Examination of Witnesses (Questions 1-19)|
14 JULY 2004
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
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 placeand you can stick to those numbersbut 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
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
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
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,
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
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
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
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.