Next year I expect a slightly lower growth rate, just under 2.5% compared with the Treasury's figure of 2.5-3%, but, as one always has to say, those differences can easily be the revision between one estimate and another. I think the overall position that the Treasury is taking is perfectly reasonable. Q15 Peter Viggers: Ms Rosewell, you have drawn our attention in a paper you have given to us to the extraordinary and inexorable rise in public sector employment in the last ten years or so going from something like seven to nine million. Is there a relationship between the growth in public sector employment and Gross Domestic Product? Is the growth in public sector employment sustainable and is there a relationship with GDP? Ms Rosewell: I used employment precisely because I am not sure about the measurement of GDP in these areas. One of the things that worries me rather a lot is that we focus on these GDP numbers and, indeed, the productivity associated with them, when having a good handle on what the real output is is extremely difficult and, indeed, measured rather differently in different countries even when they say they are doing the same thing. To me that says let us look at where people work where we have still got some uncertainties around those numbers but at least we have got fewer uncertainties around those numbers than we have over the estimates of output. When you begin to think of the outputs of the service sector in general and the public sector in particular then it depends hugely on what measurement mechanisms you are using. As I am sure you know, Professor Atkinson has spent a year looking at measurements of output in the public sector and, to paraphrase perhaps a little brutally, basically the conclusion is more research needed. On that basis I do not think we know the answer to the question you are asking. Maybe it would be a very good thing if we did but I do not think we do. Q16 Peter Viggers: Professor Miles, you have indicated a little more pessimism about the forecast for GDP growth than some others. Can you perhaps explain why and where you think the major risks lie? Professor Miles: It is primarily a view on what might happen to consumer spending on the back of interest rate increases which I do not think have yet fed through and starting from a position with a relatively low savings rates amongst households. A combination of starting with a low savings rate, real disposable income growing at relatively low rates because of past announced tax increases meaning that disposable income will not grow very rapidly, that combination of events would mean that consumer spending might grow a little bit less than the Treasury's central forecast and that is really the logic behind my feeling that it is a rather slightly optimistic view on growth over the next year or so. Q17 Mr Breed: Just turning to the US and EU, do you think that the Treasury have taken into consideration sufficiently the extent to which the risks of the US economy might affect the outlook for UK growth and inflation? In particular, do you think the problems of the sub-prime market in the US might come to visit us here as well? Ms Rosewell: Just looking at the housing market for a moment, clearly there has been a great extension of sub-prime activity in the UK market but if you look at the scale in comparison with the US it is not as extensive. The sorts of over 100% mortgages which have been increasingly common in the US have not got much of a foothold here. If anything, those sorts of offers are just beginning. There are a lot of new entrants into those markets at the moment but I think they may well have left it too late in the sense that the --- Q18 Mr Breed: Do you mean new entrants here? Ms Rosewell: Into the UK market trying to offer those sorts of sub-prime markets and, indeed, driving down the rates on some of that offer quite considerably. Equally, they are finding it extremely difficult to sell on those products. Mostly they come in, they offer the mortgages, they get the mortgages and then they securitise them, they do not have a balance sheet which supports those. They are finding it extremely difficult to securitise those in the current market and with what is happening in the States. My suspicion is that we may have escaped at least the worst of it, which is not to say that there is not a potential problem but not on the same scale. Q19 Mr Breed: So if they cannot securitise they have to hold them on their own balance sheet. Ms Rosewell: And then they have very small balance sheets so they cannot offer any more or they have to do so at a better rate. Q20 Mr Breed: So it will dry up? Ms Rosewell: It dries up, exactly. Q21 Mr Breed: Would everybody agree with that? Dr Weale: I think the Treasury view of the world economy is a perfectly reasonable one. Obviously things could turn out worse than they hope in the United States but I do not see what is happening in the United States at the moment to be the sort of thing that would be likely to cause a recession. It is going to lead to some people losing their money, and no doubt they will make a noise about that, but that is not the same thing as a recession of course. Q22 Mr Breed: What about Europe, can that compensate for any slowing down in the US economy, especially given the rather temporary slowdown in domestic demand in Germany and Italy in the first half of this year? Is that going to have a major effect? Is it going to balance out anything which we might see in the US? Ms Rosewell: I do not imagine that it is going to accelerate again fast enough to balance anything out. As soon as there is a move in that direction the European Central Bank seems to be very much on top of it and raising interest rates whenever it gets a chance. I would suspect that although there might be some compensation it is not going to be very marked. Dr Weale: Could I just make the point that, of course, the euro area is much more important to the United Kingdom than the United States is, so although I expect the euro area to be a bit slower this year and next year than it was last year, the fact that its situation has improved compared with the middle of the decade is something that is helping our economy. Q23 Mr Breed: Looking at them together it is relatively benign then. Dr Weale: I would say so, yes. Q24 Mr Fallon: The Chancellor says the economy is in good shape and he expects growth to be higher than he originally thought. Why then is his borrowing greater than he thought and his fiscal position worse? Mr Chote: The main reason why there has been a modest deterioration in the outlook between the PBR and now is once again, as we had in the PBR, down to a downward revision to expectations of North Sea oil revenues, which is a combination of the impact of investment and production trends in the exchange rate there. So it is basically a revenue story on North Sea oil, which was what we had at the PBR, so they have adjusted in the direction of addressing those issues at the PBR but clearly not enough in their view now. Q25 Mr Fallon: Does anybody think that there is any element of this that is not attributable to the collapse in North Sea oil revenues? Dr Weale: Without saying that, could I make the point that for several years the Treasury has had optimistic expectations of tax revenues. My view is that looking three or four years ahead they still have optimistic estimates of tax revenues. That does not mean that the budgetary position is unsustainable because fiscal drag is quite a powerful tool, but it does mean that I expect the current account to move into surplus perhaps a year later than the Treasury does. Q26 Mr Fallon: Robert Chote, in your Green Budget you point out that of the 22 OECD countries, 15 have reduced their debt over the last ten year period and 17 have improved their structural budget balances, but the Chancellor, on the other hand, says, "No other major economy" meets his rules today. How do we square these two statements? Mr Chote: It is probably largely down to the Chancellor's definition of "major economies". He tends to compare to the other G7 economies, so on debt to GDP comparison we tend to look relatively low in debt to GDP compared to the other G7 but not to another chunk of the OECD countries, particularly Scandinavia, New Zealand, Australia, et cetera, where in some of those countries they have taken the explicit decision that they want to virtually eliminate their public sector net debt, in part because they see the costs of ageing populations coming up and they would rather limit the future tax increase implied by meeting those costs, so they do what they describe as pre-funding and therefore aim for a more conservative position on the debt balance. The main comparison there is that Mr Brown compares it to the G7 and they tend to have larger debts than we do. Q27 Mr Fallon: Given that we have a very large economy, is that not the more relevant comparison? Mr Chote: It depends on what sorts of challenges these economies are facing. In terms of their impact on the total amount of borrowing that has to go on in the global capital market then the larger ones are the more relevant ones, but whether it is conceivable that some smaller countries might be more nimble and able to adjust to future policy difficulties than larger ones I do not think should be discounted entirely. Q28 Mr Gauke: We have got confirmation, if you like, of a slowdown in the growth of public spending announced in the Budget. How realistic do you think the spending target, the spending plan, that the Chancellor announced is? Mr Chote: The 2% increase that he has pencilled in is about half what we saw under what you might call the years of plenty since 1999. It is a lot less severe than the squeeze that was seen during Labour's first two or three years in power although it was helped then by falling debt interest and unemployment costs. If you were to compare it to the Conservative era then 2% is higher than the 1.5% increase in real public spending over the Conservative era. That was as low as that in part because capital spending fell under the Conservatives. If you compare current spending projected over the CSR period with what happened under the Conservatives it is slightly stronger but not by a huge amount. Historically it is not achievable in that sense. If you look at what it implies, given the settlements that have already been made in some areas and reasonable expectations of things that might be less in the Government's control, it is clearly implying a squeeze for those areas that were the big winners during the years of plenty, namely health, education and tax credit expenditure. We know education is going to be going significantly slower than it was during the years of plenty. We do not know whether the Chancellor will be leaving enough money aside effectively to pay for the child poverty target to be met and even if he did not do that you would still be talking about a squeeze on health, so then it is down fundamentally to are you happy with the quality of public services and the progress you can make on poverty reduction given the envelope of money that you have. If not, you have to find more money. Ms Rosewell: What it sounds like from the Comprehensive Spending Review announcement is that there is going to be a staged series of conclusions coming out of that. It is only when we see the first pain, if you like, that we will know whether it is likely that these targets can indeed be reached. To say that they are not out of line with what has been achieved in the past is not quite the same thing as saying are they going to be achieved or is there the ability of the system to deliver that much slower growth rate at any rate than has been seen in the past. Q29 Mr Gauke: We will come back to the specific departments in part two. I was going to ask Martin Weale whether you want to be brave enough to speculate. Dr Weale: Thinking back ten years I then had grave doubts that the spending plans would be met because if you looked at what happened in the previous years, at least I thought it was quite impossible and what I thought impossible happened, so I must say I think if the Government seriously sets its mind to it then it will be able to achieve these spending targets despite the fact that some people are obviously going to be disappointed. Q30 Mr Gauke: Does anyone want to speculate as to a particular area where there could be an overshoot? We have had the Olympics in the last few weeks where that seems to have more than trebled. Does anyone else want to name another Olympics? Fine. Can I just move on to public sector investment. Departments like the Department for Education and Skills and the Department of Health continue to struggle to meet their investment plans. Is there any particular reason for this? Ms Rosewell: I do not have that information. Mr Chote: I think this is one of those areas where, as we have discussed at these meetings before, the Government has taken a lot longer than it expected to be able to bring about the acceleration of investment for which it has budgeted. In some cases I think we have collectively or separately speculated that maybe it is something to do with the hoops that departments have to go through to verify whether projects need to be done with PFI or not. I think it remains relatively unexplained as to why this investment increase has taken much longer to deliver than was originally intended, although it is improving or has been closer in recent years than it was a few years ago. Dr Weale: The Government is, of course, wanting to raise the public investment ratio to 2.25% of GDP and if it achieves that then it will have to run a surplus on the current Budget in order to meet the debt rule in the medium term, which it no doubt can do if it wants but it does have implications for current spending within the constraint of the overall debt rule. Q31 Mr Gauke: Do you think there is an argument that to some extent the Government might be relying on not being able to invest as quickly as it plans to do in order to meet its fiscal rules? Dr Weale: One could think that, yes. Actually if we look at the debt target rule in the Budget Statement it is shown as going up to 38.9% of GDP and it is very easy to imagine, because it happens all the time, the sort of surprise that could take it above 40%. Being even a quarter of a percentage point low on investment is a help or at least reduces the risk. Mr Gauke: Does anybody else have anything to add on that? Thank you. Q32 Peter Viggers: The Chancellor of the Exchequer has referred to proposed asset sales of some £36 billion. Is this realistic? Do you have any further information or speculation from where the assets will be sold? We have heard that it will include the sale of spectrum, a £6 billion sale of the student loan book and further sales. Do you have further information on that? Ms Rosewell: I do not. Mr Chote: Not beyond that, no. Q33 Peter Viggers: Is the acquisition of some £36 billion a reasonable forecast in your opinion? Dr Weale: I am afraid I do not know. Mr Chote: I guess there must be uncertainty as to what price they will get for the student loan book and for the spectrum, so I am sure there are uncertainties around that but I have no reason to believe that it is a figure biased in one direction or another. Q34 Peter Viggers: To ask a very unsophisticated question: the Treasury does not distinguish between capital and income, does it concern you as economists that the Government is selling capital assets of some £36 billion transferring them from the public to the private sector and then regarding the resultant cash as income? Dr Weale: In calculating the Government current balance asset sales are not taken into account, so in that sense there is a distinction between capital and income. The Government would not be able to say, "We have met the golden rule by selling £36 billion of public sector assets", the position is much clearer than it used to be in that respect. Obviously there is a question of whether the Government gets a good price for them. One can think of it as using the benefits of the sales to retire some national debt and you want to look risk adjusted at the return on the assets sold relative to the cost of the national debt in order to ascertain whether it is a good deal for the taxpayer. Q35 John Thurso: We have received evidence over the last couple of years which suggests that the golden rule should be made more forward looking and not rely so much on the dating of the economic cycle. Do you agree with that? When would be the most appropriate time to make such a change to the golden rule? Mr Chote: I think it would be a very good idea to do that, and I have suggested that here before. There is, as it were, a political as much as any other sort of window of opportunity to do that in the next year or so, partly because Mr Brown will be in a position when we get the next set of public finance numbers presumably, albeit with some caution, to declare victory over the cycle that is just coming to an end. Connoisseurs of goal post moving may roll their eyes at that and not be convinced but that does not mean that it is not time for declaring victory on the Government's basis. Clearly a new Chancellor might have some scope to do that and obviously it would be implausible to suggest that any new Chancellor would be in a position to repudiate what had come before, but moving to those sorts of reforms of the golden rule could be sold and presented legitimately as learning some of the lessons from the success of the Monetary Policy Framework in which there is a more forward looking approach and there is more explicit discussion of the uncertainties around the variable that you are trying to target. You might then also need to think, as we have discussed here before, about the issue of whether you can introduce any greater independence into the process, for example forecasting government revenues. As we come to the end of a cycle, if that is a meaningful concept at all, and the end of a political era now may be as good a time as any. Dr Weale: Could I make two points. First of all, the golden rule as a concept made a lot more sense in the period when we had cycles with very high amplitude: the recession of the early 1990s relative to the boom of the late 1980s. Since the recovery from that recession we have seen very weak cycles and because they are weak they are difficult to date, which I think is why this Committee recommended perhaps four or five years ago that the dating should be done independently of the Treasury. Equally, the concept becomes rather less useful and I think a more appropriate approach would be forward looking to take the view - we heard earlier about pre-funding due to an ageing population - given what we know is going on in the country and what is likely to happen to the government's future spending needs, is it appropriate to aim for balance or surplus, or should we set our sights a bit higher and actually be saving up for the people who are going to grow old. My view is the latter and by focusing on the cycle we miss that long-term view. I know the Government does provide a long-term view of the public finances but I would like to see one of the fiscal rules defined perhaps with reference to that more and less with reference to a cycle which is hard to identify. Q36 John Thurso: Do you think that the golden rule itself, having been conceived, as it were, following those big changes in the cycle is less important now than it was and that amendment to it is useful because its relevance to the general economy is not that which it was a decade ago? Dr Weale: I think the golden rule as it is described has become rather discredited for two reasons. One is the variation in the length of the cycle, the other is the method of calculation which anyone thinking about their own domestic debts would not recognise, so it would now be a good time to say that has been a useful guide, let us learn from it and think about how to do something better, something that looks ahead into the 21st century rather than back into the 20th century. Ms Rosewell: Also, we do have to remember that just because we have had this rather comfortable period that does not mean to say that we cannot go back into a period for whatever reasons whether it is a collapse of the US economy or something that happens to us, it does not have to start in the UK, you could continue to have those sorts of swings and there would then be variations in government expenditure via automatic stabilisers and so on. Just because we have had this benign period, I do not think that is the main point here although it may be part of the background, but what is at issue is that we have a framework for judging the overall saving to public finances which relies on some very obscure kinds of calculations which no-one is really clear that they really agree with. The whole concept of an output gap, for example, is really quite a hard one and yet that is the whole basis on which we are judging this. It is that transparency problem which I think is at issue here. If you compare that to the monetary policy issue, we might argue about which measure of inflation but at least it is pretty clear what it is that is in whatever measure of inflation you have got and there is just a number associated with that. I think it is quite a different problem. Mr Chote: When it comes to the golden rule, and Martin touched on this, you need to distinguish between the goal that you are trying to achieve and the period over which you are trying to achieve it. There is one set of questions about is it sensible over some period or at some point in the future to try to ensure that what is defined as non-investment spending in the national accounts sense should be covered by tax revenue and you should only borrow to cover what is defined as investment in the national accounts, and do you want to do it over a fixed cycle at some point in the future over the medium-term, et cetera. There is a whole set of separate debates over do we differentiate sensibly between spending that does and does not benefit future generations and which we therefore might think is acceptable to borrow. Does a lot of current spending in education effectively constitute investment? There are separate issues. Whether you believe that the cycle is the right approach or not to take is a different one from whether the golden rule's underlying rationale is correct. Q37 John Thurso: In the Budget the Government made the statement that based on cautious assumptions the Government will continue to meet the golden rule after the end of this economic cycle with the current Budget returning to surplus in 2008-09. Do you think the decision as to whether the last year of the current financial year will be counted as the first year of the new cycle for the purpose of judging whether the golden rule will be met will make any difference to the chances of the Government meeting it? Mr Chote: If we are talking about essentially whether 2006-07 is included in the next economic cycle as well as the current one, if you see what I mean, then clearly it does in the sense that we are assuming that unless there is some very big revision that there is a deficit this year, so therefore if you were to include it you would need to build up more surpluses in the future to offset that and it might increase what needs to be the length of the next economic cycle over which you would then expect to meet it. If you do include it the cycle needs to be at least five years long. Depending on whether you include a bad year at the beginning or not may affect that but, as we have been arguing, that probably should not be a consideration. Professor Miles: It is virtually impossible to tell, for good reasons, from the Treasury's own forecast because their own forecast is that the cycle is now permanently over, there is no cycle going forward, growth is always at trend, so it is impossible to answer. Ms Rosewell: There is no output gap in the future. There is no cycle. Q38 Mr Breed: Quickly on the PFI, one of the ways in which the Treasury makes life difficult sometimes is to change the accounting treatment and they are going to change the accounting treatment of PFI and go on to the International Reporting Financial Standards. What difference might this make? Do you think it is likely to increase the number of PFI contracts and, if so, what implications might that have for the Government meeting its own investment rule in the next cycle, whenever that begins? Mr Chote: I think we would probably agree that we would hope that a change in accounting treatments should not affect whether this is done through PFI or not, that should be done on whether or not it is value for money for the taxpayer. One problem that we have is that we do not exactly know how the sustainable investment rule is going to be applied over the next cycle. Are we still going to have to try to keep the currently targeted definition of debt below 40% of GDP? Is there going to be a move to have it averaged at 40% of GDP or whatever it might be? There is also the issue about whether you might tweak the definition of debt, which I think come the arrival of Whole of Government Accounts might be a good opportunity to look at that. I would certainly hope that we would not see great changes in which projects are PFI-d or not on the basis of their accounting treatment. Hopefully one would explain why you are taking that on rather different grounds. Ms Rosewell: I think there is a much bigger issue around the accounting treatment, which is the treatment of pension obligations. That is orders of magnitude bigger than anything to do with PFI and raises much more substantially the debate about whether 40% is sensible or not because it is blown out of the water once you include the pension obligations, as you ought to do under IFRS and as companies have to do. Q39 Mr Breed: Do you think they may do that ultimately? Ms Rosewell: If they are going to adopt International Financial Reporting Standards it is not an option, it is obligatory. Q40 Mr Breed: So we have only introduced International Financial Reporting Standards in this one relatively small area at the moment? Ms Rosewell: I do not quite understand the process by which this is going to take place but my understanding is - Robert probably knows this better than I do - there is a move towards IFRS and as that IFRS is introduced, and there are some steps on the way that you can take, eventually you have to put your pension obligations on the balance sheet. Dr Weale: My understanding as far as the national accounts go is that process is not fully decided. One of the complications is that whereas in the United Kingdom we make a clear distinction between Civil Service pensions and old-age pensions, and the proposal would be to put the former but not the latter on to the balance sheet, in countries which have a much more uniform state pension system there is no distinction so the public sector liabilities of France would then look much worse than Britain because we might not be capitalising old-age pensions whereas they effectively would. My guess is that is going to be a stumbling block to putting that sort of thing in the national accounts. Q41 Mr Breed: So a few PFI contracts that might now have to appear on government accounts pale into insignificance if they then have to include pension obligations? Ms Rosewell: That is correct. Q42 Mr Breed: Some people are concerned about the overall forecast of the total estimated payments that are going to have to be made under PFI contracts over the next 25 years or so. Those have gone up some estimate around about 17%. Why do you think the forecast cost has jumped so much? That is quite a significant increase in a relatively short period of time. To what extent does that indicate that perhaps there needs to be some greater financial control exercised over all payments that are made under PFI contracts? Ms Rosewell: I have no information about that, I am afraid. Q43 Chairman: Can one of you give us an answer and we will move on. Professor Miles: I wonder how much of the increase that you mention is just a reflection of the fact that more deals get signed rather than they have increased their assessment of how much the Government has to pay in the same deals. That might make quite a difference to those numbers. Q44 Mr Breed: So you do not think it is anything to do with the accounting standards in that sense? Professor Miles: I do not, no. Q45 Mr Love: Earlier on Professor Miles mentioned that currently there is no increase in real disposable income at the present time. We also have RPI at its highest level since 1992. Are there any implications for this particular wage round and is there any evidence that there are difficulties ahead in terms of wages? Professor Miles: That was something that the Monetary Policy Committee was very seriously concerned about at the end of last year into January as we got more and more wage settlement data coming in. I think they are somewhat less concerned now because we have seen quite a lot of wage settlements in January and February coming through and they do not really show signs of wage settlements having moved up sharply. If, as most people expect, the actual rate of inflation, the RPI rate of inflation, falls from here, the outlook for wage inflation probably looks relatively benign at the moment, which is surprising given a low level of unemployment, employment having risen and RPI inflation having been really rather high in the last few months and yet it has not shown up in wage settlements. Q46 Mr Love: Would anybody like to quibble with that, especially in the context from what I understood you saying, Professor Miles, when you were suggesting that with taxes coming in in the next year or two we may well continue to have this zero increase in disposable income. Professor Miles: I think it is a small increase, it may not be literally zero. As I say, that is a factor behind my view that consumer spending will be a little weaker than the Treasury and perhaps the Bank of England. I am not sure there is much evidence that in terms of wage settlements employees are able to use the fact that inflation has been high and that real wages have not increased much to bargain for higher wagers. That really does not seem to have happened on any significant scale. Q47 Mr Love: Can I talk about the rebalancing of the economy that the Chancellor talked about. First of all, in terms of business investment there was quite a confident prediction from the Treasury and I would like to get your views on whether it will be delivered. Secondly, there was quite a negative prediction about trade overall, which I suspect you probably would not quibble with given that we have terrible trade figures all the time. I just wondered whether you felt the economy was beginning to rebalance as the Chancellor was suggesting. Dr Weale: It depends what your starting point is. The Chancellor focused on what was happening to business investment measured in constant prices and what he said was correct but that does rather flatter the figures. If you look at the share of business investment in national income in current prices, in 1998 it was 12.5%, it has been as low as 9% and it has now got back up to 9.5%. It is true that the prices of things that people are buying have made that look more favourable in constant price terms but you might think if the investment goods are cheap that they are not actually going to get very much benefit from them. So while the rebalancing is happening only at out of date prices and not at current prices I am nervous of it. It is something that ought to be happening but it ought to be happening in current prices or, to put the point another way, we should be saving more than we do. Q48 Mr Love: So are we still too dependent on consumer expenditure? Are there any threats along the line that Professor Miles is talking about feeding through from housing prices? Dr Weale: We are too dependent on the mixture of household consumption and government consumption taken together. There are obviously threats in that regard but the economy does have a bias towards consumption, although that has not been improving in the last few years. Ms Rosewell: We should put the other case too, which is that the kinds of investment goods which are, in fact, most productive - computerisation, CADCAM systems, whatever it may be - have been getting cheaper in real terms and they are easier to acquire. It does not make them necessarily less productive, which I think is the implication of what Martin was saying. You could argue that it is the constant price number which is really important and, therefore, there is this rebalancing and recovery and investment going on. Probably the truth is somewhere in the middle, I do not think one need be quite as negative as to say that the cheap goods are necessarily bad goods. We see it happening, after all, in the sorts of things that people consume and it is also true of a lot of the investment goods that people consume. Moreover, if investment is essentially being under-measured because it is in things like software and so on, which does not often get captured, or indeed in training programmes for staff which certainly do not get captured in investment statistics, improvements in human capital, then if that is indeed what is happening - question mark, I do not think we know that very clearly - then you could support a proposition which says that there is a bit more room for rebalancing. Q49 Mr Love: Surely that research should have been carried out because they have been saying that for sometime, that we have not been measuring business investment as well as we should do? Why does somebody not measure it more accurately than it has been? Ms Rosewell: It is a bit like the migration, there is a programme but it has not delivered yet. It is the job of statisticians. Chairman: Thank you very much. Part two starts immediately. Examination of Witnesses Witnesses: Mr John Whiting, PricewaterhouseCoopers and Professor Colin Talbot, Manchester Business School, gave evidence. Mr Robert Chote, Institute for Fiscal Studies and Dr Martin Weale, National Institute of Economic & Social Research, gave further evidence. Q50 Chairman: Welcome to the microeconomic session. Can you introduce yourselves, please, for the shorthand writers? Mr Whiting: John Whiting, PricewaterhouseCoopers and Chartered Institute of Taxation. Mr Chote: Robert Chote, Institute for Fiscal Studies. Professor Talbot: Colin Talbot, Manchester Business School. Dr Weale: Martin Weale, National Institute of Economic & Social Research. Q51 Chairman: A lot of the measures announced in the Budget will be introduced in April 2008. Mr Whiting, surely that is a good thing, is it not? Mr Whiting: I think in principle yes, not just 2008 but 2009 and, indeed, forward. The fact that an awful lot of figures for both personal and business taxation are set out going forward for a few years does help add certainty. Providing the figures are stuck with, that is very useful for both individual and personal planning. A slight downside, I suppose one could say, is that for individuals not all of the figures were announced, it is a bit like a Sudoku exercise of filling in some of the missing figures. For business, sadly, as this Budget also shows, figures are subject to change. In principle I wholly support the idea of announcing figures in advance. Q52 Chairman: The business community in particular have been looking for a simplification of the system and an indication of long-term thinking. Did they get that in this Budget? Mr Whiting: Again, a qualified yes. Putting to one side the environmental side where I think they would have liked a statement on where environmental duties are going then this Budget has sent some good signals in terms of reducing the rate. Yes, there are some reductions in complexity. There is a good sound coming out of it in terms of the corporation tax system, the business tax system, sounding better internationally because what one must also put into the mix is the carrying forward of the various Varney report proposals which are also very important in giving us a better business friendly system. Q53 Chairman: We are still waiting for the detail on the Varney report, are we not? Mr Whiting: The sounds are good. The two documents came out with the Budget which sound good but it is, of course, a question of carrying them through and making sure they do all deliver in terms of the various aspirations. If they are all delivered it will be a very important contribution to making the tax system more business friendly. Q54 Chairman: Given that the Chancellor in 1999 introduced a 10% tax band to "encourage work and may work pay", are any of you surprised at the removal of the 10% tax band with effect from 2008-09? Mr Chote: It is a testament if anybody is Chancellor for long enough you end up abolishing some of the measures you put in in the first place. I think the issue in the first place was it was never very clear that the 10p rate was a particularly effective tool in terms of the distributional implications that were claimed for it at the time, so removing that and the rather curious drop in the combined marginal rate of income tax and NI above the top of the upper earnings limit look like sensible changes. The Treasury's argument is that now they have tax credits which do the job that the 10p rate was designed to do to begin with. I do not think it was very clear that the 10p rate was very well designed to do that job to begin with so it would be churlish not to welcome its departure. Q55 Chairman: Why do you think it has kept the 10% tax rate for savings? Mr Whiting: I think that is entirely to make sure that the pensioner community in particular are protected from the withdrawal of the 10% main band. Keeping it on savings income for them does give them a small gesture, I question whether it is sufficient or worthwhile given the phone-in I have just come from and the amount of confusion that it is already engendering and it does make you wonder whether it really is going to achieve its objective and whether it would not have been easier just to give the pensioner community that bit extra by way of personal allowance, combine the 65-plus and 75-plus amounts into one figure and have done, although actually there will be others on low income, apart from pensioners, who will benefit from the retention of that savings band. Q56 Chairman: What is that going to cost, £600 million or something? Mr Whiting: Something of that ilk. Dr Weale: We do have appreciably lower tax rates on dividend income and interest income for people in the standard rate band than we do on labour income. One can produce quite good arguments for this, that they have acquired the capital on which they are getting their dividend or interest income by having saved up out of labour income. Some people argue that for that reason property income should not be taxed at all. Looking at the retention of the 10p rate for savings income I think can be seen in that context. It is interesting that once you get above the 40% threshold, if you take account of all the taxes imposed on labour income and on dividend income the two rates are almost the same. Mr Chote: There is probably a presentational issue in that in terms of labour income the Chancellor could say that people were compensated from raising the 10p rate to 20 by the cut in the basic rate from 22 to 20 but for savings the basic rate was 20 so there was no equivalent cut there. There may have been a presentational concern that you could not tell the same story of taking with one hand and giving back with the other. Q57 Chairman: Under the announcement of the reforms to the National Insurance system, do you think that the distinction between the National Insurance and the taxation system is now all but meaningless? Mr Whiting: In terms of the calculation of how much you should pay under each, no, it is not meaningless because the core figure on which you charge income tax and National Insurance is still different. The prime example of that is contributions to a pension fund which, of course, are deductible for income tax but not for National Insurance. What we do get is still differences in the base to which the two calculations are applied. Although employers have always argued and called for a combination of the two levies, that may be extremely difficult to achieve politically and structurally in terms of the contributory nature of National Insurance, although it should be achievable, there is still some bringing together possible of the exact base on which the two levies are charged. Q58 Chairman: Is there still a case for National Insurance, do you think? Mr Whiting: I think I would prefer to leave that to the politicians perhaps. Q59 Chairman: That is the first time I have seen you shy! Mr Whiting: Well, I would say that there is probably a lot to be said for combining the two, Chairman. One accepts that there is probably a necessity for a payroll tax on employers, which is what employers' National Insurance is, but if one swept away the contributory principle and just had done there would be scope for simplification, but I realise I am straying into quite a minefield here. Dr Weale: It seems to me the main reason for keeping National Insurance separate from income tax is that the Chancellor can say to people, "There is a standard 20p rate of tax" and forget about the employers' and employees' National Insurance contributions which are in effect also deductions from wages. Politically it follows the Colbertian principle of plucking as much as you can from the goose without it squawking. Q60 Chairman: That is not cynical; that is a realistic observation, is it? Dr Weale: Yes. Mr Whiting: It also underlines the fact that transparency in this would be a good thing if you could get to it. Q61 Mr Fallon: Robert Chote, The Times last Friday said that more than a million low earners would be worse off before they were in the position of having to claim credits. What is your figure? Mr Chote: The estimate of the winners and losers is that you have a group of losers at around 18,000. If you look at the overall number of households affected by the income tax, national insurance and tax credit changes altogether, you probably have on our estimate about 5.3 million families losing in total. Of those, 2.2 million would be single working people with no children who are not getting the working tax credit and they may not be getting the working tax credit, most of those, because they earn more than 12,500 but less than the 18,000. It depends a bit on what you define as low income, but there is clearly a chunk of people in that category. They may also not get the working tax credit because they work fewer than 30 hours or because they are too young. The losers within that group lose about £125 per year on average per family. You then have about 1.2 million losers who will be two earner couples with no children. They may not qualify for the working tax credit or they may fail to take it up. They may also be in the position where the two earners both lose from the income tax and national insurance changes but there is only one gain from the tax credit which is assessed on the household. You can imagine that the biggest loss would be £446, I think. If you had a couple, both of whom were on £7,445, that is where you get the maximum loss from the increase in the lower rate from 10 to 20 and not getting the working tax credit. You have another 0.4 million losing households who are one earner couples without children, most of them because they will be in a range of about £17,000 to £18,500 where they are not compensated. You get 0.7 million two earner couples with children who lose again twice from the income tax and national insurance changes but maybe only gain once from child tax credit/working tax credit. You have 0.3 million losers who would be tax paying women between the ages of 60 and 64 who do not get tax credits and are too young to be compensated by the rise in the pensioner tax allowance and a final 0.5 million non-workers who pay more tax on their taxable benefit or pensions than they gain. Those might be early retirees or incapacity benefit claimants. That is roughly how you get to the 5.2 million total household losers. It has to be said that this is an estimate based on much crunching over the last few days and, like shares, it may go up or down. That is our best guess at the moment. Q62 Mr Fallon: The Treasury says some of these people could of course now go out and claim tax credits but their assumption presumably is that not all of them will. Is it possible to estimate from the Red Book what the Treasury's assumption of take-up actually is? Mr Chote: I do not think you can estimate from the Treasury book that there is a particular increase in the take-up that is being pursued. For example, the figures I have just given you assume that there is full take-up of the working tax credit. The working tax credit is notably not taken up very highly by people who do not have children. Take-up is about 19% by caseload, 25% by value. If no one without kids took up the working tax credit, you would get about 5.6 million losers rather than 5.3 million. It is not a huge difference from realistic amounts of non-take-up because presumably the answer will be somewhere between the full and no take-up at all. It would make some difference to the number of losers at the margin but not necessarily an enormous one, I think. Q63 Kerry McCarthy: Can I ask about child poverty? The government has this goal of halving child poverty by 2010 and abolishing it within a generation. To what extent does the Budget help them move towards achieving that target? Mr Chote: The Treasury's estimate is that the measures here, of which the increase in the child element of the child tax credit would be the most important, will cut child poverty by around 200,000. From what we have managed to number crunch, that looks a reasonable estimate. It is quite complicated of course because in addition the other sets of tax and national insurance changes may well change median income - i.e., the benchmark against which you are comparing incomes in order to define who falls below the poverty line and the number of people at the bottom. 200,000 looks about right. On that basis, we calculated last year that the government would probably need to find another £4.5 billion in order to give itself a 50/50 chance of reaching the 2010 target which is to halve child poverty from its 1998-99 level. We would probably say, on the basis of that information, that the bill would now be about four billion. That said, I do not know when you are seeing the Chancellor. Q64 Kerry McCarthy: Thursday. Mr Chote: In that case, you will have had a new set of child poverty numbers from DWP tomorrow, I think, from the Department for Work and Pensions, so the position will be either clearer or more confused, depending on what those numbers indicate. At the moment, on unchanged policies, child poverty does not go anywhere so there is more room to be made up but we will see what progress or otherwise has been made tomorrow in 2005-06. Q65 Kerry McCarthy: Do you think there should have been more in the Budget to move towards that target? Is that something where we just need to wait for the CSR? Mr Chote: It is not clear from the CSR because tax credit expenditure comes under annually managed expenditure rather than departmental expenditure limits. Departmental expenditure limits are the ones for which three year plans are set out. The government will tell us when we get to the CSR, which Colin tells me is definitely October judging from some line in the speech. We know the overall total increase for public spending. At the time of the CSR we will find out what the total is for departmental expenditure limits and then we can say, "Is the bit that is left an amount of money plausibly able to deliver this four billion or so?" We were quite surprised at the time of the pre-Budget report that there was not more done then because of course the later the Chancellor leaves it the more money you have to find at the last minute. It has gone a bit there but there may still be some bills to pay. Q66 Kerry McCarthy: If you tried to design a tax and benefit system to address this goal of abolishing child poverty, would you go down the same route as the Chancellor with more of an emphasis on tax credits, for example, rather than benefits for people out of work? Would an increase across the board in child benefit be a better solution? Mr Chote: The most targeted way of achieving it is to increase the child element of the child tax credit. That is the main channel that the Chancellor has adopted to date. The problem, if you go too far down that line, is the implication for work incentives. It was quite interesting that in the package of measures he announced in the Budget we had an increase both in the child tax credit and in the working tax credit which may have been partly with an eye to ameliorating the impact on work incentives of just purely going down the child tax credit route. There is then the set of issues about whether you want to be focusing more on couples or on single people which complicates the story somewhat. Certainly you really do need to use tax credits if you want to hit the 2010 target but the 2020 target maybe has other issues about lifetime chances rather than cash transfers which are more important. Q67 Kerry McCarthy: The End Child Poverty Campaign, the umbrella group, is campaigning on the equalisation of child benefit for the second and third child which would obviously be a universal benefit. Is that because of the problems with take-up rates on tax credits? It seems that you are arguing that the targeted approach is more effective which makes sense. Mr Chote: The difficulty with child benefit is that you spend a lot of money giving it to people who "do not need it" for the purposes of achieving a child poverty target. If you give it to larger families, that is means testing but without the unattractive features of means testing because larger families tend to be poorer ones. If you were to be more generous to poorer families through a universal benefit, you are getting some way to greater value for money if your only concern is reducing child poverty but obviously people may support child benefit for other reasons than that. Dr Weale: This is part of the general problem with poverty alleviation. If you have generous benefit, you cannot afford it unless you have high taper rates. It is worth noting that the Chancellor is increasing the taper rates and the withdrawal rates on tax credit from April 2008 in order to try and keep the overall system within reasonable bounds but at the cost of reducing incentives to take yourself out of the benefit range. It is a standard problem and he is probably not quite sure - nor indeed would anyone else be - where the best point is to be in that trade-off. Q68 Kerry McCarthy: I am not sure it is quite a criticism but one of the comments that come from groups like Save the Children, for example, is that it is top slice in a way, children living in poverty, so it is children that are just below the poverty line that are easiest to lift above the poverty line. Save the Children, for example, are campaigning about the one million poorest children. The government's current approach is very much about incentives for people in work or on low incomes. Are we ever going to reach those poorest children without an across the board increase in benefits? Mr Chote: It is certainly true that the government has a headcount measure so it is clearly attractive to them to be able to get people jumping just over the line. The poverty line is at a very highly populated bit of income distribution, so it can make a lot of difference where exactly you draw the poverty line because a small shift will get a large number of people in or out. It has also been the case that recent figures have shown we have not seen the sort of improvement in "severe poverty" - i.e., 40% of the median as distinct from 60% - so that would clearly be a cause for concern if what you are really concerned about is not only the number of people below the poverty line but the sum total of how far below it they are as well. The caveat to that is that the lower the incomes become the more unreliable the data. Are these people who are always poor or temporarily poor? You have to be wary, the lower you get down the income distribution, as to how much trust you place on the figures, but certainly comparing 40 to 60 we have not seen the sort of improvements some way below the poverty line that we have seen at it. Dr Weale: The problem you are describing is a very general one which arises from the way the government sets targets in terms of thresholds: so many children to get five A to C grade GCSEs, so many people to get above the poverty line. It is bound to keep recurring while targets go on being set in this way. Q69 Kerry McCarthy: This would be on children that might get three or four GCSEs? Dr Weale: Exactly, rather than helping the people who are in probably the greatest need of educational help. We see the same sorts of things with waiting times. With hospitals it was the other way round. There the issue was the very long tail. That came down when average waiting times went up but it demonstrates that a lot more thought needs to be given to how the targets are set, given the importance they assume in policy making. With what we are seeing here, we are bound to get the distortions you describe. Q70 Angela Eagle: Is there a better way of setting the target? We all know what sort of outcome we are trying to achieve with this target, albeit crossing a line. Is there a better way of reaching the same kind of outcome and measuring it in a way that would not have these distorting effects? Dr Weale: I would set a target with reference to extreme poverty as well as poverty itself. Q71 Angela Eagle: You could add another target in for raising the ones at the very bottom higher up, even if it is not above the poverty level. Dr Weale: I think so. One might well want to say that raising those at the bottom higher up, even if they do not cross the poverty line, is a greater social improvement than moving people from just below to just above. There are broader measures of inequality which can be used. They are perhaps more technical and might therefore be less satisfaction but one does really need to think about who is in greatest need of help and does this target encourage people to think about policies which give them as much help as they might need. Q72 Ms Keeble: Looking through the figures, it looked as if there was also an announcement. It might have been in a previous Budget but next year the amount of money that women can claim to help with childcare is going to increase from 70% to 80% of their weekly childcare costs. Is that right? Mr Whiting: Yes. That was already pre-announced. It was in last year's Budget. It is a component of particularly the working tax credit. Q73 Ms Keeble: When is that coming in? Mr Whiting: From April. Q74 Ms Keeble: What assessment do you make of the impact that is going to have on incentives to work and also on some of the poverty issues? Secondly, do you think it needs any protections around it to prevent it simply leading to inflation in nursery and child minders' rates? Mr Chote: The more you rely on this, it certainly raises the issue about the extent to which you should try to help by giving people money to buy childcare versus improving the quality and supply of good quality childcare and the issue about whether you should be putting the money into nursery provision or into a transfer payment which can be used for that and will be raised more by that. Q75 Ms Keeble: That is up to £17 a week. That is a lot of money, is it not? Mr Chote: Yes and whether that money could be better spent through supply rather than on transfers --- Q76 Ms Keeble: What do you think? Mr Chote: Probably more of a move towards providing good quality supply might be a better route to go down. Q77 Mr Breed: Do you think the environmental measures outlined in the Budget provide a coordinated policy response to the Stern Review? Mr Whiting: As far as tax is concerned, I think the honest answer is no. We still lack a major framework in which business would like to see and understand fundamentally where we are going with all the environmental tax levies that we have in the country. They are undoubtedly going down the route of answering the Stern Review. What many would like to understand is are we going to use environmental taxes to raise substantial amounts of money or are we aiming for them to be behaviour changing. Q78 Mr Breed: What do you think? Mr Whiting: I think the jury is still out. That is the problem. I do not think we have a clear statement yet as to what we are trying to achieve with them. Mr Chote: The Chancellor clearly has not been persuaded yet by the green switch argument that the Opposition parties have made about using a significant increase in revenues from environmental taxation to offset cuts in other taxes. As you will be aware, the share of national income rates in environmental tax revenue has been declining since 1999 largely because of fuel duty going up, not much in cash terms and not in real terms. Clearly the Chancellor is edging a bit in the other direction there, not enough yet to put us back on to the path of the sort of rations of environmental revenues and national income that we had in 1999, but it will be interesting to see how far he is willing to push that. It has to be said that that is not necessarily a very good metric of your green credentials. There are other areas where you look at specific taxes and say, "Okay, in terms of the contribution." Every Budget or pre-Budget report is announcing ever more dramatic increases in the landfill tax which seem to go quite beyond the levels justified by the Treasury's original estimates of the environmental cost of landfill. We may be running into the same sorts of issues on fly tipping there as you have had eventually restraining the growth in spirit duties and other things and cigarettes and smuggling. They certainly seem to be pushing the envelope quite a way on landfill. Q79 Mr Breed: I think landfill tax is going to hit council tax more than anything else. Professor Talbot: On the spending side, we do not know what the environmental priorities are going to be yet. Q80 Mr Breed: What about the changes in vehicle excise duty? Are they going to make any difference at all? Dr Weale: Since what I think it is we are concerned about is use of fuel rather than ownership of cars, I should have thought the right thing would be not to tamper with the excise duty on cars but to put it more on petrol tax, on fuel use, so that people with large cars would think more carefully about how they use them. It is often said that that is unfair to people who have to be heavy car users, often because of where they choose to live or something like that, but a basic economic point is that if you want to discourage use of something like petrol you can offset the distributional effects by other changes in taxation. Mr Whiting: There is the slightly perverse point that, having forked out for a larger vehicle excise duty, you might as well go on and amortise it over more mileage and therefore potentially use the car more. Q81 Mr Breed: On the basis that the sticks have not worked very much, what about the carrots? What about the modest range of incentives for energy efficiency? Are they likely to have any great effect? Mr Chote: I do not know whether the whole issue about lower VAT rates for environmentally friendly products is going to open the "is a Jaffa cake a biscuit or a cake?" type debate in terms of what is or is not exactly --- Q82 Mr Breed: These are crumbs of comfort, are they? Mr Chote: Very good. Q83 Mr Breed: Overall you are pretty underwhelmed by the environmental taxation agenda? Mr Whiting: I would come back to my opening remark. There is a strong argument that you are better off looking at incentives, the carrots rather than the sticks. We do not have very clear, obvious incentives to take particular courses. The more of those we could set in stone, particularly to give business a clear message that that is going to be there for many years; therefore you can gear up to take advantage of those allowances, that is what is needed. Therefore we are back to the need for a clear framework. Dr Weale: I would go for sticks rather than carrots. The basic argument, particularly with fuel use carbon emission, is very simple. Carbon emission is damaging. You should charge the people who emit the carbon for the damage that they cause in so far as you can. That certainly implies sticks rather than giving people a rebate on insulation in their lofts. Q84 Mr Gauke: Can I return to educational spending? Robert Chote, will spending on education rise as a proportion of national income during the course of the 2005 Parliament, assuming we go to 2009? Mr Chote: I do not know the answer. In the CSR period, the real growth per year on education depends on how you define education. There is a 2.7% a year increase for the DfES's departmental limit which corresponds to a 2.5% a year increase in education spending in England and a 2.4% a year increase in education spending in the UK. Over the period of the CSR the Treasury is making the cautious estimate, for the purposes of public finances, that the economy grows by 2.5%. That would imply on the UK education spending measure that it will be fractionally below at effectively at or around the growth rate of the economy. David Miles, who was here beforehand, in our Green Budget this year said that he thought 2.5% growth was more likely to be a central estimate than a cautious one. That all goes to suggest that education spending is unlikely to rise as a share of national income over the CSR period. What it implies for the Parliament I am not clear. Professor Talbot: In table 6.4 on education spending in the UK in the Budget, they give the figures of UK education spending as a proportion of GDP. On those figures it is shown as stabilising from 2007-08 onwards at 5.6%. That is page158. Mr Chote: That would reflect the fact that they are taking the cautious growth rate estimate and 2.4% versus 2.5% is not going to trip that measure over that period. Q85 Mr Gauke: To what extent is the funding that has been announced already committed to individual programmes to which the Chancellor referred in his Budget? Mr Chote: On education? Q86 Mr Gauke: Yes. Mr Chote: I do not know. One way of looking at it is to say, "Is this new money in terms of contributing to this goal of getting spending per pupil in the state sector up to the private sector?" There, as you will recall, we have spending in the state sector of £8,000 per pupil in 2005-06. The Treasury was pencilling in 5,263 for 2007-08. The capital spending for education announced in the Budget 2006 fills out another £124 of the gap. The current spending announced in this Budget fills up another 329 of the gap. Lower pupil numbers will fill up effectively and spread the cake more widely and will knock 84 off so that leaves you with a gap of about £2,200 between the state sector and where the private sector was in 2005-06, which would have to be met. On our estimates, if you were to continue to increase education spending at the rate that is now pencilled in for the CSR, that implies that that target will be met in 2020-21. Mr Gauke: It will be too late even for my children. Can I ask about some of the assumptions in there as far as pay, pensions and the cost of extending education and training up to the 18th birthday and whether we have assumptions as to the cost of that? Do all those assumptions seem to be reasonable or unduly optimistic or pessimistic? The Secretary of State for Education and Skills has suggested extending education and training to the 18th birthday. Are we happy with it? 200 million capital spend and 700 million a year revenue. Are we happy? Q87 Chairman: Cheer us up. Give us a negative answer. Mr Chote: No. Q88 Mr Gauke: At the pre-Budget report last December, you will recall that capital spending was very much at the heart of what the Chancellor was saying, at least within his statement. Robert Chote, you described the pre-Budget report as being opaque in this respect. Do we know anything more about this now? Is it less opaque than it was? Mr Chote: Our concern then was that it was not clear whether the figure applied to schools, FE or precisely what. We are getting more and more bits of the jigsaw of what we need to know in terms of assessing how quickly it is plausible for this target of getting to the private spending per school. In that sense, it is less opaque than it was because we now have the figures for current spending for schools through the CSR period. It is now suggesting 2020-21 as the period at which you get that. Ironically of course that is a longer time lag between the public and private sector than there was in 2005-06, the Chancellor's base year, when the private sector was nine years ahead. By 2020, if you continue the CSR growth rate, it will be 15 years behind, so it is a rather odd moving target. It seems to be getting further behind rather than closer to it. Professor Talbot: One curious thing in the figures in table 6.3 is that the PFI component of the capital budget seems to be frozen, whereas the overall capital budget is going up, which implies that they are going to be less reliant on PFI as this progresses, which is an oddity given how much they are using it in other areas. Mr Chote: Is that a projection for PFI? Professor Talbot: Yes. Q89 Mr Gauke: Where is that? Professor Talbot: It is in table 6.3 on page 157. The total capital budget goes up from 2007-08 from 8.3 billion to about 10 billion, whereas the PFI deals are frozen at 1.3 billion over the whole period. It suggests less reliance on PFIs for new schools and colleges building projects. Q90 Mr Gauke: Another missing piece of the jigsaw is the local government settlement. The Treasury has said that the annual spending by capital programme depends upon the interaction between capital and revenue allocations in respect of the local government settlement. Is this a fair observation? Is that an important point that we need some clarification on which we will get at the CSR before we fully clear up what is happening in education? Professor Talbot: We will not get it until the CSR. Mr Chote: The estimate of 2.4% growth for UK education spending includes the education element of the DfES's expenditure limit plus an estimate of education spending by local authorities, plus assumptions or forecasts of education spending by the devolved administrations. Whether we get any news that takes you away from the estimate of 2.4% real growth over the CSR period I do not know. There is some estimate clearly of local authority and devolved administration contributions within that number. Q91 Mr Gauke: The Chancellor announced an increase in the sum going into the financial assistance scheme for those who have lost their occupational pensions from two billion to eight billion. Does anybody know by any chance what that additional six billion means in so far as net present value is concerned? Has anybody looked at that? Is there anything that gives us a clue as to how much this is going to cost the Exchequer? Mr Chote: As you imply, I think it is the sum of the nominal amounts rather than the present value estimate but we have not done one. I do not know whether there is one out there. Dr Weale: I do not know of one. Q92 John Thurso: I want to turn to the efficiency programme. The Budget announced 15.58 billion of savings to the end of December 2006. What is the quality of that figure? Professor Talbot: We do not have any additional information other than the NAO report published at the beginning of this year. Their estimates at that point for the efficiency savings, which were then running at 13 billion or so, were that about 25% of the figure was reliable. About 50% was slightly doubtful and about 25% was pretty doubtful. Assuming that nothing dramatically has changed in the last two months, I would probably apply the same yardstick to the current figures. Q93 John Thurso: Do you think it is a problem that particularly the Gershon figures are reported gross rather than net of the cost of achieving them? I have seen some stuff which says the payback periods run into several decades. Professor Talbot: Yes, and even more so in light of the commitment to 3% net efficiency saving during the CSR period from CSR 2007. If you recall, of the current Gershon savings, only about 1.5% are cashable. Of that, they have not netted them so we have got somewhere below 1.5% of the current savings are net cash savings in efficiency terms. To hoick that up to 3% per year which they are planning to do for the next CSR period, is a massive step change in the amount of money which is supposed to be saved in efficiency savings. Q94 John Thurso: When we had the Office of Government Commerce before us, I was asking questions about the actual value. I came to the realisation that my concept of value as a businessman which is cash I can move from my bank account to theirs was very different. I was surprised by how little was cash. Can you really call these efficiency savings if there is very little cash being saved? Professor Talbot: The targets were for 60% of the existing efficiency drive to be cashable. How much of that has been delivered is questionable based on the NAO's estimates of what are reliable figures. It is difficult to see in some cases how it has been reallocated in real budgets. Even if they were making the figures that they say they are making in the current efficiency drive - and that is doubtful according to the NAO - a step change up to 3% net cash savings in the budgets from 2008-09 onwards is a considerable increase. Q95 John Thurso: If we look at the headcount, which is perhaps slightly easier to measure, the reported workforce reductions are said to have reached 50,000. Interestingly, in the evidence we had in part one this afternoon, there was a great rise in employment in the public sector. Can we find those 50,000 in that total or is this reallocation? Professor Talbot: Some of it is reallocation and the government accepts that. The 50,000 figure that you are citing is the 50,000 net total reduction, including reallocation. They say 84,000 in terms of gross reductions and the 50,000 is netted of the reallocations that are supposed to have taken place. 34,000 are supposed to be reallocations of staff. The curiosity of this is that these staff reductions do not seem to match up with the efficiency savings in departments. The most obvious example is the Home Office which is now not fit for purpose but seems to be positively anorexic in terms of the amount of savings that it has made. It is now at well over 100% of its efficiency target at just over half-way through the programme. At the same time, it is nearly 1,500 staff short of its net savings in terms of reductions in staffing. How these figures measure up to one another I am not quite sure. It would be interesting to get some explanation from them. Dr Weale: Explanation is obviously needed but you would not necessarily expect a close relationship between the two because shedding people on low pay may be a lot easier than shedding those on high pay but result in smaller cash savings. More money might be saved by losing one high‑paid person than two and a half low‑paid people and, again, it is a fault of the target system that there are these two running in tandem. Of course there is an additional point that the staff losses may not be cash savings because the work may be contracted out instead of being done by civil servants. Q96 John Thurso: The overall point is that efficiency gains are presented to a certain extent to the public as money saved that can be relocated to frontline services and therefore money not required to be raised as revenue from other sources, ie taxation or whatever, but if one digs into them it is not always easy to substantiate that, so there is a real need for some clarity and transparency in what those numbers mean if we are to see whether they have met the objective or not. Professor Talbot: The fundamental problem remains, and this was raised in the macro economic session you had earlier, that unless we have reliable measures of inputs and quantity and quality of outputs then it is very difficult to see how any reduction in expenditure is an efficiency gain, so it is very easy for something to be said to be an efficiency saving when it may simply be a cut in services, and part of the problem we have, which is a genuine problem which the Government has not managed to resolve yet, is how you measure the quality and quantity of outputs across something as large and diverse as the public sector. Atkinson and ONS have made some progress in that direction but certainly not enough to be confident that the efficiency savings are not leading to, in some areas at least, reductions in services either in quantity or quality. Chairman: I think I quoted in the Budget Speech last week that the efficiency targets were round about 95% and they are even better since then, so they obviously get better during the day and work even at weekends when we are asleep, and are now well over 100%. What a Department! Fantastic! Q97 Mr Love: Can I ask about the change in the small business tax rate? It has been suggested that the reason for this is that they want to change the balance in the amount taken by directors in the form of dividends rather than wages. Is that sufficient reason, and are there downsides to the change? Mr Whiting: I was told by the Treasury there were two reasons for the changes; one was to encourage greater investment by the small business sector and the second was basically to get at the tax‑motivated in corporation again. On both of those counts one raises some doubts, not least because there have been various attempts to encourage the small business sector to invest in the past. It is not clear why this one will do any better and at a minimum I think we need a review in year or two as to whether it will work and, if not, please can we have lower rates. Secondly, even if a smaller business does invest for a couple of years, at some stage very often proprietors need to take some money out to live on, so it is not automatic and one cannot help feeling that the increase in tax rates is just a little strange. It is also very strange, if I can just make the observation, as a sort of mirror image with the impact on large businesses, because here we have at the smaller end encouragement to the manufacturing side with putatively higher allowances which might help your rate and which certainly is something of a hit on the service sector, because you do not get the allowances, you just get the higher rate, and that is rather a mirror image of what is going on at the large business end where it is generally manufacturing and the like that is being hit and the service sector being helped. So are we supposed to be a nation of small manufacturers and large service industries? I do not know. Q98 Mr Love: Let me ask you very specifically about the R&D tax credit. It has been suggested, or at least there is evidence to suggest, that quite a lot of the companies that are gaining from the R&D tax credit would have carried out the investment anyway. Is that borne out by research, and do you think that the changes introduced in this Budget will make any significant difference? Mr Whiting: Certainly my own firm did a survey last year which bore out exactly what you say, that it tended to reward expenditure that was already being undertaken, and what also showed in many cases was that the R&D tax credit, rather like certain other tax credits, is not always claimed because it is too difficult both to establish that we qualify and to go through the hoops. Will, therefore, the increases help? Well, nobody is going to object to a greater credit and it is useful that the higher rate for the smaller businesses goes up a little in terms of size of the company, so I do not think anybody is going to grumble at it but whether it is sufficient to be really behaviour‑changing I very much doubt. If you go back many, many years Japan had an allowance which was basically 106% of a spend, and that was what you got as a reduction from your tax bill, not from your profit, so at that point R&D really did pay. I am not saying we should go to that extreme but you really do need to go, I think, a little bit further really to get the behaviour change in place. Q99 Mr Love: That leads me to ask how far do you need to go. There are many that would suggest if you really want to change behaviour you do have to go to something like the Japanese model. Are you suggesting that evidence would say that you can change it at a much lower level of support? Mr Whiting: I cannot claim to have done the research that would enable me to say that the breakpoint is 200% and I do not think you would expect me to say that, but it has overtones of the question asked earlier that environmentally you have to make the incentive very overt so it really is virtually a no‑brainer in parlance to do it. Failing that, you are back to the evidence that does suggest that most small businesses would certainly prefer simpler systems with lower rates. Q100 Mr Love: Let me move on to carousel fraud. How significant have the measures been there in the Budget? Mr Whiting: Progress is being made. There is another adjustment in the Budget in terms of the goods that will be subject to this reverse charge mechanism for combating carousel fraud, so I think we are making progress there and that is all that can be said. The figures do suggest that HMRC are making progress on tackling it at their end as well. Q101 Mr Love: The Chancellor told us last December that there would be a yield of £500 million, and it has been suggested that the yield from the measures announced last week will be somewhat less, so are we making that much progress? Why has he changed from last year in terms of how they are addressing this problem? Mr Whiting: I am not really close enough to the figures to give a full opinion but I think there may be an element of him feeling that he is steadily choking off avenues so the new changes announced last week are to tackle new problems, because obviously the nature of this fraud is that once you have stopped something it is not something that is going to give you a yield year‑on‑year. Q102 Mr Love: Let me ask you the very obvious question which is if it does stop this type of fraud with computer chips and mobile phones there are going to be a lot of people who have done rather well out of this in the last few years. Will they move on to something else and is there something very apparent that they might move on to that would yield the very significant criminal gains there have been in this area? Mr Whiting: You have to accept that the nature of VAT is that there is something of an incentive to fraudsters in this because of this very simple thing that the fraudulent trader can charge, they have paid the VAT and disappear with the proceeds. It is just innate in the system. So I think we always have to be vigilant to keep an eye on what is happening. The attraction of computer chips and the like is, of course, that they are small, they are portable, they are easily sent round and round in the carousel which, as it were, dynamises the basic fraud, so I do not think we as a country are ever going to be able to say that we have stopped VAT fraud. We are always going to have to be very careful to monitor what the fraudsters are looking at next. Q103 Chairman: Professor Talbot, the Chancellor stated in the Budget that 75% of all new spending during the period covered by the CSR would be improving frontline services. Is there a definition of frontline services? Professor Talbot: I would love to see one because there is also this issue in the announcements about the 5% saving in administrative budgets. It is unclear to me how that relates to the efficiency savings and it is unclear how frontline services are defined in relation to both redistribution of money and redistribution of personnel, and it would be interesting to see what those definitions are. Q104 Chairman: He has mentioned health, education, transport, defence and policing as frontline services. Do you think the definition he is using is specific to those spending areas rather than referring to customer‑facing roles across Government? Professor Talbot: It could be but the other issue is that this rhetoric about frontline services is very interesting but a lot of the efficiency savings in Gershon are not from frontline services. The efficiency savings have to be made in back office services and that requires some resources put into back office services to make them work. The whole Varley review requires fresh investment to develop the infrastructure for back office services to work better, and that just worries me that there is this emphasis somehow or other that if the money goes to nurses and teachers that sounds extremely laudable but if nobody is organising supplies for them that is a bit of a problem. Q105 Chairman: Before we meet the Chancellor, from your point of view can you leave us with one burning issue you think we should raise with the Chancellor? Mr Whiting: I think you could ask him about the impact on large business, which is not to downplay the smaller business, and whether he is sure he has done enough to make sure the UK does become more attractive to international business, and in doing what he has done has he really struck a fair balance, because there are some businesses that are undoubtedly losing out. Q106 Chairman: The financial services area has done quite well, has it not, and highly mobile businesses? Mr Whiting: Indeed, provided you are not somebody in long‑term property infrastructure, including some very prominent projects that are around at the moment where commitments have been made on the assumption that allowances are going to come in over 20/25 years and suddenly they are not. Mr Chote: I think you could ask him whether it would be an aspiration of a Brown Government further to simplify the structure of income tax and national insurance and whether he sees any scope for effectively merging the two systems. Professor Talbot: On the general process point about CSR, on page 141 of the Budget they place great emphasis on the fact they are going to transform the delivery of public services by developing the performance management framework to continue to drive outcome-focused improvements, et cetera, and I would be very interested to know what thinking is behind the new form of PSA, strategic objectives, delivery agreements and national indicators, which are outlined in brief in the Budget documentation. I have no idea how these are supposed to fit together in practice. Q107 Chairman: I think we have mentioned that before but I am taking that as a perennial question. Professor Talbot: And if you want to be sneaky as well you can ask him about paragraph 6.58 which says they are going to have a new mechanism somewhere in the heart of Government to manage all the performance and finance data that is being produced. You might like to ask whether that is going to be in the HMT heart of Government or Cabinet Office/Number 10 heart of Government. I suspect it will be the latter. Q108 Mr Love: Shall we ask him whether the CSR will be in October? Professor Talbot: It will be in October. He let that slip during the Budget speech and I spoke to a very senior civil servant on Monday who confirmed absolutely clearly it is the beginning of October. Q109 Chairman: Stephen Timms in a confessional approach to us in June mentioned that when he appeared before the Committee. Dr Weale: We have had now a number of Budgets from the Chancellor covering wide‑ranging issues - this one, for example, has a section on the Congo - but as far as I know none of the budgets has addressed the question whether the country's overall level of saving is adequate, and I would ask the Chancellor whether he has any views on whether the country as a whole is making enough provision for the future. Chairman: As usual, thank you very much. You have been very helpful to us. |