Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1-19)

14 JULY 2004

MR ROBERT CHOTE, PROFESSOR COLIN TALBOT AND MR DAVID WALTON

  Q1 Chairman: Good morning. May I ask you briefly to set the scene by each of you indicating what you regard as one or two key issues which you would highlight from this Spending Review and was there anything unexpected in that?

  Mr Walton: Our economists have mainly been looking at the macro-economic implications. There was not very much new in the Spending Review, given that the Budget had pretty much set out the public spending totals. At least in macro-economic terms, we knew the shape of this Spending Review and it was the detail that was going to be filled in. I would just say that since the Budget there have been a couple of developments, which perhaps have made the outlook for the public finances look a bit worse. The first is that the actual outturn for last year was a couple of billion worse than expected and most of that was a shortfall in tax revenues. That just makes it that much harder looking forward. The other is that the economy is doing somewhat better than assumed at Budget time and it looks as though the growth performance this financial year is going to be about 0.5% stronger than the Chancellor expected. The implication for that is that the output gap is going to be narrowed sooner. The amount of slack in the economy is going to be eliminated in this financial year, which is a year earlier than the Treasury was assuming, and that will make it harder to meet the golden rule looking into the future.

  Mr Chote: To pick up on what David Walton was saying, the first point to note is that the overall envelope numbers are the same as they were in the Budget, so there is no new news in terms of what the Chancellor said on Monday as regards whether we are or are not likely to hit the fiscal rules. As David has said, other things have been going on which may have changed our view on that but in that sense the Treasury is right that Monday was not a fiscal event in the sense of telling us anything new about the state of public finances, and so therefore there was not that much unexpected. Amongst the winners and losers in departments, I do not think there was a great sense that there was anything particularly surprising about who did well and who did relatively badly. The key question of course is whether these efficiency savings are going to be achievable or not. Our view certainly is that if you look at what governments have managed to achieve in the past, you clearly have to have some sorts of doubts about that. There is one point it is perhaps worth adding and where I think there is some confusion is that if these savings and efficiencies are not achieved, then that in itself does not mean that the need for tax increase is greater than it would otherwise have been. If the savings are not achieved, then it means that the quality of the public services, the bang for the buck, is going to be rather less than the Chancellor was hoping for. If those efficiencies do not materialise, that is likely to show up in the quality of public services rather than in the fiscal position, provided that the overall spending totals are kept.

  Professor Talbot: There is one overall point first, which is one I made in the brief, that we are creeping back to being just about on the average for public spending as a proportion of GDP over the average for the last forty years or so. I think that is important to get into perspective because a lot of the discussion around public spending over the last couple of years has tended to suggest we were heading for some Scandinavian levels of public expenditure and we are not at all; we are on a fairly average level. In terms of the details that have come out, my primary interest is in the efficiency reforms around Gershon and Lyons. I have to say, and I hope this will come out in discussion this morning, that the more I have dug through the Gershon Report, the less and less convinced I have become that it is actually going to deliver what it was promising.

  Chairman: We will come on to that later.

  Q2 Mr Beard: The Expenditure Review has taken place against a background of increased deficits in public finances. Are these spending commitments affordable if the Chancellor is to stick to his fiscal rules? How much margin for error against the golden rule does the Treasury have if the public finances turn out worse than expected?

  Mr Walton: I think we know that there was never going to be much margin for error if you look at the budget projections. The Treasury is expecting the golden rule to be to be just in a small surplus over the average of this current cycle, which it is assumed will end in 2005-06, and then it projects a surplus of 0.1% of GDP over the period 2005-06 to 2008-09. So the margin for error is going to be very small. As I say, I think there are two things which have made that margin for error even smaller. The first is that outturns continue to be slightly worse than expected, particularly on tax receipts, and it is taxes which are important because you can fix the overall level of public spending if you have got the sufficient machinery in place—and you can stick to those numbers—but you have very little control over the taxes. If taxes undershoot, they have obviously got to surprise positively to bring it back on track. The other thing is that the economy looks as though we are operating quite close to potential now. I think the Bank of England's view is that there is not very much slack. My own judgment would be that there is not very much slack, given that we have seen unemployment fall to new lows and we are beginning to see wage inflation pick up. It would be prudent I think to assume that the slack is going to be used up in this current financial year, given that the economy this year is probably going to grow by about 3.5% or so, above trend. I think we are in a position where it is looking increasingly hard to see how the golden rule is going to be met over the future without some increase in taxes over that future period as well. That is not to say that there is back hole or anything like that in the public finances; the public finances overall are in very good shape still on any kind of international comparison or indeed over any historical comparison. The net debt ratio last year was under 33% of GDP. Even if you get a bit of an overshoot in borrowing, it is probably only going to be around 37% of GDP by 2008-09. In any long term sense, the public finances are looking in extremely good shape but if the Government is determined to stick to the golden rule, then I think we are getting much closer to the point where taxes will need to increase.

  Mr Chote: Essentially I would agree with that. The Treasury's view is that the golden rule will be met with a modest safety margin over the current cycle and then they will go into the next cycle building up current budget surpluses, which would mean they would be on course to meet it then. Our view is, as you will recall, that we are somewhat less optimistic than the Treasury about the degree to which tax revenues are going to flow in above and beyond any improvement arising from stronger performance in the economy. We have not re-done our forecast but our last view was that we still think the rule will be met pretty much exactly over the current cycle but that, moving into the next cycle, if revenues do not come in as much, that would mean that there would be a need to raise taxes if you wanted to bring in the revenue that the Treasury is relying on (a) to pay for the spending plans and (b) to meet the golden rule in a forward-looking way. Obviously, if the spending plans are over-shot, then that makes the situation more difficult and, as David's note points out, obviously the fact that there may be less spare capacity in the economy for the Treasury, would mean that the underlying position is worse and therefore there was more ground to catch up.

  Q3 Mr Beard: You have both mentioned the revenues. Have the revenues during this financial year met the Treasury's forecasts or do you think the tax revenues will bounce back to the Treasury forecast?

  Mr Walton: We had figures at the end of June, complete national accounts figures, for the financial year that has just ended. Those numbers can still be subject to revision but essentially they show that overall public sector receipts undershot the budget projection by £1.6 billion. That is relatively modest but when you are running to quite tight margins of error to begin with, it clearly would have been much more helpful if we had had an overshoot of receipts of that magnitude rather than an undershoot. As for whether or not you get a bounce back, I think it is the case that when the economy is growing rapidly, you do tend to get a faster pick-up in receipts than most of these rules of thumb suggest. Most rules of thumb indicate that for any given overshoot you can multiply that by a particular elasticity and that gives you the extra receipts. My own casual observation is that when the economy is growing rapidly, that is when tax receipts do tend to come in better than expected and, when the economy is obviously in a downturn, tax receipts are worse. Clearly companies and individuals have an incentive to try and economise their tax liabilities when things are doing fairly badly. I would not be at all surprised to see a pretty strong bounce in tax receipts but do remember that the Government is already expecting a strong bounce in tax receipts. It was projecting the ratio of public sector receipts to GDP to rise from 37.8% last year to 38.7% of GDP this year, a 0.9% increase. That may happen but we do know that the starting point is 0.2% GDP worse than was projected in the budget. You have just got that much more ground to make up.

  Q4 Mr Beard: When we raised this at the time of the budget, the answer we got from the Chancellor was, "We have got direct access to the Inland Revenue and Customs and Excise and their direct knowledge of what firms are doing and what they are expecting and that gives us pretty good confidence that we will hit our targets". Do you accept that argument?

  Mr Walton: I think they come up with their best guess but, frankly, the margins of error are huge. We know from historical experience that in trying to forecast either the current budget or the overall public sector net borrowing the average error is about 1% of GDP and it increases at that rate each year you go into the future. With the best forecasting models in the world, you can still very easily come unstuck. I do not believe that the Treasury have not given it their best shot but there are lots of things that can actually blow you off course along the way.

  Q5 Mr Beard: Robert Chote, if we are not going to meet these targets for revenue, when does the crunch come for the golden rule?

  Mr Chote: Because the rule is defined in such a way that it only has to be met on average over the economic cycle and not in any particular year, then unless we take a particularly rigid interpretation of the golden rule over the current cycle and then if the Chancellor were to have a forecasting error which went in the wrong direction which meant that he suddenly had some ground to make up by 2005-06, then that would be a crunch, but it would also be a rather silly rigid way to interpret the rule, simply to make a policy adjustment at that stage just to hit that somewhat arbitrary target. In terms of the longer term outlook, there is not a particular point at which you have to say, given we do not know how long the next economic cycle is going to be, that something has to be done by this date. Clearly, for as long as the Treasury forecasts a rise in tax revenues and people bow to its coming in, and your point that they argue that they have better information and they can forecast things better, there is a strength to that argument. Of course it has not stopped them getting the forecasts wrong in the past. Concerns expressed by, for example, Mervyn King, et cetera, would clearly create pressure, but there is no particular year on which you have to say, "The job has to be done by now".

  Q6 Mr Beard: The implication of what you are both saying is the current economic cycle is going to finish earlier than the Treasury are expecting?

  Mr Walton: That would be my belief but the nature of these things is that we are not going to know for some time as to precisely when the economic cycle is on trend, if indeed we would ever know precisely, because you cannot measure in any definite way what the output gap is. The proof is in the pudding, in a sense, in that if inflation is actually on a rising trend, that gives you some kind of prima facie evidence that the economy is above trend, but these things can really only ever be dated some time after the actual event.

  Q7 Mr Beard: What would be the implication of the golden rule if the cycle was foreshortened in this way?

  Mr Chote: It would make it easier to hit it in the current cycle and more difficult to hit it in the next one. That is the answer. Basically you are shifting a year of bad news from the current cycle into the next one.

  Q8 Mr Beard: Robert, the IFS noted that in the previous two Spending Reviews the Chancellor was able to revise up the spending plans to release resources in annually managed expenditure for spending on items such as the Child Tax Credit in the New Child Trust Fund. Do you think we can rule out that possibility of such a favourable addition during this spending cycle?

  Mr Chote: It is annually managed expenditure and therefore can be returned to year by year. Partly I guess that would depend on what else was going on with the social security and tax credit budget. One difficulty which we start to see now with social security expenditure within AME being projected to pick up towards the need of the cycle is that you are starting to see female baby-boomers retiring, which is pushing up pension expenditure somewhat, so that may make life rather more difficult at the margin. The Treasury has a testing starting for child poverty which would imply there are some areas of tax credits and social security which would need to be increased relatively strongly if you are going to make further progress in that direction.

  Q9 Mr Beard: The Atkinson Report has not been published with this review. What evidence is there of the extent to which the additional public expenditure in services has translated into increased output and improved services rather than increased public sector inflation?

  Mr Walton: There is some evidence in the figures. Health care output has been revised up in real terms in both 2002 and 2003 from 3.2% a year to 3.8% a year. You have also seen upward revisions to real government consumption. The statisticians have found more real output. There are some oddities, though, and I will just give you one, which is that in 2003, despite the increase in the real output growth, overall government output growth has actually been revised down from around 2.5% to around 2%. There are some funny things going on in the numbers. While I can understand that the ONS, as soon as they have a methodological improvement, they will want to get that into the statistics as best as possible, and there is quite a helpful note explaining what they have done with health care, nevertheless, there is a lot else going on and it is very difficult to unravel precisely what is actually happening. It is odd, as I say, that the growth in public sector output overall seems to have been revised down last year despite the fact that health care output has been revised up.

  Q10 Mr Fallon: Professor Talbot, could you enlighten us a bit about this 2.5% efficiency saving? What proportion of that is taken up by the job reductions in the civil service and what is elsewhere like centralisation of purchasing and so on?

  Professor Talbot: That is interesting because if you go through details of the Gershon Report and the fact, as you will recall, we start to go through the individual departmental numbers, there are no figures given in the body of the report for that. You have to rely on going through individual bits at the back from the departments. There is a very uneven picture there because they do not actually give you information. On none of the individual departmental reports are the numbers of staff reductions calculated then as a proportion. For example, if you take the Department of Education and Skills, on page 47 of the Gershon Report, they give a number of bullet points about things that are going to lead to the overall £4.3 billion saving by 2007-08, but on the first point about the staff reductions, they do not give an amount for that, whereas for there second, third and the fifth points they say they are 30%, 35% and 15% of the total amounts. They do not actually give any figures.

  Q11 Mr Fallon: You are the expert. What do you think the proportion is? What bit of the 2.5% efficiency savings is job reductions and what is the rest?

  Professor Talbot: I would guess probably somewhere between one-fifth and one-quarter.

  Q12 Mr Fallon: That is between one-fifth and one-quarter of 2.5% of the job cuts?

  Professor Talbot: That is of the total amount, and the CBI has put out estimates, and I am sure you are aware of that, of about £5 million, which seems a bit excessive. That would be about one-quarter of the overall total. I suspect it is going to be lower than that.

  Q13 Mr Fallon: So the rest of the 2.5% is better working, centralised purchasing, stuff like that. Is that right?

  Professor Talbot: Yes.

  Q14 Mr Fallon: Of the job reductions, how can the Chancellor enforce the 20,000 reductions in the devolved administrations in Scotland and Wales?

  Professor Talbot: With great difficulty, I suspect.

  Q15 Mr Fallon: What is his mechanism?

  Professor Talbot: There is no direct mechanism. The funding mechanism to the devolved administrations is automatic, so they get their money. They make the decisions about how that money is allocated. There are all sorts of indirect and informed pressures that can be exerted but there is no direct formal mechanism that enables the Chancellor to say to either of the devolved administrations, "You will cut so many jobs".

  Q16 Mr Fallon: Is it a letter or a prayer or what?

  Professor Talbot: I think it is probably a prayer.

  Q17 Mr Fallon: How does he enforce job reductions and efficiency savings on the rest of local government and NHS trusts? How does he enforce back-office savings on those areas?

  Professor Talbot: I think that is one of the central difficulties about this whole initiative. The whole trend recently has been towards devolving powers, particularly over operational management issues and choices about how public services are managed through their own managers who are to some extent the users of those services. Gershon relies quite extensively on centralising back-office services, centralising the decisions about things like staffing numbers and so on, in order to make the efficiency savings. I think there is a fundamental clash between those two different approaches. It has already come out in things like the Health Service where Nick Timmins reported earlier this week that a particular initiative to do joint services worth £100 million with £400 million worth of savings had not worked simply because Ministers had been unwilling to impose it on the NHS trusts. Ministers can be confronted with a choice. They have either got to impose on those organisations on which they can impose, and that is not all of them, and there will not necessarily be autonomy, or say, "It is up to you whether or not you adopt these new initiatives". If that happens, the track record has been that some of them will say "no".

  Q18 Mr Fallon: Is it possible that the Chancellor could fire his 80,000 in England but not secure 20,000 redundancies in Scotland and Wales and in fact see an increase in public sector employment outside the Civil Service?

  Professor Talbot: There will be an increase in public sector employment outside the Civil Service anyway.

  Q19 Mr Fallon: This is in the back office. I do not mean teachers.

  Professor Talbot: In back-office terms, it is entirely possible that in Scotland and Wales that could happen in theory. I do not know whether it will. It will obviously be up to the political decisions of the devolved administrations. At the moment, both of those are saying that they are going to go for comparable efficiency savings.


 
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