House of COMMONS






Monday 21 March 2005



Tuesday 22 March 2005


Evidence heard in Public Questions 1 - 312




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Oral Evidence

Taken before the Treasury Committee

on Monday 21 March 2005

Members present

Mr John McFall, in the Chair

Mr Nigel Beard

Angela Eagle

Mr Michael Fallon

Mr David Heathcoat-Amory

Mr George Mudie


Examination of Witnesses


Witnesses: Mr Robert Chote, Institute for Fiscal Studies, Professor Peter Spencer, York University, Mr David Walton, Goldman Sachs, Mr Martin Weale, National Institute of Economic & Social Research, Mr John Whiting, PricewaterhouseCooopers, examined.

Q1 Chairman: Good afternoon. Welcome to the Committee's hearing on the 2005 Budget report. Could you introduce yourselves for the shorthand writer, please.

Mr Whiting: John Whiting, tax partner at PricewaterhouseCoopers and chair of Chartered Institute of Taxation Tax Policy Committee.

Mr Walton: David Walton, Chief European Economist at Goldman Sachs.

Mr Chote: Robert Chote, Director of the Institute for Fiscal Studies.

Mr Weale: Martin Weale, Director of the National Institute of Economic & Social Research.

Professor Spencer: Peter Spencer from York University.

Q2 Chairman: Welcome. Even more than usual, we are short of time. I am trying to get everything done within 60 minutes, so we will be short with our questions and I am sure you will be equally, if not shorter, with your answers. We will focus on one particular individual rather than everybody having a bash at the same question, if you do not mind. It has been reported that the deterioration in the UK's fiscal position since 1999 was bigger than that of any other G7 country other than the US. To what extent, therefore, should we thank this loosening in the fiscal position for the US and the UK's position near the top of the G7 growth league table?

Mr Walton: Part of this was clearly planned. It was very useful that the planned increase in public spending did start to kick in just at the time that the world economy was going into quite a marked slowdown in economic activity. It is noticeable that countries which have eased their fiscal stances quite a lot over this four or five year period have performed rather better in avoiding some of the worst effects of the global slowdown than might otherwise have been the case. In particular, it is investment which really got hit very badly during the global slowdown. There is not much you could do about that, and so, to have a bit of extra government spending and a bit of extra private consumption as a result, that turned out to be quite fortuitous.

Q3 Mr Fallon: At the time of the pre-Budget report, you said the probability of the Chancellor meeting his fiscal rules in the current cycle was somewhat lower than 15%. Now you say it is around 65%. Can you elucidate.

Mr Chote: The distinction there is between a calculation that simply looks at what the Chancellor should think his probability is, based on his own forecasts, and the distribution of forecasting errors that the Treasury has had in the past, in which case the position at the time of the last Budget was a probability of roughly 60% and the position is roughly the same now. Our view was that the current Budget deficit was going to be somewhat larger than the Chancellor was predicting in the Budget and pre-Budget reports of last year; indeed, it has turned out for 2004/5, if the Treasury is right, this time to be pretty much what we said in the Green Budget in January, and we are more pessimistic than they are about where the deficit is going to be next in the coming financial year. So, based on our forecasts and our past forecasting, the probability would be less than 50%; based on the Chancellor's forecasting and the errors around his forecasts in the past, it would be greater than 50%. That is the distinction.

Q4 Mr Fallon: Peter Spencer, is that your view?

Professor Spencer: About that, yes. We also thought that the current balance for this year would come in at a deficit of around about 14/15 billion, and of course the out-turn has been slightly worse than that. But the real problem, going forward, is that we really cannot see such a strong economy and such a strong growth in the tax share of GDP to bring the Chancellor's estimate of 16 billion deficit for this current financial year down to the kind of figure of 6 billion that he is talking about for next year. As usual, it is just possible, but it is right on the margins of error as we see it.

Q5 Mr Fallon: Does it follow from that, that the Golden Rule cannot be met in the next cycle without either a cut in spending or additional tax revenue?

Professor Spencer: I think the considerations, going forward, are slightly different. We have to assess where we will be in the first year of the next cycle, which is almost certain to be 2006/07. On our estimates the cycle will actually begin with a small deficit, probably around about 0.5% of GDP. I am afraid that the Chancellor is probably assuming that fiscal drag and a corporate recovery will gradually erode that deficit and push it into surplus during the course of the next cycle, and I am slightly concerned that the Treasury may be planning to go ahead on that kind of basis. It is just possible, if the economy really is as shock-proof as the Chancellor seems to think it is now, that he might just get away with that kind of, what I call, "muddling-through" strategy. But, in my view, that would be very dangerous because I do not think the world economy is at all shock-proof, even if the UK economy is. We were talking earlier about the effect of a world recession on the UK's public finances - even though the UK on that occasion, post-millennium, avoided recession - and I think it would be just too dangerous to go ahead on that basis - which is why, I think, on the precautionary principle, a prudent Chancellor after the election would try to tighten fiscal policy to buy some leeway in case things go wrong.

Q6 Mr Fallon: But I asked you not what you think should happen but how likely it was that the Golden Rule would be met in the next cycle without either a cut in spending or additional tax.

Professor Spencer: If I am right in thinking that there will not be a significant tightening over the next two or three years, then I think it is likely to be broken in the next cycle.

Q7 Mr Beard: Why should that leaving the tax framework unchanged be described as "muddling through"?

Professor Spencer: Because the margin for error would be just so small if we started with a small deficit in 2006/07, then worked into a balance, and then, assuming that things continued on the rosy path that we have had, that would move it in to surplus. That is possible - that he would get away with it - but it would be extremely dangerous.

Q8 Mr Fallon: David Walton, the ONS looks at roads' maintenance for a couple of years and then suddenly, four weeks before the end of the financial year, moves 3 billion of it from one side of the line to the other. The ONS is funded by the Treasury, reports to the Chancellor and is staffed by a large number of Treasury officials. How damaging to its credibility do you think that decision is?

Mr Walton: I do not think it was presented in perhaps the best way it could have been. At the end of the day, if they have made an error - and it looks as if they did make an error in terms of the way they were treating the spending on repairs and maintenance - then it is important that it should get corrected. As I understand it, the ONS position is that they corrected it at the first possible opportunity.

Q9 Mr Fallon: First opportunity, after October 2002?

Mr Walton: That is what they claim in terms of what they have put into the public domain. All I would say is that it does not look very good doing these sorts of changes so close to a budget. You would hope that you would be very sensitive to the budget timetable, so you would either get this stuff out a couple of months earlier or it would be something that you would ----

Q10 Mr Fallon: There would be a closed period, in other words.

Mr Walton: I think that would be desirable. Supposing it had been the other way round and suppose they had suddenly found that current borrowing had been somewhat higher, then suddenly to release that a few weeks before the Budget, a few weeks before a General Election, yes, they are independent, but it would not really take account of the political sensitivities that attach to these things. I have no doubt in my own mind that the ONS is independent. I would not entertain any thoughts of political shenanigans behind the scene. But I do not think, frankly, that they did handle it in the best possible way. I think that when they announced they were going to do this they should have given upfront some indication of the orders of magnitude rather than allowing the press that weekend after they said they were going to do this to speculate about some quite wild numbers which were obviously inaccurate. So all round I think they could have done a bit better job in presenting this.

Q11 Mr Mudie: Have you looked at local authorities and how they treat similar expenditure?

Mr Walton: No, not in any detail. I presume actually that with some of this repairs and maintenance spending quite a bit of this is done by local authorities.

Q12 Mr Mudie: You get approvals, I suppose, from the Treasury, and I see what you say, but local authorities spend money on goods, maintenance and road repair all the time. We must have a policy. You cannot have the national Government saying this is capital and local government doing something different. Or do you?

Mr Walton: The ONS will treat this in the same way. I am sure they have looked at both.

Mr Chote: We have had issues in the past where spending has simply been re-categorised from capital to current or vice-versa and things have gone in both directions. I think this was a case where they think they have identified some double-counting, because they have done calculations in two different ways. So this was identifying basically a foul-up as distinct from making a judgment that something which you had hitherto thought was current is now capital.

Q13 Mr Mudie: That is different, is it not? That is purely an accounting measure. Are you sure that is what it is?

Mr Walton: That is what the ONS says and I have no reason to believe otherwise. The other point, of course, is that it does underline the fact that, putting an awful lot of significance on whether this rule is met or missed by a few billion either way, when these sorts of issues show the blurred line between current and capital, I think tells you more about the rule than about this precise case.

Mr Weale: Perhaps it is appropriate to mention that, although I am not here representing the Statistics Commission, the Statistics Commission has looked into that. There is some public correspondence on its website and it is going to report on the issue. But my understanding is exactly the same as Robert's, that it was double-counting of depreciation expenditure and it was unfortunate that it was originally described as a miss-classification. That I think added to the confusion.

Q14 Mr Fallon: Serendipity, then.

Mr Weale: Well, I agree with the view that the timing was rather unfortunate.

Q15 Mr Fallon: If he was going to miss his target by as small a gap as 3 billion and suddenly an extra 3 billion is found, it does make one rather suspicious, does it not?

Mr Walton: But I think Robert's point is right, which is that the focus on whether or not you hit the rule by 2 or 3 billion or you miss it by 2 or 3 billion, economically it makes absolutely no difference.

Q16 Mr Mudie: He described that as very dangerous.

Mr Walton: I do not understand how it can be very dangerous.

Q17 Mr Mudie: What is very dangerous, as you say, about missing the target by that amount?

Mr Walton: It is partly the way the rules are formulated. Clearly the Chancellor has told people to judge him.

Q18 Mr Mudie: It might be very embarrassing, but not very dangerous, is it?

Mr Weale: The Committee did say after the pre-Budget report that it might be a sensible time for the Treasury to look at re-specifying the rule, and there is an obvious question why should it not be more like the inflation target, with a boundary on each side?

Q19 Chairman: You did say it was dangerous, Mr Spencer.

Professor Spencer: Yes. There is a distinction between failing at the end of the day to hit by the odd couple of billion and planning the next cycle with no margin of error. That is dangerous because if something comes along like a world recession to knock you off balance, then that will force you into a discretionary tightening of policy to offset the effect of the automatic stabilisers. To put it differently: to come back to where we started this discussion, the current cycle started with some very large surpluses, which is why the Chancellor was able to fight the last election, to fight a war and to fight a world recession within the room for manoeuvre that he had. None of that will be possible if he plans to run the next cycle on the kind of tight margin that we are looking at here.

Q20 Chairman: You have looked into a golden ball and you are assuming all these things. If I remember the press at the weekend, in our golden ball prediction, the Chancellor in the next year is going to impose 4 billion windfall tax on the banks. Who are the important people you are talking to who can tell us that? It could save us a lot of bother in the Treasury with finding these out pretty quickly.

Professor Spencer: That was unfortunate. I was simply asked where I thought the Chancellor's axe might fall and I gave that unguarded response.

Mr Walton: On the point about war, for instance: we have fought a war and so far it has cost 5 billion or so. Traditionally, if you look back at the evolution of public debt, public debt has gone up massively at times of war. It went up massively during the First World War; it went up massively during the time of the Second World War. The code for fiscal stability does not say that you have to adhere to these rules at all times. In fact, it says that if you actually breach the rules then the Chancellor has to just explain. It would be perfectly sensible to say, "We have spent 5 billion - if that happens to be the margin by which you have missed the rules - "Well, this was a war that was unforeseen and the ongoing expenditure was unforeseen." I am not saying that rules are not a good thing; all I am saying is that you have to keep them in perspective. If we are just talking about a situation where debt is absolutely very low, then it would be a bit odd to make too much of it.

Q21 Chairman: We are beginning to get a wee bit wandered here. Martin, would you put us right on the straight and narrow again.

Mr Weale: Whether I will put you on the straight and narrow, I do not know, but could I make two observations. On the question of the chance of the Golden Rule being broken in the next economic cycle, I am with, I think, many other people in believing that taxes will probably need to go up, that there will be a gap of something between 10 and 15 billion to be closed, but the margins of error in projections three or four years ahead are such that if I had to put a probability on it I would say that with those numbers the probability of meeting the Golden Rule target is probably about 45%. It is not much less than evens. With the Treasury numbers it is slightly higher than that - maybe it is 55%. It is not much above evens simply because the future is so uncertain. The other issue that I think needs to be addressed is: Is the Golden Rule tight enough for the British economy? The point - which I think was due to Mervyn King - is that the country is not saving enough and perhaps the Government should be setting an example; in other words, it should be running a surplus and not be satisfied merely with balance.

Q22 Angela Eagle: The economic cycle to come is maybe not subject to staring through a golden ball but maybe a crystal ball. No future cycle is going to be the same as a past cycle. Surely the point of these rules is to navigate us through so that we can get some kind of handle on where we are and how relatively safe or dangerous it is in terms of good economic policy. It seems to have worked quite well so far, does it not? We have had 50 consecutive quarters of growth. We are not doing so badly, are we?

Mr Walton: I think that is right. These rules give you very good benchmarks for achieving fiscal sustainability.

Q23 Angela Eagle: It is a navigation process.

Mr Walton: But whether or not at the end of the day, after the end of the cycle, you are a few billion either side of that objective makes absolutely no difference in any economic sense.

Mr Mudie: In terms of economic catastrophe, unemployment, inflation, whatever, the world would move on with very little change if he did not meet his rules by those. It is more his credibility. It is self-imposed rules he puts down by which the City judges him. And if he fails, he has lost a bit of credibility but it is for him to explain. But the economic world will go on. I would rather they were broken and we got rules as Europe treat the rules that seem to defy real life.

Mr Beard: Are the Treasury in the best position to judge the buoyancy of future revenue? We have just gone through a period where everybody was scoring the Chancellor's chance of bringing the revenue up to his forecasts but the answer from the Treasury was, "Well, we know the Inland Revenue, we know the customs, we know what is lying in wait." Is that not the case in looking at the Golden Rule for the next six years?

Q24 Chairman: We have revenue further on, Nigel. We have completely lost the thread here.

Mr Weale: To pick up the previous point, if you look at the Treasury's forecasting record of government borrowing in the recent past, it has not been bad relative to what might have been expected but it gives you no confidence at all that their numbers are going to be right and other people's are going to be wrong looking into the future. To take the navigation analogy, I think if someone was navigating a boat, they would tell you how they were going to steer the rudder if they got blown off course instead of merely asserting that nailing the tiller to the boat will steer them safely through all possible obstacles that they might meet. And that is the difficulty that I have with the current debate about the Golden Rule.

Q25 Mr Heathcoat-Amory: Tax revenues are projected to rise by over 8% next year. I think that would make a bigger real increase than perhaps we have ever seen. Is this realistic? Is it cautious, as the Treasury say? Or is it, as the IMF say, over-optimistic?

Mr Chote: There is the issue there about the coming year. I think the IMF as well was referring to revenues over the next three, four, five years as well. Certainly our view - and the view of a number of other people here - is that we are not convinced that revenues are going to be as buoyant in the absence of the announcement of new policy measure over the next few years as the Treasury thinks. Our concern principally in the past has been whether corporation tax will come in as strongly as hoped. Clearly, the Chancellor had a couple of very good months on corporation tax in the early part of this year but I think there still remain doubts as to whether corporation tax revenues are going to grow as strongly as he hopes. Looking further into the future, the Chancellor is relying particularly on continued very strong growth from the financial sector so much depends there. Linking back to the point Mr Beard was making, when the Treasury say they have more beneficial information, that may be true over fairly short time horizons with the sort of information they are likely to have from HM Revenue and Customs. In the longer term, you are making judgments about how quickly the tax base is growing, whether there are other factors that would lead you to believe tax revenues are likely to grow more strongly than in the past for a given state of the economy. I am not sure there that the Treasury necessarily has greater information than any of the rest of us. It does not mean they will be right or wrong but it may be true over the much shorter term. I would certainly be sceptical about their tax revenue forecasts.

Q26 Mr Heathcoat-Amory: I wanted to ask Mr Whiting about corporation tax because you observed recently that this tax is vulnerable to the European Court of Justice decisions which are using single market powers to undermine our tax base. Do you think this has been tackled or do you think this is a continuing vulnerability given that corporation tax receipts are due to increase next year by 28%?

Mr Whiting: That is a particularly vulnerable forecast. It may come through but it is predicated on very energetic City type activities which may well happen. The City is doing well. Whether it will deliver that bounce in the corporate tax revenues is a very moot point. You are quite right I still have to point to the impact of a number of the European Court of Justice cases that show that the UK tax system is at variance with the freedoms under the European treaties. A number of those are pending, as we discussed last time I was here. Those could bring in quite a financial penalty for the UK and indeed many other countries' tax systems with a forced repayment of taxes that are found to have been illegally levied. It is not huge in the absolute terms we have been discussing in terms of golden rules but it could still put a little dent in. I would also look at this whole issue from a slightly different point of view or put another point of view down, which is that if the Treasury think that they are going to take this sort of money from corporate tax, particularly the City, I would expect them to be coming forward with policies and tax changes that are orientated towards making sure that business comes to the UK, stays in the UK and is retained in the UK. I think there is a lot of good stuff within this Budget and in previous statements, but I would expect that to be very much a policy that one could detect through all budgetary statements. I am not sure it is there as much as it should be.

Professor Spencer: If we are talking about the longer term, over that sort of time horizon we are looking at a lot of other factors which the Inland Revenue's models are going to find it very hard to pick up. Most obviously, if the effective rate of corporation tax paid by our companies rises, as it rises, according to the Treasury towards peaks which we have only ever seen when the economy has been very strong, we can expect all sorts of disincentive effects to kick in. We have to remember that there is this problem of tax arbitrage going on. Those past peaks were seen at a time when our corporation tax rates at 30% were relatively low compared to the rest of Europe but we have seen a lot of competition from eastern Europe, most obviously Poland and Slovakia who are moving over towards so-called flat taxes, and in response to that Chancellor Schroeder in Germany last week brought in a reform package which will see German corporation tax rates cut, I believe, to as low as 19% for very large companies. We have to be very wary that we simply will not be able to attain the kind of share of tax in corporate profits that we have seen in past cycles.

Mr Whiting: I would agree wholeheartedly. We have another example on our door step with Irish rates being 12.5%. Corporation tax is being used as a loss leader by some countries to attract the business in. I am not saying we should go to that level but it is a factor that we have to be aware of.

Q27 Mr Heathcoat-Amory: Since we are therefore in an international tax competition, can I ask our witnesses about the tax take as a %age of GDP? This is rising strongly, going up by a projected increase to 37.3%, which is nearly 2% more than two years ago. Are we now getting out of line internationally in this respect and are there dangers both to our competitiveness and our tax base if companies and activity migrate away from us due to increasing tax burdens?

Mr Weale: No. If one looks at the tax share in general, I do not think we are very out of line. Obviously, the numbers move around a bit. The United States tend to be a lower taxed economy. The continental economies which have stagnated for the last four or five years tend to be rather higher taxed economies and we are somewhere in the middle. I would be surprised if even the general increase that is projected here would be likely to lead to large tax migration. The issue of corporation tax competition is a rather different and specific one and that could be a problem whether there was a general increase in the tax share projected or not. I think we should focus on that more than the issue of whether you and I are going to decide to live in a tax haven rather than in the United Kingdom.

Q28 Mr Heathcoat-Amory: The reason I ask is that this Committee has been very concerned about tax migration on excise duties, so we are sensitive to these international comparators. We also are advised that the tax burden on the non-oil sector is at a record. Therefore, are we in uncharted waters in that respect?

Professor Spencer: We most certainly are. If you look at the notes that I prepared for this Committee at the time of the pre-Budget report, I first took chart C3, which is the tax/GDP ratio, on page 255, which shows total taxes as a share of total GDP. If you look at that chart, we appear to be nudging up towards the peak that we saw back in the early 1980s. As my chart showed, if you take out North Sea companies who of course were paying 12 billion a year or thereabouts in tax back in the early 1980s, the peak falls back to around about 35/36%. We are in uncharted waters in terms of the burden of tax on non-North Sea economy.

Mr Whiting: If you lose business, it is not just corporation tax that you are losing. You are losing all sorts of other revenues as well. There is some evidence, because ours is so much more of a service economy, that businesses are looking at where should services, particularly electronic based services, be located. What is the main tax affecting them? Very often, VAT. I think there has been a certain amount of publicity and perhaps businesses could put a certain amount of electronic based business in Luxembourg which has a rate of 12/15% VAT rather than here at 17.5%. It may seem like a very small shift but it is something companies are looking at. It is not and never will be the sole determinant of where business is located but it is a factor and it is not just the corporate tax revenues that could be at risk.

Q29 Angela Eagle: There does not seem to be a great outpouring of service industries offshore at the moment, does there? It is all rather alarmist, is it not?

Mr Whiting: I would not claim that ----

Q30 Angela Eagle: The whole of our business is going to flood out to Luxembourg to save 2% on VAT, is it?

Mr Whiting: I do not think I would try and sound that sort of note, no, but if we are asked by an organisation, "Where should we locate or relocate?" there are many factors that they will take into account. Tax is one of them along with everything else. Many years ago, if a Japanese company asked, if it was supposedly the quality of the golf courses that was a factor as well as taxes!

Q31 Angela Eagle: I do not think we do badly on golf course quality.

Mr Whiting: We do extremely well on that, perhaps why, we have a lot of Japanese inward investment! Tax factors are now more important, I think than ever.

Q32 Angela Eagle: Many of you at the time of the pre-Budget report were very sceptical about the Treasury's corporation tax forecasts but the Budget papers reveal that corporation tax receipts came in a billion higher than forecast. Is there any apology to us for your constant scepticism about the Treasury forecasts in this result?

Professor Spencer: I do not think an apology is in order. We give the best advice that we can.

Q33 Angela Eagle: Is constant scepticism your only gear?

Professor Spencer: When you are looking at forecasts which appear on an objective basis to be extremely optimistic, yes, I am afraid a central forecast would cause you to be sceptical.

Q34 Angela Eagle: The outturn was a billion better than the forecast.

Professor Spencer: On this occasion it was.

Q35 Angela Eagle: You were wrong?

Professor Spencer: Yes. That shows the margin of error that we are looking at.

Mr Weale: Yes, behind any forecast you can unpick the components. I made the point earlier that the Treasury continued to underestimate government borrowing or current account borrowing even into the autumn of last year. It has now turned out worse than even the National Institute were expecting. If they did well on corporation tax, they must have done even worse on some other component of borrowing because overall borrowing has been 3.5 billion higher than they were forecasting. You always find swings and roundabouts which perhaps demonstrates why it is best not to get too excited by any individual number.

Q36 Angela Eagle: In other words, it is a navigation process, which I was saying earlier, rather than an exact science.

Mr Weale: We have never claimed it was an exact science. I would draw the Committee's attention to the fact that two and a half years ago it asked the Treasury to produce a fan chart for government borrowing. I would strongly suggest that you ask them to do that again.

Q37 Angela Eagle: How does the Treasury's forecast for the level of tax/GDP ratio compare historically in this country and internationally, because there has been rather a lot of worry about that in the papers over the weekend.

Professor Spencer: In terms of our own past history, if we were to push up from the current 37% of GDP area towards the 39% the Treasury are looking at, we would be in uncharted waters. In terms of the burden of tax on the non-North Sea sector, that would be ----

Q38 Angela Eagle: I am talking about the economy as a whole, not only the non-North Sea sector. The difference between tax and GDP ratios is not that different historically, is it?

Mr Chote: It would get the tax burden, if I am right, for the whole economy back to what would be a 25 year high by the time you get to the end of the Treasury's forecasting period.

Q39 Angela Eagle: In your Green Budget, you yourself pointed out that that would be the highest since the mid-1980s but it would still be lower than the whole average during all the Conservatives' four terms in government, so it is nothing to have nightmares about, is it?

Mr Weale: If you are concerned about tax migration, the only point you might make is that there is greater international mobility of business than there was in the 1950s and 1960s.

Q40 Angela Eagle: We said earlier, did we not, that there is no sign of mass business migration at the moment?

Professor Spencer: It is early days yet. The new EU accession countries only joined last May and the real impetus for tax competition is coming from the east in the way that I indicated earlier.

Q41 Angela Eagle: You think the City is going to decamp en-masse to Slovenia or something?

Professor Spencer: No, but that is the kind of risk that we are running.

Mr Walton: Can I make a point about this tax/GDP ratio and compare chart C3 with chart C4? Yes, it is true that taxes as a share of GDP are rising back to the highs that we saw in 1978/9, but if you look at spending it is a long way below those sorts of levels. Spending still looks pretty low in a historic sense. What has really changed is that borrowing is a lot lower now than it was during much of that period. This is one of the reasons for the fiscal rule. The current Budget was persistently in deficit. The government was persistently running down its net worth right up until 1997 and since then you have had a much bigger change. Yes, we are in deficit at the moment but the underlying current Budget position has just been a lot better in the past few years than it has been through much of the 1970s and 1980s and even the 1990s. If you want prudent levels of borrowing and achieve these sorts of rules in a way that we did not achieve them for much of the 1970s, 1980s and 1990s, it is inevitable unless you want very much lower levels of public spending as a share of GDP that the taxes are going to have to be higher. Something has to give.

Mr Chote: We get less non-tax revenue. The government gets less. The difference between current receipts and tax revenue is smaller now than it was, so you are not getting as much revenue from other sources other than tax.

Mr Weale: I remember hearing Mr Kenneth Clarke saying that he thought a government spending of 40% of GDP was fine and the sort of thing he was comfortable with. We now have a different government and that it should be comfortable with 42% rather than 40% does not seem to me to be the sort of straw that would be likely to break a camel's back.

Chairman: It will be a big issue for the General Election.

Q42 Angela Eagle: The Budget speech contained some interesting strategic comments by the Chancellor about the challenge of China and India and some investment in stem cell research science. Do you have any comment on the strategic positioning the Chancellor is taking in that area to protect our ability to compete in future in the global economy?

Mr Weale: I suppose they are taking a deep breath and wondering how far and whether it is possible for the government to see a long way into the future and to see which areas are going to be the growth industries that Britain should be aiming to compete in. In the 1970s we had a history of rather unsuccessful attempts. We are not talking of the same sorts of things now but the government needs to make people await the changes. It needs to ensure that the British economy can function efficiently. Whether and how far it is sensible for the government to pick the technological winners of the future I am rather less clear about.

Q43 Angela Eagle: The issue is whether it is appropriate at this moment to be putting a lot of money into science funding to do pure research, whether you are looking at things like stem cell research and some of the areas that may open up pharmaceutical or medical issues. It does not seem to me that they are picking individual companies but they are looking strategically in quite an interesting way at what the government can do to strengthen these sectors. You are saying you disapprove and it should be left completely to the market.

Mr Weale: On the contrary. I think supporting basic research is something that other countries have historically done rather better than us. I am very glad to see that happening. I hope it will help us compete more effectively than if we did not do it against the emerging economies. We should be doing it whether we are confident it will or not but the process is a peer process rather than identifying risk.

Mr Whiting: The commitment to look at how well the research and development tax credit is working and to make sure it is aiming in the right direction is very welcome because it is part of making sure we are supporting the things which you are alluding to, which I think is very important.

Q44 Mr Beard: Mr Chote, what factors have led to current spending overshooting the Treasury's forecasts in 2004/5?

Mr Chote: One of the issues has been the department's making use of end-year flexibility. As you will recall the traditional problem that there has been for many years about there being an incentive for departments to rush off and spend money in the last couple of months of the financial year or willy nilly, simply in an attempt not to get their budgets cut in the following year, that was seen to be undesirable. The government said, very sensibly, that to avoid creating that incentive departments would be allowed to bank their underspend and to spend that money in the future so that there would not be this rush to spend things inefficiently. It looks as though some departments have taken advantage of that on this occasion. That is part of the explanation.

Q45 Mr Beard: What implications do the reserves under the end year flexibility arrangements have on the Treasury's ability to control departmental expenditure and ensure that the golden rule is met?

Mr Chote: It is awkward for them, other things being equal, that this has happened at a point when we are relatively close to the end of the cycle and it is a point at which the margin of error on meeting the golden rule or not is relatively tight. This is not an ideal time to lose a couple of billion in that area. One of the question marks is whether this is likely to continue in future years or whether this will have released some of those pressures. From the Chancellor's point of view, not destroying the very sensible incentives created by end-year flexibility - i.e., not saying, "This is an awkward time for you to be spending so we do not want you to do it" - there may have been a little bit of that but the door has not been slammed on that. If it had been, it would have created damaging incentives for the efficiency of public spending which would have outweighed the danger of the real underlying significance of whether we meet or miss the golden rule by some small amount of money or by two billion more.

Mr Beard: Does anyone want to add anything?

Q46 Chairman: Again, Robert Chote, at the time of the PBR (the pre-Budget report) you told us that the consistent shortfalls in investment spending compared to plans were a genuine puzzle. The 2005 budget indicates that the investment spending in 2004/5 will be around 3.4 billion less than forecast at the time of the PBR. Has the Budget thrown any light on why these shortfalls are continuing to recur and recur and recur?

Mr Chote: No, as far as I can see it is the same problem and I am no better able to explain what is happening to you now than I was then. It is part of a longstanding difficulty. The Treasury has not managed to get the investment spending out of the door as quickly as it would have liked to. We have seen it again.

Mr Weale: As Robert has said, it is a very familiar story and it goes on and on.

Q47 Mr Beard: But it is a very strange story considering the complaints, when people are under tight budgets, that when they are not under tight budgets they cannot spend the money?

Mr Weale: Yes, on the other hand, you can be under a loose budget but still looking carefully at whether the money is being well spent. Value for money is a different issue from tight budgets, and so wanting to make sure that money is being well spent may be a factor slowing the process up, but we have had several years of this happening and one might have thought that the appropriate processes would be running smoothly by now.

Q48 Mr Beard: Are there any views on what action the Government should to take to improve the delivery of public sector investment projects? What does the Government need to do about it?

Mr Chote: I do not know. Whether there is a case for looking at the process of approval, whether there are some sort of bottle necks there which are causing a problem, I do not know, but I guess that would be something that is worth looking at. Coming back to what Martin was saying, it is better that this money is not spent than it is spent stupidly. You would have imagined that if this were an issue about, "Oh, well, actually we have decided we are going to think quite carefully about this", that that might have made a step‑change in the forecast, but it is hard to see why investment continues to come in underneath if that is basically the explanation, but it might still be worth having a look.

Professor Spencer: That is surely the point. It is extremely difficult to know how to solve a problem if you do not understand the problem. What we need to do is to get on top of the problem, find out what is doing it and then perhaps we would be in a position to suggest something.

Q49 Mr Beard: I think there has been a suggestion that it may be because people are doing a PFI comparison before they get on with the project and that may be slowing it down. Is that substantiated?

Mr Chote: It is hard to see, if that were the case, why that would be continuing. If you knew that old people were actually taking six months longer than had been previously thought to do a PFI evaluation some years ago, then that might have resulted in a step‑change in the expectations, but it does not really seem to me to be a plausible explanation of why it continues to disappoint. We do not believe that people are now being vastly more careful about PFI evaluations than they were six months ago or a year ago. They may be but I have no evidence of that.

Mr Walton: This may be where end-year flexibility is kicking in. To the extent that departments are not under pressure to do all of their capital spending in any one year, if they do not spend it they can keep that money for future years. There is just that. I do not know the precise breakdown of the stock of end-year flexibility, but I suspect a reasonable chunk of it is actually under spend on capital spending. To the extent they still have that, it is‑‑‑

Q50 Mr Beard: It is government spending about which I am talking.

Mr Chote: Yes, but under spend on the capital bit rather than on current spending. To the extent you can carry that forward to future years, there is not the pressure to suddenly get these projects out of the door, but, as the others have suggested here, it would not be very good if it was done in a wasteful manner.

Q51 Mr Mudie: I want to take another look at that in this town. At the last PBR time when we were looking at the books, I think the figure of 10 billion was mentioned. That is the amount of stored up end of year flexibility there is in the department. That is a fair bit of spending power when we are getting excited over 2 or 3 million. Say a scenario came where a change of government was anticipated, maybe thinking of expenditure cuts, et cetera, tax cuts, you could see a situation where departments could suddenly become alive to, "We had better spend this money or we will lose it". Does nobody worry about a stored up sum that exceeds 10 billion that the departments have permission to spend. The Treasury, in other words, cannot stop it?

Mr Walton: That is another part of this may be: the fact that public spending plans have been pretty generous in recent years. If there is an expectation by departments that they are going to be less generous going forward, then actually having some of this end-year flexibility does potentially give them scope to smooth the growth of public spending, rather than doing it very rapidly now and then having to go through a bit more famine later.

Q52 Mr Mudie: If you are talking about the Golden Rule and we are worried about two or three billion and the departments have the capacity, the permission, to spend 10 million if they speed themselves up and get their act together. If they wish, they could spend this money. That would have affected, for example, the Golden Rule, which we all get excited about, but it would be a fair amount of money to spend and inject into the situation, and it is sitting there deferred at the moment at their pleasure. Does that not worry anyone at that table?

Mr Walton: I confess, I do not know how much of this stuff on end-year flexibility is current spending and how much is capital spending ‑ I do not know if anyone else knows ‑ because clearly, I think, these numbers are available. Certainly the Treasury in its own response to your pre-Budget report says where these numbers are published. I do not have these in my head, I confess, but if most of it is capital spending, then clearly it does not affect the Golden Rule type calculation.

Q53 Mr Mudie: But if it is revenue?

Mr Walton: If it is deferred current spending.

Q54 Mr Mudie: Yes?

Mr Walton: I suspect it is easier to defer capital spending than it is to defer current spending.

Q55 Mr Mudie: That is just a suspicion, Mr Walton?

Mr Walton: It is. That is true.

Professor Spencer: My impression is that the uncertainty lies on the Revenue side, not on the public spending side, and I am afraid it is not just the odd two or three billion pounds that we are looking at. If you just look at the revisions to the Treasury's forecast for the outgoing financial year‑‑‑

Q56 Mr Mudie: You have got your second wind, have you not? You have been thinking about this?

Professor Spencer: ---the numbers are much bigger. The revisions over the last three years to this current year's forecast that the Treasury is making for the current balance add up to 25 billion. That is where the real uncertainty lies, not so much on current spending.

Q57 Mr Beard: We are not going to do the projects we were intended to get?

Professor Spencer: That is true, but the orders of magnitude on investment are much smaller than on current spending, and those uncertainties on current spending again are an order of magnitude less than the uncertainties on tax revenue.

Q58 Mr Beard: This year the under spend 4.1 billion. That is hardly petty cash.

Professor Spencer: I agree, but that is of the order of the under shoot in tax revenue, and if you go back a few years the revisions to revenue have been much bigger.

Chairman: For George's information, the total stock of end-year flexibility carried over to 2004/5 was 11.4 billion of which nearly 9 billion was current spending.

Mr Mudie: That is interesting, is it not, Mr Walton?

Chairman: I meant to close it down.

Mr Mudie: You sound like Gordon!

Q59 Chairman: Before we go on to the micro‑parts of the Budget, could each of you briefly indicate what you regard as the most important non macro‑economic elements of the Budget? Was there anything significant you were expecting or hoping to come up which did not?

Professor Spencer: I think the help to home owners was very real, and obviously, coming from Northern Britain, I can hear that from people that I speak to. It is just a pity that the help for regeneration in urban areas was withdrawn at the same time.

Mr Weale: I suppose, no, again I worry more about what was not done and said rather than what was done and said, that the extension of the higher limit on ISAs is valuable, but I do think the need for the Chancellor to take a coherent overall look at saving in the country grows stronger by the day, and it is not there. I also think that, there is really a major need for a substantial review of the taxation of land and property in the country. Maybe these things will come up after the election, but the Budget struck me as one which was tinkering here and there rather than addressing these sorts of key micro‑economic issues.

Mr Chote: I have to say on the overall balance of the Budget, given what we have said about the structural position and what has been the character of previous pre‑election budgets, overall it was commendably restrained in the balance between give away and take away. Clearly the stamp duty issue is an interesting one. I think one question though is whether this actually helps first‑time buyers or does it help the people who already own houses in that tax bracket if it gets incorporated in the house price. The tax avoidance issues, others will be more expert on whether these will deliver the amounts of money that are claimed for them, but I think there is the interesting accounting issue, that if we are going to claim the benefit or claim the results of tax avoidance measures as being a fiscal tightening, effectively, we should have a clear idea of what the Government thinks the on‑going losses for tax avoidance are in terms of the tax revenue so we know how fast they have to run to stand still. Obviously, in terms of the distribution impact, the one‑off pensioner measure was very interesting. I merely note that we seem to have rather a lot of one‑off measures year after year and eventually a lot of one‑off measures become a large stream of spending on pensioners which may or may not be a good idea.

Mr Walton: I do not think there was anything too surprising in the Budget. The one thing that I thought was quite interesting that we have not talked about is just the stuff on productivity and the narrowing in the gap that has been taking place in recent years ‑ there is a chart on page 43 ‑ so, for instance, output per worker versus Germany, it appears the UK is now more productive than Germany, which was not the case a few years ago. We have narrowed the gap by ten percentage points versus France in the past ten years or so and even versus the US the gap has narrowed a bit. Whether this is due to the Government, I am not going to say it is, I do not know the answer to that, but it is interesting that the actual productivity performance of the UK has been improving on a relative basis over the past decade.

Q60 Chairman: One thing we noticed as a committee is that the Budget has few measures in the directorate in encouraging more business investment, given the need to rise to the productivity challenge, I wondered if that was a significant omission?

Mr Walton: Again, it is difficult to know, but clearly the Chancellor has not had that much room for manoeuvre at this time, and so I guess it is not that unreasonable to think that this close to an election his interests were simply elsewhere.

Mr Whiting: Just to reiterate two points I think have been discussed before, I would have liked to have seen more in the Budget on Europe and an acknowledgement that the impact of the European Court of Justice decisions are being considered. Also more drive and orientation towards making sure the UK's competitive position is maintained. I would echo the points already made on Stamp Duty, and I would point to the North Sea measure, which sounds as if it was a nice easy measure. It does arouse some concern as to whether this impacts the viability of some marginal North Sea fields.

Q61 Chairman: On the issue of savings, apart from the announcement that ISA limits would not be reduced, there does not seem to be any other initiatives to promote individual savings. The result of the consultation process on the proposed changes to taxation of life insurance companies has now been announced. Maybe I have been quoted as saying that this proposal would represent a significant extra charge on the policy holders and contradict the government's desire to encourage more saving. The Inland Revenue have been quoted as saying that they are trying to find the appropriate tax rate for income that is not needed to pay policy holders. I turn to you, John, and ask if you can shed any light on that for us?

Mr Whiting: It is a difficult area. There is undoubtedly a change of policy here. You recall that we touched on this when we were talking about pre-Budget report. Subsequent to that there has been quite good discussion between the Inland Revenue and the industry and some movement has taken place. I think at the end of the day naturally the companies would rather things were left as they were because that leaves more money in their hands, money that is not fully allocated. I think one of the remaining concerns is that there is still a determination to extract that money as of 1 January this year, which is seen as a little unfair. Inevitably taxation is all about discussion and trying to get to about the right answer. There is still a feeling that the Revenue is still trying to take a little too much but a recognition probably that something is going to change. I would hope that the discussion continues and that maybe somehow there can be a reasonable meeting of minds. I would also mention the power that seems to be within the insurance company changes for the Inland Revenue, or more correctly the Treasury, to make quite a dramatic impact on the insurance company tax system by way of statutory instrument. The industry is a little concerned about how that might be used in the future as well.

Q62 Chairman: On protecting tax revenue, the Budget documents give figures for estimated exchequer yields for individual tax protection measures, and the estimates over the last three budgets show broadly a rising trend. Is there any medium term strategy in this area? Can the yield from tax protection measures continue to increase in future years.

Mr Whiting: There is always going to be a yield from tax protection measures. The amounts that are quoted in the red book this time seem to be quite significant, and one does begin to wonder if they can all be delivered. Indeed, some of them show some very large figures, some of them, for example the changes on private equity financing, are very small, so there is a bit of a mix here, and one wonders how robust those figures are and how they are, indeed, measured.

Q63 Chairman: A number of the measures announced relate to international issues such as place of domicile or business. Can anyone shed any light on what is the long‑term trend here. Given international obligations and competitions is this an area in which the UK are likely to be fighting a losing battle, or, indeed, any other government?

Mr Whiting: All governments around the world are trying to make sure they increase their share of the international tax cake. There are fights all around the world about it. The UK is certainly trying to police its revenues at the moment; the US is as well, although in different ways. I think we just have to acknowledge that this is an area where one can see continued pressure from fiscal authorities around the world with continued attempts to try and take a share. It does worry me that the UK is trying to be a little stricter on UK based MNCs - multinational companies - than it is perhaps on inward investment. Again, I come back to a point I have made before, that I am just a little concerned about the design and orientation of the whole UK tax system.

Q64 Mr Beard: On the question of the change in stamp duty to help first-time buyers, Kate Barker has argued that if you lower the price of owner-occupation and more people come in to buy houses then the price is going to be pushed up again. Do you agree with her?

Mr Weale: I think this is why there is the question of who actually benefits from the reduction in the tax and why I was saying earlier that it would be nice to have an overall strategy behind the tax of land and property rather than the system that we have at the moment where we have stamp duty because it was introduced, I think, in the 18th century and so it is still there and it raises revenue. From an economist's point of view, although perhaps not from a politician's, it would make a lot more sense to tax the use of house and land than simply the sale and purchase of it.

Q65 Mr Beard: You do think that house prices might rise as a result of this change in the stamp duty?

Mr Weale: I do think that the benefit may well accrue to the existing owners through an increase in prices, yes.

Q66 Chairman: In terms of the stamp duty and house prices, the IMF recently described the possibility of a sharper than expected drop in house prices as "perhaps the greater near term risk to the outlook". In its discussion of the outlook for consumer demand, the Treasury does not even mention the housing market, however elsewhere it talks of an "emerging revival in sentiment in the housing market". Is the Treasury being complacent about the domestic risk to growth from the housing market?

Mr Weale: You always have risks to growth from one thing or another. The National Institute has said that there is a very significant risk of a 20-30% reduction in real house prices over the next three to five years or so, so there is the possibility that consumer growth will be considerably weaker than the Treasury is projecting. If that were to happen, of course, then the Bank of England would reduce interest rates sharply and the overall impact would be considerably less than simply taking the housing knock on its own. We have to bear in mind that if things do turn out badly in that respect there are offsetting adjustments that will happen.

Professor Spencer: There are worries about both the housing market and the High Street. You only have to look at the dip in retail sales, which form 40% of total consumption, comparing the three months to February with the previous three months. Again, apparently there is a housing glut emerging. I think that it is reasonable to suppose when you look at the strength of the economy, when you look at very high levels of employment and very low levels of interest rates, relatively speaking, it is most likely that we will get through this without too much trouble in either the housing market or the High Street.

Q67 Mr Beard: I am surprised to hear you talk about a glut in housing because that is the opposite of Kate Barker's analysis when she looked at the housing position.

Professor Spencer: There is a fundamental shortage. The underlying position is one of a housing shortage and, of course, that in itself is a reason for expecting house prices to hold up unless they are hit by a pretty large employment shock or something like that. What I am talking about is essentially the balance of supply and demand as reported by Right Move, for example, which monitors around about 50% of houses coming on to the market. Their report this morning suggests that there is an emerging surplus of houses coming on to the market this spring, but whether or not that is going to be a problem is difficult to say.

Q68 Mr Beard: She was talking about the same thing. She was saying that the reason for house price rises was there are too few of them so it is the natural process of demand pushing prices up.

Professor Spencer: I think there is a bit of a difference between the number of houses on the market at any one time, like this spring, and the underlying balance of demand and supply. One is essentially a flow of houses coming on to the market and ultimately being taken off the market as they are either withdrawn or sold, and the other is the underlying stock of housing relative to the population and the number of households.

Mr Walton: Can I add one thing really to echo Martin's point which is that housing is just one bit of the economy. The job of the Monetary Policy Committee, in particular, is to look at overall aggregate demand. It may well be that if house prices fall that will weaken consumer spending growth, but we have to remember that investment spending is likely to be growing rapidly this year, Government spending is still going to be growing quite rapidly, the drag on the economy from the external sector is rather less now than it has been, and if those other bits of the economy are doing well then generally you would expect the consumer to do quite well, you would see employment growing and wages picking up. It may well be that to stop the economy overall from growing too rapidly, a modest decline in house prices may be what is required to push the savings ratio up a little bit. You can argue it both ways: if it went too far then, as Martin said, the Bank of England would react to that by cutting interest rates.

Q69 Chairman: On the tax revenues protecting them, are you aware of any studies of whether past estimates for savings from tax protection measures have been accurate? For example, in the year just finishing (2004-05), do you think the measures brought in in the Treasury 2003 Budget in the preceding months achieved the 1.4 billion predicted by the Treasury because Barclays Capital Budget Analysis tell us that they think the revenue protection measures will bring in less revenue than the Treasury expects? Have you seen any of these schemes working?

Mr Whiting: I am not aware of any studies that have tried to prove those figures one way or another; others may be. In general, my observation is that it is a very difficult thing to get at as to what is the actual yield of these protection measures. This is not a recent phenomenon. If we go back a few years to when Ken Clarke was Chancellor and announced the Spend to Save Initiative, a certain amount spent to raise such and such an amount, trying to get at and prove that amount had been delivered proved enormously difficult. To a degree it is an act of faith, the monies just tend to get lost in the overall pot. It would be a very interesting thing to ask the Treasury to try and monitor this in some way, I think we would all be quite interested in it.

Q70 Chairman: Have most of the anti-avoidance measures announced since the new 2004 rules (requiring disclosure of avoidance schemes) been as a result of those rules?

Mr Whiting: I would say the majority. I do not think I would say "most" by any means because there are some, particularly in this tranche, that have been around for many, many years and are nothing new, particularly in the international structuring area. Perhaps it is around 50/50 and when you look to see that one of the anti-avoidance measures which will bring in extra money is to do with policing red diesel more carefully, the use of farmers' diesel for everyday use has been there for as long as I can remember, you can say there is a mix of the old and the new. Yes, the disclosure regime has undoubtedly had an influence on the measures that we have.

Q71 Chairman: The Government is now extending the disclosure obligation to cover stamp duty land tax on commercial property. Do you know why this was excluded from the original provisions? What has happened since last year to make inappropriate avoidance in this area a problem?

Mr Whiting: I think there was an element of starting with the main taxes - income tax, capital gains tax, corporation tax - and provision was in the Finance Act for a number of other taxes, including stamp duty land tax, including inheritance tax, so I suppose it is just moving on . There may well be an element of the Inland Revenue feeling that there is avoidance here and that it needs more information. I think in particular for stamp duty land tax, what you have is a very new tax, it is just settling down, and therefore the Inland Revenue are probably just saying it is now time to see what extra information we can get, so I think it is just a natural evolution.

Q72 Chairman: Is creativity in the tax avoidance industry picking up again since you last gave evidence to us on it or are there signs of a permanent change of approach?

Mr Whiting: I think there are definite signs of a permanent change of approach, yes. I would always say that people will look to minimise their tax bills within the law, that is never going to change, but the way one looks at it has changed and is changing. One of the things we discussed last time, the threat of retrospective action, has had a certain effect. I think it is becoming clear in certain sectors of the avoidance industry that they do have to play within slightly tighter rules than they have perhaps done in the past.

Q73 Chairman: Since the PBR, the Treasury seems to have pulled forward slightly its assessment of when the current cycle is likely to end from "early 2006" to "around the end of 2005". Professor Spencer, what has motivated that change?

Professor Spencer: There is actually a detailed description, if I can find it, which I thought was quite plausible without being able to remember exactly why that was. It is in Part B.

Mr Walton: Paragraph B38.

Professor Spencer: It is saying that growth over the second half of 2004, when we had that little dip, has been slightly below the PBR projection and partially offsetting that cumulative growth over previous years was a little bit higher. They are just saying that the balance of those two forces may have brought the end to the cycle forward a little, but it is hard to see if you compare chart B3 with the previous one in the PBR.

Q74 Chairman: Nobody wants to add to that?

Mr Walton: Only to say that there is as much art as science in this. The IMF and the Bank of England think the output gap essentially has been closed, the Treasury think it is about 0.75 % of GDP.

Q75 Chairman: I will ask this last question and if we could have very quick answers, if you do not mind. Business investment is recovering, but the recovery is subdued relative to the previous cycles. Indeed, the recent corporate reporting season appeared to see companies opting to use recovering profits to pay higher dividends rather than invest more in their businesses. Why do you think companies are so reluctant to invest?

Mr Walton: This is a global phenomenon, it is not just a UK issue. First of all, a lot of investment took place in the second half of the 1990s and subsequently there was a very sharp correction and it has taken time for companies to become more confident again about investing. You can look everywhere and see that the incentives to invest have increased sharply. The return on capital has increased substantially relative to the cost of capital and yet the response of investment pretty much everywhere has been much weaker than you would have expected. This is much more of an issue in the eurozone economy than it is in the UK, but there is certainly a global story to this.

Professor Spencer: Having said that, the downturn in business investment in the UK has been very modest compared to the kind of downturn that we have seen in previous episodes. It is really only in the manufacturing sector that there has been a significant fall in investment over the last few years. In that sense there is much less to make up and presumably fewer opportunities for profitable investment going forward.

Chairman: Thank you very much for your time, it has been very helpful. We now come on to the Treasury officials. Thank you.

Witnesses: Mr Jon Cunliffe, Managing Director, Macroeconomic Policy and International Finance, Mr Dave Ramsden, Director, Tax and Budget, Mr Tony Orhnial, Director, Personal Tax and Welfare Reform, Ms Sarah Mullen, Director, Public Spending, and Mr John Kingman, Director, Enterprise and Growth Unit, HM Treasury, examined.

Q76 Chairman: Mr Cunliffe, welcome to you and your colleagues. I believe you are hotfoot from the ECOFIN meeting on the Stability and Growth Pact.

Mr Cunliffe: That is right, yes.

Q77 Chairman: We will maybe come on to that.

Mr Cunliffe: I bring news from the battlefield.

Q78 Chairman: Can you introduce yourself and your colleagues for the shorthand writers, please.

Mr Cunliffe: On my right is Dave Ramsden, the Director of Tax and Budget; on his right John Kingman, the Director of our Enterprise and Growth Unit; on my left Sarah Mullen, the Director of Public Spending; and on her left Mr Tony Orhnial, the new Director of Personal Tax and Welfare Reform.

Q79 Chairman: You are all welcome. Can you update us on whether there was a satisfactory agreement at that meeting today or does the Chancellor want to tell us that tomorrow?

Mr Cunliffe: I think the Chancellor probably will want to tell you that tomorrow.

Q80 Chairman: Okay. What a lovely way to say no. Some commentators complain about the scale of the deterioration in the UK's fiscal position since 1999, suggesting that it has been "bigger than that of any G7 country, other than the US". By how much has the fiscal stimulus which has been delivered over the past few years contributed to UK growth?

Mr Cunliffe: I think I would say it has contributed quite a considerable amount. I think starting points matter and we went into the downturn of economic activity led by the world downturn in 1999-2000 with a very strong position because in the years 1997-2000 we had tightened fiscal policy by 4 percentage points. Having gone into that period of downturn and slower growth with a strong fiscal position, having tightened fiscal policy in the upturn, we were able to have fiscal policy support monetary policy in 2000, 2001 and 2002. It is always difficult to be precise about these things but if you look at what happened in some other countries that suffered the same downturn, the fact that we were able to have fiscal policy support monetary policy during that period contributed a lot to ensuring that the UK experienced no quarter of negative growth and in terms of the impact on the economy we have come out of that downturn relatively unscathed.

Q81 Mr Beard: In the Budget you sound notably more confident about the global outlook than you seemed to in the Pre-Budget Report saying that risks have diminished because of increasing evidence that high oil prices reflect strong demand. Even so, oil prices hit a new high last week and there are growing market fears that the limited production capacity could leave the market highly vulnerable to disruption. Is not any large surge in oil prices, whatever the cause, going to be destabilising to the international position?

Mr Cunliffe: Clearly if you had a very large surge that happened very suddenly, if you had a break in supply, some incident that knocked out some of the world supply, that sort of risk, yes. I think the point we were trying to make was when the oil price is high because the world economy is growing very strongly and demanding a lot of oil, a higher price will knock down some of that demand but it is the strong oil demand that is causing the higher price. When you get the sort of oil-related problems we have had in the past where the higher price has been driven by the supply side, it has knocked demand down when demand was weak. We were not trying to be complacent in that assessment of global risks, the point was simply that we have lived with those higher oil prices going up and down - oil prices being quite volatile - for just a little over a year and it has not caused the sorts of problems that we had seen in the past. The judgment was that this was more of a problem on the demand side; energy intensity had gone down in the developed OECD economies: and even in the emerging market economies, where you would expect to see a bigger effect that there has been, a bigger impact because their energy intensity is higher, they use more energy per unit of output, their debt positions and their foreign currency reserves have been strong and they have not suffered quite as much as you would have thought. It was really looking at what had happened over the last year that made us review the risk of prices remaining where they are now. With supply being tight, slight or relatively small problems like a hurricane which take out a little bit of supply for a while, or some problem in Nigeria, will cause the price to spike - we will probably encounter more of that - but the world economy seems quite robust by the evidence of the last year.

Q82 Mr Beard: After the Pre-Budget Review you told us that the received wisdom was that when a trade deficit gets above about 5% of GNP it has to correct. But on Budget Day the US announced record current account deficit for 2004 of 5.7% of GNP. Is enough being done internationally to ensure the necessary corrections are being made in an orderly way?

Mr Cunliffe: The 5% figure is based on IMF research which was done on what had happened in the past. I suppose they tried to look at the levels at which that correction took place. Alan Greenspan would say that the world has changed; the international savings market has become deeper, has become more liquid; it is easier for deficits to be financed. Nonetheless, I think the US current account deficit heading or increasing past 5% is a concern. I think internationally a lot has been done with the US in explaining to them other people's perceptions of the problem - although, I have to say it is a perception they share. Greenspan has said that it is too high and it needs to come down over time and I think the US Government have said the same thing. So it is not as if this is a perception they are resisting; I think it is a perception they share. They also share the view in part that some of the problem is not on the current account but on the capital account side, that there is not enough saving going on in the US and that therefore over time they need to address that problem, in particular through correcting their budget deficit. So I think there is some US recognition of the issue.

Q83 Mr Beard: In what way does the recognition amount to doing something about it? How far can this go on before this becomes the chief threat to international stability?

Mr Cunliffe: I think personally that the most likely outcome is still that this corrects over time.

Q84 Mr Beard: Corrects, but with what consequences?

Mr Cunliffe: As with all imbalances, if it corrects slowly, then the US economy is able to adjust and the economies on the other side of the imbalance are able to adjust. There is a chance - I think it is a minority chance - that you get a very sharp correction and it all happens at once and then currencies are affected and economies all around the world are affected. But I personally think that the majority chance is that the Americans are taking some action; it is starting to happen. The evidence I would give for that is if you look at what has happened to the dollar over the last 18 months, it has come down a long way. That has caused difficulties for some economies: it has caused difficulties for Europe; in Asia a number of countries have tried to maintain the value of their currency against the dollar and that has caused them to build up big dollar reserves. But we have had a very big fall in the dollar without instability. The markets have managed to accommodate it. There has not been a run on the dollar. It has not hit world growth in a material way. World growth is 5% for 2004, which is the highest in 25/30 years. We have managed to have a big change in the value of the dollar - which is part of the deficit - without causing abrupt changes in economies. I think the likelihood is that that will continue. In the US there were some signs until very recently that their exports were starting to come back. Generally speaking, when your currency depreciates your exports do come back, but it takes some time. There were some signs - although recent evidence is much more mixed - that there was some cooling off on the import side. But some of the correction has taken place on the currency side and it has taken place without huge instability. I do not think it is unreasonable to think that that might continue.

Q85 Mr Beard: The IMF recently described the possibility of a sharper than expected drop in house prices as "perhaps the greatest near-term risk to the outlook" - this is to the UK economy. Do you agree with that?

Mr Cunliffe: There clearly is a risk to the housing market both ways.

Q86 Mr Beard: What do you mean by both ways?

Mr Cunliffe: House prices have stopped growing at the very high rates - the 5% a month, 30% a year that they were at a couple of years back, at the peak. I think they are now flat. It depends whether you take the Halifax or the Nationwide - there are lots of different measures - but the overall picture seems to be that house prices are pretty flat. One school of thought is that they stay flat. One is that there is a downside risk, which is what the IMF mentioned, and you get an abrupt fall in house prices. But I think there is also a risk that they could start to move up again. The housing market is quite a difficult thing to estimate. I think I would agree with the IMF in part. If we had a very sudden movement in house prices, of the sort we have seen in the past, would there be a risk to the economy? It probably would not be as big a risk as it has been in the past, because one thing we have seen over the last house-price cycle is that the link between house price increases and consumer spending is nowhere near as strong as it was in the past. The Bank of England have published material on this. That relationship between consumer spending, mortgages, equity withdrawal, house prices that drove a lot of the UK cycles in the past, no longer seems as strong. Whether if you had a sharp fall in house prices it would impact on consumption in the way it had in the past, I think is a very open question. Personally I do not think it would. There must come a point at which a reduction in house prices impacts on the economy. I suppose the IMF quotation used is relative: Is it the largest single risk? I would say it is a risk. It is a risk both ways: on the upside and the downside.

Q87 Mr Beard: They are not mincing words. They say, "it is the greatest near-term risk."

Mr Cunliffe: It may be one of the most important single risks, but I am not sure I would have described it in quite the same way.

Q88 Mr Beard: The press have suggested that your projection for a decline in the house price/earnings ratio implies that you are forecasting a small fall in house prices in the future. Is that correct?

Mr Cunliffe: I am grateful to you for using the word "projection" because that is what it is. We do not forecast house prices; we do not forecast earnings. Our forecast is a formal document and a formal output which is the basis of the Budget and the PBR. We do it twice a year. The projection that we published shows the house price/earnings ratio going down, but of course there are two ends to every ratio and that could easily be as much to do with house prices not growing as quickly as earnings rather than house prices falling. I saw something in one of the papers last week on this which looked to me to suggest quite a low earnings growth figure, but, without knowing how they worked out from our ratio what would happen to house prices, I do not know. I assume they must have used quite a low earnings figure.

Q89 Mr Beard: Kate Barker, who has gone into the housing position in some depth, says, "Simply put, a change which increases demand for housing, such as a beneficial shift in taxation which reduced the cost of owner-occupation, would cause a jump in house prices to restore equilibrium in the market. What did your pre-Budget analysis suggest would be the impact on prices, in that tier of the market, of the move to cut stamp duty on houses under 120,000?

Mr Cunliffe: I do not think our analysis is that that will have a material impact on house prices.

Q90 Mr Beard: It will not have a material effect?

Mr Cunliffe: It would not have a large material effect on house prices. I think it is quite hard to say there is a one-to-one relationship between any change in the tax structure and what happens to house prices. But also, as the Barker report a year ago showed, house prices are driven by a number of things but primarily and fundamentally they are being driven by an imbalance between supply and demand.

Q91 Mr Beard: That is not what she is saying. She is saying that if through the changes in stamp duty the price goes down, more buyers will pour into the market and house prices will go up.

Mr Cunliffe: Yes, but I guess the change in stamp duty here would not be one to cause a huge impact on house prices. The fundamental drivers of the housing market are, if you like, basic supply and demand and the things that drive it are more, to my mind, on the supply side. Obviously if you had a large enough reduction in house prices, as a result of any change, more people would be attracted. All other things being equal, more people will be attracted back into the market, but there are lots of other factors at work.

Q92 Mr Beard: Your analysis suggests that house prices would go down on this stamp duty change and stay down.

Mr Cunliffe: That the stamp duty price would actually drive them down? I do not know that we have done enormously detailed modelling on the housing market because it is a very difficult thing to model, but I think our analysis is that the effect on the housing market will not be strong.

Q93 Mr Beard: If it is not strong, then it is not going to help first-time buyers, is it?

Mr Cunliffe: It might help first-time buyers come back into the market without having an effect on house prices all the way up the housing market.

Q94 Mr Walter: I have a question which relates to my constituency, which has average earnings 15% below the national average. I looked at the local papers over the weekend and I could only find three houses below 120,000. Have you done any assessment on how many extra buyers would be attracted into the market as a result of this move?

Mr Cunliffe: I think we have done some analysis on how many buyers are likely to be affected by the change. It is quite difficult to work out how many would be likely to come back into the market. If I could turn to my colleague, Mr Ramsden.

Mr Ramsden: I am not wanting to play pass the parcel, but Tony Orhnial may be able to add further. I think we are looking for 200,000 or 300,000 properties being taken out of stamp duty, of which a reasonable proportion will be first-time buyers. There is obviously quite a significant regional distribution to the incidence of this. I am not sure which region you live in -----

Q95 Mr Walter: The South West.

Mr Ramsden: There may be some effect there, but from what I recall of the analysis the highest incidence was some way from London, up in the North, in terms of the beneficiaries of this change.

Mr Orhnial: Our analysis suggested about 300,000 transactions would be taken out of stamp duty, and about one-third of those associated with first-time buyers.

Chairman: As Members of Parliament who have constituencies beyond the Watford Gap, they will recollect you saying "somewhere up North".

Q96 Mr Fallon: Could we now turn to public finances and the state of borrowing. On your analysis you seem to have about 6 billion spare to meet the Golden Rule if the cycle ends next year. How does that 6 billion reserve compare with your average error in forecasting borrowing over one year?

Mr Cunliffe: It is quite difficult to try to compare those two things because I am not sure they are exactly the same.

Q97 Mr Fallon: What is your average error at forecasting borrowing over one year?

Mr Cunliffe: The average error of borrowing one year ahead I think is somewhere round about 1%.

Q98 Mr Fallon: Which is how many billion?

Mr Cunliffe: I am sorry, how many billion on what?

Q99 Mr Fallon: Analysis we have had from the IFS is that your 6 billion margin is around half the Treasury error at forecasting.

Mr Cunliffe: If I could just finish the point I was making, we are actually forecasting the fiscal revenues and the fiscal position on a case which is not our central case. So we have already forecast it on cautious assumptions, the most important one of which is that we do not use our central economic projection. Over the years people have told us that our central economic projections are optimistic, unlikely to be met - some of your witnesses have been quite strong on that - but actually over the years they have tended to be met. But we have not forecast the public finances on them, we have forecast the public finances on a more cautious assumption, which is 0.25% GDP below that. There are also a number of other cautious assumptions in the forecast. So to go from an average error which does not take account of the fact that we already have caution in the picture, is actually comparing two things which are not quite the same.

Q100 Mr Fallon: Okay, but 6 billion is pretty tight, and of course you had not had the adjustment to roads maintenance it would have been 3 billion, would it not? It would have been half that. Could we just turn to how you managed to get this adjustment by the ONS to spending on roads' maintenance and repair. I do not know if this is you, Mr Cunliffe. Whose fingerprints are on this one?

Mr Cunliffe: It is a number of us who can talk about it, certainly. The ONS removed a double counting. That double counting meant that the figures that we had calculated up to now had actually scored the cost of roads maintenance twice, so the correction - and I will call it a correction - I think is a fairly normal one. There are revisions that go on all the time one way and the other in the public finances.

Q101 Mr Fallon: This was a revision of some magnitude which had first been discussed back in 2002, and suddenly, magically, the answer pops out three weeks before the end of the financial year and a couple of weeks before the Budget. Was the Treasury involved in this?

Mr Cunliffe: No. I mean the -----

Q102 Mr Fallon: They were not involved?

Mr Cunliffe: The Office for National Statistics, the National Statistician, has said - I think on the record - that it was his decision, that he made it, that the timetable was at his choosing. When the ONS come across errors that need to be corrected - and this is an error; this is not a revision of new data; this is double-counting brought about by a strange amalgamation of two accounting systems - as I understand it, their policy - but you would have to ask him - is to change it as quickly as possible. But he has made quite clear that it is his timing; it is his judgment; it is his decision.

Q103 Mr Fallon: So there was no Treasury role in this? There were no discussions through the Treasury and the ONS?

Mr Cunliffe: This is his decision entirely.

Q104 Mr Fallon: That is not what I asked you. Were there any discussions between the Treasury and the ONS about this?

Mr Cunliffe: The roads maintenance expenditure on which this change is based - and the expenditure figures on public spending are of course fed by the Treasury into the ONS .... The ONS are commenting on figures which they get from us. They get their revenue figures from us and they get their expenditure figures - for central government, not for -----

Q105 Mr Fallon: I know where the figures come from. I am asking you: Was there any discussion between the Treasury and the ONS on this particular reclassification?

Mr Cunliffe: This was a decision, a judgment, taken entirely by the ONS, for which they are entirely responsible.

Q106 Mr Fallon: But it was not discussed with you?

Mr Cunliffe: It was not discussed with me, no.

Q107 Mr Fallon: With the Treasury?

Mr Cunliffe: I do not think the Treasury had any part in the making of this decision.

Q108 Mr Fallon: Could I take you on to the reform of the fiscal rules. You have said, I think, that at one stage you will look at the fiscal framework. Are there any particular candidates there for future improvement in the fiscal framework?

Mr Cunliffe: I think we said we would keep the fiscal framework under review.

Q109 Mr Fallon: Yes.

Mr Cunliffe: That is a sort of continuous review, but we have no plans to make any changes in it.

Q110 Mr Fallon: One of the suggestions made by this Committee a couple of years ago and now by the IMF is that to increase transparency there should be a link between the probability of meeting the Golden Rule and the targeted current surplus by way of fan charts. Is that something you have considered or are likely to consider?

Mr Cunliffe: The IMF produced a fan chart, I think, some time ago, and I read the piece that they did on it, and I think the National Institute also had a look at it. I know the concept from the Bank of England, which produces fan charts. The answer to your first question is that we have no plans to make any changes. But, on the concept itself, yes, it is one with which we are familiar. There are some difficulties with applying fan charts to fiscal policy, some of which have been acknowledged by the IFS, some of which are acknowledged by the Congressional Budget Office, which tried to do something like that. I can go into the technical issues if you wish.

Q111 Mr Fallon: In your reply to the IMF, you said that you doubted whether a "probabilistic approach to fiscal policy" would improve public understanding or confidence in the framework?

Mr Cunliffe: Yes.

Q112 Mr Fallon: But clearly the Bank are quite happy that it improves transparency and public understanding of the inflation target?

Mr Cunliffe: There are a number of different points here. The first point is that if you want to use average errors and generate a fan chart in this way, you have to make an assumption about the relevance of past errors to the future. So you automatically run into some issues about the sample period and how strong your error is and there is a difference in the way that monetary policy statistics and fiscal statistics work. The second issue you have to deal with - and remember forecasts go over a number of years, so you produce them five or six years out and the fan chart sort of widens out - is that when you say a forecast was made in the year zero and the outcome, looking back at the run of figures, was x % away five years later - in relation to your forecast five years out - you have a big issue about how you deal with policy changes. If at any time in those intervening years policy was changed, how do you strip out the fact that the forecast and the out-turn actually assume that nothing has happened in between and that in fact you can have a policy change in between? The IFS acknowledge this is an issue. You also have a problem with stripping out the economic cycle. If you use past forecasts in those ways, when you have generated some sort of probabilistic distribution, you the have to apply judgment to it. The Bank of England apply judgment to it. They set out how they do this in 1999. It is easy for them to apply a judgment around it because they have nine voices on the Monetary Policy Committee, so they can discuss it and have different views, but there is actually a subjective judgment in there. It is not a purely statistically driven thing at all. You have problems with the sample period: How far back do you go? There were some major periods of volatility in the British economy in the 70s, in the early 80s, some around the output gap in the early 90s and mid 90s, which, you could say, with the Bank of England operating the way it is, are unlikely to occur in the same way. When you use a past period for monetary policy, you do not have some of those problems of regime shift. If you do what the National Institute did in trying to get round these problems, by not assuming that the past is a guide to the future, by doing random simulations. They do thousands and thousands of random simulations and they see how fiscal policy would respond, but they model those random simulations on shocks which they think have occurred to the economy in the past and you have some of the same problem again. Personally, I am not convinced that a probabilistic method based on that is actually going to give a better understanding of fiscal policy. Of course, when the Bank of England do it, they have the other issue which is that they meet every month, they can change policy very easily. There are costs if they get monetary policy wrong, very major costs, but if they get policy wrong one way when they assess the probabilities, they can readjust it the other way without too much of a cost. And they can move policy up and down fairly frequently if they feel the need and they can reverse their decisions. Fiscal policy carries cost because when you change expenditure decisions there can be big costs involved; when you change tax decisions there are big distortions. And you cannot change it all the time. I think in the 60s and 70s there were some parliamentary powers taken to allow the government to move certain taxes up and down without consulting parliament, the so-called regulators. But that sort of power has not been used, so far as I know, with any developed economy for 20 or 30 years. How you would fit a probabilistic system like this onto fiscal policy decisions in the way we take them, I am not very clear. We accept that there is uncertainty. We use cautious assumptions. We set out clearly what we do and we say, for credibility reasons, "This is the rule and we will meet it." I guess we could come to you and say, "This is our fiscal outcome on our central projection of the economy." We would not use the cautious one of course. "This is our probability based on the past of meeting it," but I suspect on fiscal policy there would be much less tolerance for that sort of approach by the legislature than there is of monetary policy.

Q113 Mr Fallon: This year you asked the Auditor General not to audit the trend growth assumption. Why was that?

Mr Cunliffe: Because our view is that the output gap will close around the end of this year. The best way to audit the trend growth assumption is to look at how much growth there has been between two on trend points and work out what trend growth has been. We will want that assumption audited anyway once the cycle has closed, so it seems to make more sense to wait until we have gone through an on trend point than to do it now. If you were to do it now, growth since our last on trend point has been 2.8% and our assumption is 2.5%. Growth in the last cycle, if you calculate it between the two on trend points, was just over three. All of the evidence is on the high side of where we are. We are coming up to an on trend point and it seemed sensible to allow him to audit it when he had an extra trend point on which to do the audit. We did something similar on VAT and asked him to delay until we had reached an evidential point a couple of years back.

Q114 Mr Beard: Does this vision of the cycle ending at the end of this year mean that you and the Bank of England are converging because the Bank of England have said that the gap had virtually closed during this year?

Mr Cunliffe: The Bank of England do not publish an output gap in the way that we publish one and they do not use it in the same way that we use it. There is a difference between monetary and fiscal policy. The Bank in recent reports saw less spare capacity in the economy than we do. The amounts are not hugely different. We are showing an output gap of about 0.7% of GDP. I do not know exactly where they are but they may have the economy on trend. The IMF is somewhere between those two points. The EC is a bit closer to us. The output gap is something you cannot observe directly and there is a range of views around where it is and when it is going to close. Rather than for me to comment on others, the easiest thing is for me to explain why we hold the view that we hold.

Q115 Mr Beard: The Treasury is running a budget deficit at the same time as the Bank of England is running a fairly tight monetary policy. Are not the two pulling in opposite directions?

Mr Cunliffe: The fiscal position is tightening as the economy comes back to trend. Monetary policy tries to look a couple of years ahead. The Bank of England tries to bring inflation back to target over the normal operating range of monetary policy, which is about two years. They are taking action now to deal with the evolution of prices over the next year or two. We are projecting the fiscal stimulus to be reduced going forward as the output gap closes. Those two things, to my mind, are quite consistent. If the economy were above trend, you would expect to see us generating surpluses. We are not projecting the economy to be above trend. We have a fairly stylised projection that goes back to trend and stays flat and then we start to generate surpluses.

Q116 Mr Heathcoat-Amory: On receipts, the non-tax receipts are expected to be about 1.5 billion lower than expected and the Budget report comments that very little in year data is available in the public corporation sector until final accounts are available after the end of the financial year. Can you tell us a bit more about these public sector corporations, why their surpluses are unexpectedly low and why, unlike ordinary corporations, they do not apparently produce interim accounts which give you a better feel for what is happening?

Mr Cunliffe: I cannot answer the latter question. There is a large number of these corporations ranging from the very large to the very small. We do not know why their surpluses are below the normal projections. The reason it says what it says is because we do not know the answer to that. It is a picture made up of a large number of individual components. There could be offsets. One of the things that we think is happening - this goes back to the highways change - is that some of these public corporations are market but some are non-market like a sort of highways agency, where they will have been credited with double the income for roads maintenance, because we were scoring double the expenditure. This is a bit like government buying services from National Health Service trusts. You book it on both sides. In the same way that we are now only scoring the depreciation once, this has probably affected them by reducing some of their income. That is a proportion of the change but as to why this myriad of organisations has produced this overall picture I am afraid I cannot give you an answer.

Q117 Mr Heathcoat-Amory: Have we discovered a rather dusty corner of the national accounts here that perhaps ought to be subjected to a few more vigorous disciplines?

Mr Cunliffe: We will certainly have a lot of interest when the accounts come in as to why this has happened. Whether that will lead to any changes in future I do not know.

Q118 Mr Heathcoat-Amory: It is a concern given the size of the undershoot in your revenues which you expect to carry forward to subsequent years, so we are not talking about pennies here.

Mr Cunliffe: We have knocked some of that through. Whether we were right to take as much through the future years as we have done, I do not know the answer to that yet. Some of these figures are a bit volatile because the accounts are not in. They are often subject to quite major revisions as well.

Q119 Mr Heathcoat-Amory: Can I turn to the big tax figures? You were expecting another big increase in tax receipts next year. Indeed, over 8%. Are you still calling this a cautious estimate? Our witnesses earlier on today expressed considerable scepticism about this and I would like to probe your assumptions on this.

Mr Cunliffe: All of the public finance projections are cautious in the sense that we project them on a weaker economy than is our central forecast. We use a number of assumptions, both economic and others, which we have audited by the NAO, which are designed to be cautious. In that sense, all the tax forecasts are a cautious base but the forecasts themselves are our best estimate of what we think will happen.

Q120 Mr Heathcoat-Amory: Can I be specific? Emboldened by your better than expected corporation tax receipts - and I give you credit for that - you are expecting a 28% increase in revenue next year. We know that there are some very big vulnerabilities here in the legal sphere. The European Court of Justice is having a shot at this and there are some important court cases pending which may further undermine our ability to set autonomous tax policy in this area. What have you built into your estimates on these court cases? What are you expecting there?

Mr Ramsden: I will come on to the court cases in the ECJ in a moment, if I may. As we set out in the Budget document, the forecast for overall taxes in 2005/6 is very little changed from PBR time. You have drawn attention to one of the forecasts where we have revised up our forecast, which was the CT forecast, but there are other forecasts where we have revised down our forecast for in year growth slightly, such as VAT. These are our best estimates and we try to take account of the very latest data. The CT forecast is very important going forward because it contributes quite significantly to the rise of over 8% in current receipts that we are forecasting for 2005/6. The kind of figures we are talking about, a 26.5% growth rate in non-North Sea corporation tax, and a 28% growth rate overall, as we discussed with you at PBR time, are not unusual increases in corporation tax at a time when both the economy overall is growing strongly, when the financial sector is picking up very rapidly and when we are also seeing considerable revenues from the North Sea. That financial sector effect also is beneficial to our income tax forecast and enables our best estimate of income tax to be for significant growth. As to the effect of the ECJ, as we point out in the Budget document in chapter five, we are going to defend robustly any challenges to UK law that come from the ECJ but at present what we are talking about is potential future challenges. We see much discussion - I think you have discussed it in this Committee - as to how these challenges might manifest themselves. We are not even at the stage of having an Advocate General's opinion in some of the high profile ones, so we will have to wait. Our forecast is rightly based on recent trends and on the forecast of the underlying economy and what that implies for future trends for CT. To try to factor in some hypothetical amount for potential outcomes from ECJ decisions when we have made very clear in the Budget document that we will defend robustly the corporation tax system would be a difficult thing to do.

Q121 Mr Heathcoat-Amory: I am sure you will defend it brilliantly, but this jurisdiction is in Luxembourg. You seem to be saying that you are anticipating that we win all the cases. I am asking you whether you are building in perhaps a more realistic assumption that we may win some but we will lose others and there may be a degradation of our tax base. Are you taking an optimistic or a pessimistic view there?

Mr Ramsden: We are not taking a different view from the one we were taking at the time of the PBR. We are producing our best estimates of forecasts. We have where possible taken action to remove the uncertainty which was produced in the past by ECJ decisions. There were decisions that we took in April 2004 in terms of changes to corporation tax after the ECJ's decision on thin capitalisation. There was a response there but in terms of our forecasts going ahead it would be extremely difficult. These are very non-linear things. I am not quite sure how you would do that through a fan chart or any of the ways of estimating uncertainty that people come up with. You have to produce your best estimate of the forecast and then recognise that there is an ECJ process taking place, making very clear that we would robustly defend the UK's corporation tax system.

Q122 Mr Heathcoat-Amory: Could I ask about another vulnerability which is the entry into the EU of east European countries with low, sometimes flat, corporation tax rates? Germany is cutting its rate of corporation tax. There could be another competition opening up here within the single market. Given that the ratio of non-oil tax revenues to GDP is going to hit an all time record next year, do you see that we are vulnerable to migration of tax activity and do you factor that in?

Mr Ramsden: Can I start on the point about CT because I think next year we are forecasting that non-North Sea CT as a share of GDP will rise to 3.1%. It has been higher than 3.1% in 10 of the last 20 years so I do not think that counts as a record for non-North Sea CT as a %age of GDP. It is a significant increase over this year and it is forecast to continue rising and to stabilise at 3.5% but even that 3.5% as we discussed with you at PBR time is below the kind of levels that were reached in the late 1980s. I am using a different denominator from you for this calculation. That is the share of non-North Sea CT as a %age of total GDP. That is the equivalent of the figures that we publish.

Q123 Mr Heathcoat-Amory: I am talking about all taxes here, not corporation tax.

Mr Ramsden: You were talking about corporation tax in the context of Germany lowering its corporation tax.

Q124 Mr Heathcoat-Amory: I have widened the debate a little. At least one of our expert witnesses said that, excluding North Sea oil, which hit a record some decades ago, the rest of the tax revenue as a %age of GDP was going to reach a record in this country. We are increasing that burden and a lot of other countries are reducing it. I am putting it to you that this is going to create problems in an increasingly globalised tax environment and I wonder if you factor this in when you predict your tax revenues.

Mr Ramsden: We can certainly look at what your expert came up with. The figure that we have always published - and this is true of previous governments as well I think - for net taxes and social security contributions as a %age of GDP - we have a very long back run in table C24 - that series is not rising to anything like a record level next year. That series is rising to 37.3% on our forecast and it was closer to 40% in previous periods. On the German point, I know that the Germans are announcing that they are going to cut their federal corporate tax rate from 25% to 19%. That is an announcement that Chancellor Schroeder has made but you have to remember in Germany that as well as a federal tax rate they have a solidarity surcharge of 5.5% and state corporate taxes which range from 13% to 20%. The overall average German corporate tax rate will be 32%, whereas the UK's main rate of corporation tax is 30%. You have to bear that kind of thing in mind rather than just picking out one change announced in one rate at one period.

Mr Cunliffe: The detailed point is that it is not just corporation tax rates; it is tax bases and the way it is applied. One of the things we found out when we started looking in Europe as to fair and unfair tax competition is that sometimes the headline rate does not tell you very much about what is happening. There is a shift going on in the world economy generally. The general point is that we have always said in Europe we are in favour of tax competition. We have always made clear that rather than a tax harmonisation approach we believe in tax competition, because that is a way of allowing countries to compete, provided they compete fairly - by competing fairly I mean you do not offer tax breaks for foreign companies that are not available to your domestic companies. Tax competition is one of the ways that countries compete. Before investment decisions are made and before people decide to put capital in one place or another, they look at a range of issues. Economies compete in that way for international investment, not just on tax. The UK had the highest number of FDI projects last year on the normal survey and the UNCTAD figures suggest that FDI is growing again to make us the leading recipient in Europe. Our stock of FDI is very high. Some of that is tax. If some countries want to run a very low tax, very low spend economy, provided they do it in a fair way, that is competition one has to live with. There are also high tax economies - Sweden comes to mind - that are very successful in attracting certain sorts of investment. One has to broaden this out from the tax question and say where, when there is a secular shift in global production, will the UK's comparative advantage lie and how do we maximise that. Tax will be an element of that but it is only one element.

Mr Heathcoat-Amory: Can I clear up this issue with Mr Ramsden? I am looking at a table here from the pre-budget report which is headed "Net Tax and NICs as a share of GDP." It quite clearly shows that for the non-North Sea sector next year will be an all time record. This is your table, B14 and B26.

Chairman: This is from Peter Spencer's evidence.

Q125 Mr Heathcoat-Amory: It is a Treasury table. We must get to the bottom of the fact here.

Mr Ramsden: I am very happy to report back to the Committee to get to the bottom of whatever Peter Spencer has provided you with.

Q126 Mr Heathcoat-Amory: It is not Peter Spencer. It comes from the Treasury. It is one of your tables. It is slightly alarming that you come here saying it has been exceeded many times in the past when your table quite clearly shows it has not.

Mr Ramsden: Which table?

Mr Heathcoat-Amory: The source is the PBR, tables B14 and B26, Inland Revenue statistics. This is our report but we did not make this chart up. It comes from you. The non-North Sea sector is predicted to be a record.

Q127 Chairman: It is Peter Spencer's chart but your data.

Mr Ramsden: Which page of your report?

Q128 Chairman: It is just coming to you. Evidence 82.

Mr Ramsden: It looks to me as if he has derived the non-North Sea series from what he says are PBR data so we will check on that derivation as quickly as we possibly can.

Q129 Mr Heathcoat-Amory: Assuming that is right, we all know that things like the quality of our golf courses is a factor in attracting Japanese investment but tax is tremendously important and that was emphasised by our witnesses again. Whichever way you look at it, we are becoming a high tax jurisdiction here as a %age of GDP. This is, according to our witnesses, beginning to have a deterrent effect in investment decisions being made at the minute on the basis of these projections. To what extent do you factor in or attempt to calculate the possible damage to the economy and to future revenues of highly mobile tax investment decisions being made to the detriment of the United Kingdom in view of this rising trend which, to some extent, conflicts with what other countries are doing?

Mr Cunliffe: Of the EU countries, our nearest geographical competitors, we are one of the lowest in tax GDP share and one of the lowest in corporation tax. My guess is it is taxes on capital that matter here, not overall tax. Secondly, you have to look at all the things in the equation. The thing I hear most of all about London - I apologise in advance for a southern orientated view - is about investment in London and the south-east into transport infrastructure. One hears that in other major conurbations and that is also very important to investment coming in. You hear also that the education system is extremely important. It is difficult to look at just the tax side of the equation. Our tax GDP share is fairly low in relation to our European partners. The US is more difficult because you have state taxes to add on to federal taxes. It is certainly lower in most of the Eastern Europeans, I will grant you that, but you have at the same time to say: what is that tax financing? Is it financing the sorts of things that might actually make internationally mobile companies want to come to the UK? Is it financing public infra structure? Is it financing education? Is it financing the things that actually allow you to compete? Otherwise you might decide the best thing to do would be to reduce taxes to the absolute minimum, but then, of course, you would have to do something on the other side of the account.

Q130 Mr Mudie: Your DEL expenditure, current expenditure, was two billion over the figure you gave us at pre Budget time only three months ago. We will forgive you for that, but what could we say.

Ms Cunliffe: Three months and one week, I think.

Q131 Mr Mudie: There is some suggestion that you have been leaning on departments over their spending of end of year money so that that did not rise higher. Is there any truth in this?

Ms Mullen: I will answer that.

Q132 Mr Mudie: Is this what you came here to answer, Jon?

Ms Cunliffe: No. I will give you a general answer, if you like.

Ms Mullen: Just to explain the estimates that we now have in the Budget and the increase since the PBR, 340 million of that increase was an increased allocation to the special reserve to meet our costs for Iraq and other international obligations. The remaining 1.7 billion was consumption of EYF stocks by departments, and this is a result of the system we have in place which allows departments to draw down that EYF and retain it going forward. What has been happening historically is that, in fact, although departments have drawn down significant stocks of EYF at winter and spring supplementaries, the out‑turn data has shown that departments have under spent against their DEL allocations. This year in the Budget we are making an estimate that there will be an increase in DEL and some consumption of EYF, but obviously we will not have the out‑turn figures until the out‑turn white paper in July.

Q133 Mr Mudie: That was one of my questions, what international commitments there were, because I could not find them reflected in any departmental spending. Where would I pick up that figure in a departmental figure?

Ms Mullen: In terms of money that is then allocated from the special reserve to departments, are you saying?

Q134 Mr Mudie: Yes.

Ms Mullen: It will appear in potentially a number of different departments, DEL lines, obviously MOD, but also some others.

Q135 Mr Mudie: Is the total explanation for that international commitments?

Ms Mullen: It covers costs in Iraq plus other international obligations, like Afghanistan, I believe.

Q136 Mr Mudie: What has Iraq now come out at? What are we spending extra in Iraq?

Ms Mullen: Let me see if I have got the actual figure for that. I understand that the out‑turn figure for MOD has been 843 million in 2002/3 and 1,311 million in 2003/4, and our anticipated out‑turn this year is about 950 million. That covers resource and capital costs - the special reserve covers resource costs ‑ but again we will not know the out‑turn until July.

Q137 Mr Mudie: Apart from your first figure, the big one, I am not sure I see those figures reflected in the defence budget either as capital or revenue. Should I, or have there been other savings that mask the fact they are spending more in Iraq?

Ms Mullen: We do not give a detailed break down of MOD's DEL, if that is what you mean.

Q138 Mr Mudie: No, I am just looking at the figure along three years. If you put additional money in it should show.

Ms Mullen: It may be there have been some offsetting changes, but they should appear in the MOD DEL line, I believe.

Q139 Mr Mudie: That detailed technical explanation, wonderful as it was, takes me off my starting point, which is on good authority from none other than the Daily Telegraph, March 14, that you are leaning heavily on some of our defence officials not to spend money. Is there any truth in this, Mr Cunliffe? I cannot believe it.

Mr Cunliffe: I do not think that is true. I do not think the Treasury ever leans on any department not to spend money. It is a myth. Certainly, but more seriously, I think we have an end year flexibility system that has been running for a number of years. Personally, I think it is a good system because it has enabled departments to‑‑‑

Q140 Mr Mudie: Is it for both capital and revenue - current and capital - or is it just capital?

Mr Cunliffe: No, they can use it for capital and revenue.

Ms Mullen: The two are separate.

Q141 Mr Mudie: I understand the two are separate, but there was a reference here to saying you allow capital and I wondered if current was not, but carry on?

Mr Cunliffe: The pattern up to now, as my colleague has said, has been for departments to under spend. It has also been for departments to draw down EYF in the winter and the spring and then to return it. That is on average. Some departments have used it; others have cautiously drawn it down.

Q142 Mr Mudie: I am sorry; Ms Mullen was speaking about this. What do these initials stand for?

Mr Cunliffe: End Year flexibility. I apologise.

Q143 Mr Mudie: So they draw it down?

Mr Cunliffe: They draw it down because they think they are going to need because they do not want to over spend, so they need to draw it down, and they are allowed to draw it down ‑ Parliament approves it ‑ and then it turns out that they do not need it, some of them, and they pay it back again. Some do and some use it. As a way of stopping those end-year surges in expenditure which are bad for value for money and which the Treasury always used to get concerned about, it has been quite a powerful way of doing that. This year, for the first time, more of them on average, because it is an average, have done that. As that situation started emerging...

Q144 Mr Mudie: What did you do?

Mr Cunliffe: We obviously started, because one gets reports in, we need to know where we are at the end of the year, so if the situation was going to be different to previous years, we obviously wanted to know what their plans were, not just what their draw down was because you can see that in the parliamentary draw down, but how many of them are going to return it and how many of them are going to spend it. There was a lot of discussion with departments about, "This year are you going to spend it?", and in the end the sum of that was that some departments said yes.

Q145 Mr Mudie: Is that the context of the discussions? Is the context of the discussions, "Are you going to spend it?" with heavy overtones that, "If you are, we do not want you to spend it"?

Mr Cunliffe: By the time these end-year discussions took place, if they needed it they had to spend it: because had they not spent it, had they not drawn it down ‑ and they are entitled to draw it down and spend it ‑ they would have over spent. So there was no sense that you cannot spend it.

Q146 Mr Mudie: Mr Cunliffe, thanks to the technical brilliance of our Chairman, we know that this end of year spending - current spending - is something in the region of 9 billon. Can you afford to have all 9 billon drawn down? You must impose some limits on them, must you not?

Mr Cunliffe: The stock is about 8 or 9 billion, I think.

Ms Mullen: At the beginning of 2004/5 the stock was 8.8, I believe. We obviously will not know how much of that stock has been used, but‑‑‑

Q147 Mr Mudie: That is big enough, though is it not?

Ms Mullen: ‑‑‑historically departments have added to the stock rather than taken away from it, and we have no reason to believe that there will be significant consumption of that stock.

Q148 Mr Mudie: No, but it is a pretty recent policy introduced recently, not recently, but in this administration's lifetime, of allowing end of year flexibility.

Mr Cunliffe: Yes.

Q149 Mr Mudie: So the 8.8 has been built up over that period of time. Are you rationing the ability of departments to spend that, and, if you say "No" to me, what happens if departments decided to spend it in one splurge? What would happen to the Golden Rule this year? Take the two questions first. Are you rationing them per year?

Mr Cunliffe: We do not ration them in the way they spend it. They have to explain what they want to use it for, they have to come to Parliament, et cetera, but it is not‑‑‑

Q150 Mr Mudie: So if education, social services and health came this year and had said, "Look, there is an election coming. There is some question that other parties might want to cut public expenditure. We had better get this money spent", you would have just allowed them to spend that 8.8 billion in this financial year?

Mr Cunliffe: But actually they do not do that. What they do is they have three‑year expenditure plans, they have programmes. This change went along with trying to make the whole public expenditure system‑‑‑

Q151 Mr Mudie: No, what you said is that this 8.8 billion that is stored up, deferred spending, is extra to the three‑year public expenditure?

Mr Cunliffe: No.

Q152 Mr Mudie: So they cannot spend it?

Mr Cunliffe: No, I am not saying that. What I am saying is that if you look at how departments spend, what they spend on, they have programmes. They do not suddenly run in at the end of the year and say, "We want to spend X". But the other thing, which I think the system has proved pretty much, is that‑‑‑

Q153 Mr Mudie: Jon, when you say that, though, take education, education will have built up in those figures a good proportion of that 8.8 billion. If education wished to spend that money in any given year, is it negotiated with you or do they have the permission to spend it automatically?

Mr Cunliffe: As I said, they have to discuss it with us; they have to discuss it with Parliament. With all the incentives in the system, all of the history and the evidence is that actually what they do is they use it sometimes to smooth out, and this seems to me what they have done this year, but they tend to accumulate it because they like to be in control, and, if you like, it goes the other way but it builds up. This hypothetical case of them all deciding in February that they all have something they want to buy urgently I think is theoretical, but it is not real.

Q154 Mr Mudie: There is no truth in the rumour that the Treasury are stopping departments such as defence spending some of this brass to keep the expenditure level down?

Ms Mullen: No.

Q155 Mr Mudie: That is reassuring. There is a reference in here to some of this money moving from health's DEL to the AME for foundation hospitals. What is this all about? Why are you raiding the mainstream budget for these foundation hospitals?

Ms Mullen: I do not think the change has any impact on the fiscal aggregates. It is just a classification change, I understand.

Q156 Mr Mudie: Could you give us a note about that?

Ms Mullen: Yes.

Q157 Mr Mudie: There is some wording in paragraph C63 that I would like to clear with you. Maybe it is just written as it should be, but it says something like, "Net payment to the EU were higher than expected payments in 2004/5, being offset by lower expected payments in 2005/6". That could read one way or it could read another way. The other way is you have been hit by higher than expected payments this year to the EU‑‑‑. Let me put it a different way. Are you guaranteed to get those back in the next financial year? Is that what this means?

Mr Cunliffe: Pretty much. There are two things happening here. One is the EU operate on a calendar year basis, not a fiscal year basis, and they are able to call forward some of the assessed contributions in the first quarter of the year, which is the last quarter of our year, so there is some calling forward, but that will be offset from the future. The second thing that happens is that we pay out structural funds and they pay us back. The time lag between those two things happening‑‑‑

Q158 Mr Mudie: So the figures are not, "We have spent more this year than we expected"?

Mr Cunliffe: No, it is the timing. I think there is something in C77 also about this.

Q159 Mr Mudie: The last thing is under spending by departments on capital. The last three years, our brief says, you have under spent to the tune of 10 billion. In view of the fact that public expenditure is very important to make up the shortfall from previous years, what action are you taking to do something about this and who are the major culprits?

Ms Mullen: Our estimated out‑turn in the Budget is now 18.3 billion. That figure is still 20% higher in real terms than the figure for 2003/4 and I believe it is the highest real figures for net investment going back some time to the mid seventies. There are two things going on, I think, firstly, central government. Historically we have been reasonably good at meeting our forecast on central government. This year we have been slightly less good, and the reason for that is that we have not actually allocated the capital reserve. We also have a capital reserve as well as a resource reserve and we have not allocated that this year. That is the reason why central government investment is coming below where we were expecting it to be at the PBR, although I think it is still broadly in line with where we were at the last budget. The other factor is local authorities and public corporations which, of course, are subject to more devolved decisions, and, in fact, they make their decisions on the basis of what they think makes sense from a value for money point of view. On the local authority side, apparently asset sales have been financing quite a lot of their activity and net investment is net of asset sales. That is why the public sector net investment figures for local authorities is lower than expected, because they have sold more of their assets than expected which has been financing the activity.

Angela Eagle: How much extra has been spent on pensioners since 1997 by government changes?

Q160 Mr Mudie: If you cannot answer, the Chancellor will answer cheerfully tomorrow?

Mr Orhnial: Certainly in this budget the measure that we are putting in as a council tax refund is 800 million. They stack up on top of what was in the PBR, which was another 250 million, so the numbers are indeed large. I cannot supply it for you right now.

Mr Cunliffe: The figure of 11 billion a year. You want the total?

Angela Eagle: Eleven billion a year?

Q161 Chairman: We are getting it.

Mr Orhnial: At paragraph 5.69 of Chapter five as a result of measures implemented since 1997, 11 billion a year more on pensioners.

Q162 Angela Eagle: That would be eight billion a year more than if it had simply been spent by linking the basic state pension to earnings?

Mr Orhnial: Yes.

Q163 Angela Eagle: Can you tell me how you are going to work the free bus‑pass for pensioners throughout the country; particularly also how you will treat those authorities that currently already offer that? Are you going to refund money?

Ms Mullen: What was announced was that the statutory requirement will increase from 50%, which is what we assume in our allocation to local authorities, to 100% funding. Under the new burdens principle we will be funding all local authorities for the increase from 50% to 100%.

Q164 Angela Eagle: So those authorities that currently provide a full bus‑bass, and there are some, will get a rebate from central government to pay for 50% of that?

Ms Mullen: They will. We have done it that way because of the new burdens policy and also because it would not be fair to penalise those local authorities that have‑‑‑

Q165 Angela Eagle: Sure. My authority is such an authority, so I am not particularly interested in your reply. Can you tell me how many people are currently accruing entitlement to the second state pension and how much that is costing?

Mr Orhnial: I do not have that number to hand.

Q166 Angela Eagle: Perhaps you would write to us about that?

Mr Orhnial: I will.

Q167 Angela Eagle: Not everybody knows about the second state pension, but it is quite a significant issue. I also saw from the announcements in the Budget that the free bus‑pass is going to apply to some two million people with disabilities. Can anyone enlighten me as to how those two million will qualify, who they will be?

Ms Mullen: I do not know the answer to that. I do not know if anyone else does. We can send you a note on exactly how that is going to be implemented.

Q168 Angela Eagle: In terms of the work towards ensuring that child poverty is reduced to meet the government's target, can somebody explain to me what progress has been made there and what, if any, policies there are in the Budget announcements that help us make that target?

Mr Orhnial: As you know, I think, we are on target to meet our current PSA of cutting the child poverty numbers by a quarter. Since then, in the Budget last week the Chancellor announced that we would be up-rating the child elements of the child tax credit by earnings until 2007/8. We are also working as a result of the Child Poverty Review last year with a number of departments to try to improve on some of the measures on material deprivation that form part of our three‑tier target.

Q169 Angela Eagle: So there will be more policy announcements on that in due course. There are working parties going on?

Mr Orhnial: I would expect more policy announcements as we go through to 2009, 2010 in order to keep on track for that, but our quarter way target is set, or we are set to meet that, and independent commentators are also satisfied as far as that is concerned.

Q170 Angela Eagle: In terms of the announcements on having children's centres in every community, can you tell us what monies have been laid aside in this budget to expand the Sure Start scheme and create more children's centres in local communities to give children a better start in life?

Mr Orhnial: We are set to reach a figure of 1.8 billion in 2007/8 devoted to Sure Start childcare and early years, but the bulk of that was agreed in the spending review last year. That is the bulk of what we have.

Q171 Angela Eagle: Will that money pay for the expansion or is there extra money for the expansion that the Chancellor announced?

Mr Orhnial: He has also announced an additional 35 million in 2006/7 and 2007/8 for parenting and early learning which will help towards that.

Q172 Angela Eagle: Could I also ask briefly about what is happening in the labour market, because there is disagreement between independent experts and Treasury forecasts about how tight the labour market is? Many independent forecasters seem to think that the labour market is basically so tight that we are risking wage inflation if we continue creating employment, but the red book actually talks about creating another 5% of people in employment, taking it from 74.9% to 80% of the working age population. Clearly the Treasury and the forecasts there are not so worried about a tight labour market, but can somebody explain what the difference of approach is that is leading to this difference of interpretation?

Mr Cunliffe: First upon the tightness of the labour market, there is a range of evidence and some of it is mixed but I would highlight a number of points. Earnings growth is around 4.5% for the economy as a whole and I do not think people could say where the sustainable rate, the rate at which inflation would start increasing, occurs but it is probably above that rate. It has grown remarkably slowly over the last couple of years. Going through that, if you look at price inflation, that is remarkably low as well. If we had a really tight labour market you might have expected to be seeing some of those pressures coming through in pay growth. Unit costs for the last couple of years have been a long way below the long run average when the economy is on trend. That said, there are some areas where recruitment difficulties are being faced and there are some firms reporting capacity constraints but, of course, you will tend to find regional pockets within the labour market and certain skills shortages in other pockets. If you look at it from the other end and say are there more hours in the economy to be worked - if we assume we are going to have more people working are there more hours to be worked - I remember I was asked this question about a year ago and I think I said the Treasury's view was hours worked had declined in 2000-01 when the economy grew more slowly. We knew that hours worked generally were declining, that was a social trend, but we thought there were more spare hours in the economy to come back. I know a number of the other commentators said the trend in declining hours, the social change, was more pronounced and the economy was tight as there were not more hours to come back. In the last quarter or so, and we covered this in the Red Book, hours have come back quite sharply but you have not seen an increase in earnings, which is what you would expect if hours were coming back, but that was because people are working more and more overtime and the labour markets are very tight. Our overall view is that there is still a little bit of slack in the labour market. The last point I would mention is one that was covered in the PBR, we did not cover it in the Red Book that rate of unemployment which is consistent with low inflation ----

Q173 Angela Eagle: The NAIRU?

Mr Cunliffe: The NAIRU, yes. You cannot observe it, you have to estimate where it is. Clearly it has come down in recent years but it may well be below the current rate of unemployment. If that is true then unemployment could come down further without creating inflation. In all our calculations of when the cycle ends and the output gap we have not put that down, but there is a chance, and a number of commentators have mentioned it, that actually the NAIRU is a bit lower. All of that suggests there is a bit more in the labour market. You can read the figures the other way but I would say looking on the pay unit cost hours data, I do not see a very strong story for an extremely tight labour market. Could we increase labour force participation? Yes.

Q174 Angela Eagle: You have said you are going to try by 5%.

Mr Cunliffe: Some of it is around inactivity, some of it is around single parents. There is some evidence that what has happened to single parents has increased participation and also the pilots on inactivity have reduced the time that people spend on disability benefits and get them back into work more quickly. I think there is some scope there, yes.

Q175 Angela Eagle: Do you think these active labour market policies are structurally bringing the NAIRU down?

Mr Cunliffe: Yes.

Q176 Angela Eagle: Do you think you have made a structural change because of the active labour market policies and that future changes to Incapacity Benefit and continuing work, for example, on the New Deals has got a chance of bringing the so-called natural rate of unemployment down further?

Mr Cunliffe: Yes. If one assumes there is a stock of long-term unemployed who stay in unemployment then the rate of unemployment that you could sustain without inflation is the temporary one around that, but you have got this stock that find it very difficult to get back into work. If you bring the stock of long-term unemployed down then you ----

Q177 Angela Eagle: One final question which is on productivity. There seems to have been some kind of sea change in productivity and evidence of us catching our competitors in terms of productivity gaps that have persisted for very, very many years. Can you explain what you think has been going on and how we can accelerate it further?

Mr Kingman: Certainly there has been some very encouraging data over the years, both in terms of the UK performance and in terms of narrowing the gaps. We say in the document that the gap with France has narrowed from 22% in 1995 to 10% now; we have closed the gap with Germany; the gap with the US has narrowed. We think it is too early to say definitively, as it were, that we think something has changed in relation to the UK's own performance, although, as we say in the document, the data on performance between trend points is rather encouraging. In terms of what we think is necessary to sustain it, I think the Budget itself set out some important measures and we will be pursuing those.

Q178 Angela Eagle: On training and lifelong learning?

Mr Kingman: On training, on investment, on enterprise, on competition and so on.

Angela Eagle: Thank you.

Q179 Mr Walter: I have got one question on savings. We have discussed in these sessions before the whole question of ISAs and ISA limits and so on, but obviously there is a reduced attractiveness of ISAs, particularly for standard rate taxpayers because of the tax changes to the underlying funds. There was confirmation in the Budget that the ISA limits were not to be reduced but some would say freezing them was a real terms decrease anyway. I want to move on to a slightly different point about savings because, according to an Inland Revenue document that was issued on Budget Day, the tax rate on the income produced by orphan assets - those are investments held in with-profits funds but not earmarked for payment of policyholder bonuses - is to be brought into line with corporation tax. This means that the tax paid on those assets could rise from 20% to 30%. The Norwich Union says the changes could drain its with-profits fund of about 140 million over the next decade. The Inland Revenue was adamant that it will only impact on life assurance companies rather than on policyholders. Gary Withers, the Chief Executive of Norwich Union Life, said it would fall squarely on the shoulders of policyholders because: "Under FSA rules the assets of our with-profits fund are entirely separate to the assets of Norwich Union as a corporation. This tax change affects policyholders and not shareholders." It is not Norwich Union special pleading because the ABI - the Association of British Insurers - has said: "This proposal would represent a significant extra charge on with-profits policyholders...." These are exactly the same people who have had problems with endowments, endowment mortgages and shortfalls on returns. What can you say to reassure these life assurance policyholders?

Mr Cunliffe: I think it might be best if we gave you a note on that.

Chairman: I thought that was going to be the answer.

Q180 Mr Fallon: On public service pensions, in the Pre-Budget Report you reported the net figures on an FRS17 basis but in the Red Book at page 260, in the Budget, you decided to report them on a national accounts basis. Why?

Ms Mullen: This is table C11. In this table we are reporting on a national accounts basis. The reason why is because this table is about the fiscal position and the relevant presentation for the fiscal position is national accounts. Previously we had shown these figures on an FRS17 basis, which was in accordance with GAAP. However, that then involved a number of technical adjustments to the figures to get to the right fiscal aggregates, so we are now presenting the figures on a national accounts basis because this is a fiscal table. The figures will still be set out on a GAAP FRS17 basis for scheme accounts and they will also be set out on that basis in PESA, the Public Expenditure Statistical Analysis document that will come out in April. For the purposes of this table we have presented it on a national accounts basis.

Q181 Mr Fallon: That is rather misleading. The last time you officially estimated the total amount of net unfunded public sector pension liability was back in March 2003 and that figure was 425 billion. Consulting actuaries have recently estimated that has now risen to 690 billion. When will we see the official figure updated?

Ms Mullen: I believe that figure may be in PESA but I guess we can provide a note on ---

Q182 Mr Fallon: When will it be updated?

Ms Mullen: We can provide a note on that. The figures that will appear in scheme accounts will still be on an FRS17 basis.

Q183 Chairman: The Budget documents give figures for estimated exchequer yields for individual tax protection measures. The estimates over the last three Budgets show, broadly, a rising trend. Is there a medium-term strategy in this area? Do you expect to be able to continue increasing the yield from tax protection measures in future years?

Mr Ramsden: I think it is fair to say that having revenue protection measures has been a feature of Budgets and PBRs through the years. What we have tried to do over the last year in Treasury, and in Revenue and Customs as they are brought together, is to take a more strategic approach to the issue of avoidance. Alongside the work that particularly Customs have done at the illegal end of the compliance spectrum on evasion, which your Committee has recently published a very helpful report on, if you look at what we have done over the past year on avoidance, a year ago we introduced the disclosure rules which, as we said when we discussed this before, were to take a more proactive approach. We then went further in a kind of second phase by taking an innovative approach on employee remuneration at PBR and now in the Budget we have introduced two targeted anti-avoidance rules on double taxation relief and arbitrage. Whilst it does yield, all of this activity is in the context of trying to think how we can stop being one step behind the avoiders, can get more in real time with avoidance activity and also take more account of the global trends that we are seeing in the economies whereby avoidance pops up in different places and we need to respond to it. If you look at the billion or so that is raised from anti-avoidance measures in the Budget in 2006-07 onwards, a lot of it is either from the disclosure rules or from these new targeted anti-avoidance rules. It is consistent with the past in the sense that there are quite a lot of measures but I think we would argue we are trying to take a more strategic approach.

Q184 Chairman: I hope you will act on our recommendation in our excise duty fraud report and get your Customs personnel away from Hong Kong up to Beijing. Are you going to do that, Mr Cunliffe?

Mr Ramsden: I would say on that, the evidence that you saw in China is a very interesting example. If cigarette fraud is becoming so prevalent in China we need to look at how we can respond working with HMRC and trying to be more proactive and being up with, if not ahead, of what the fraudsters or the avoiders are up to.

Q185 Chairman: You should not need the Treasury Committee to go out to China to give you that recommendation, that was what surprised us.

Mr Ramsden: Obviously the Government will be responding to your recommendations in the normal course.

Q186 Chairman: It was very clear to us. Judging from the measures announced in this and earlier Budgets, the emphasis in respect of direct taxes seems very much to be on addressing tax avoidance rather than fraud. Is that correct?

Mr Ramsden: Certainly the measures that we have introduced are principally on direct tax avoidance. It is easier with indirect taxes to know when it is illegal and when it is fraudulent behaviour. Definitions differ as to what is avoidance and what is fraud or worse. Principally the measures are on direct tax, yes.

Q187 Chairman: The Government has accepted the recommendations from the Better Regulation Task Force that it adopts the Dutch approach of reducing the administrative burden of regulation and its cost by first measuring the administrative burden and then setting a target to reduce it. The target in the Netherlands is to cut the administrative burden by 25% over four years. Is that the sort of figure that will be set for the UK? Are cuts of this magnitude feasible?

Mr Kingman: I do not think we have any idea yet. The purpose of the BRTF recommendation being in two stages is very much that we need to do the work before we can establish the target. There is some reason to believe that when they started down this road the Dutch economy was more regulated than the UK economy is now, but we have an open mind and the purpose of the work that the BRTF has recommended and we have agreed to do is very much to establish what is feasible.

Q188 Chairman: Why have the Treasury taken the decision to end the stamp duty exemption for commercial property in enterprise areas?

Mr Orhnial: This was introduced in 2001.

Q189 Chairman: We know that.

Mr Orhnial: It was one of those reliefs that was time limited as a state aid and it was due to end in 2006. What is being done is to replace it with some other measures that are rather more targeted and ---

Q190 Chairman: So it has not been very successful?

Mr Orhnial: Not at all, that is not the reason, we have simply found other measures to replace those ones. The measure was going to die out in any case.

Chairman: That does not seem a very convincing answer to me.

Mr Mudie: What other measures have you got? There is a fear now that we will not get development in regeneration areas because you have stopped it and we are not sure what you are replacing it with.

Chairman: Exactly. That is a good point and, if I may add to it, during our inquiry into regional productivity we heard that this incentive was poorly targeted and the definition of deprived areas included parts of Holborn in Central London and Canary Wharf. With hindsight, could that not have been targeted and done better?

Mr Mudie: East Leeds, Dumbarton, Liverpool.

Q191 Chairman: Somewhere north of the Watford Gap.

Mr Kingman: Can I say something about the measure that we are bringing in to replace it which is something we are consulting on in this Budget: the Local Enterprise Growth Initiative Scheme. The proposition is that this should be available to local authorities in Neighbourhood Renewal Fund areas which will be particularly deprived. This is something that we expect to be particularly geared to getting local authorities with the most imaginative proposals for using this money to drive enterprise in deprived areas. We think it will be much better targeted. Also, we think there are significant sums of money that we are putting on the table rising from 50 million to 150 million.

Mr Mudie: With the greatest of respect, the only difference is you have put a lot more money in and you have mentioned targeting, but it could have been targeted in the first place. Any area indices will tell you where deprivation is, we do not need one withdrawn and another Act of Parliament or whatever coming through with a gap in between. It was successful, maybe the targeting needed tightening up, but why the hell withdraw that and not just tighten it up?

Q192 Chairman: As someone coming from north of the Watford Gap, like a few of us here, was it not foreseeable all along that property transactions, such as those we have seen involving the sale of offices occupied by London investment banks and law firms, would benefit from that relief? It was a bit dumb in the first place, do you not see that?

Mr Orhnial: One could not predict precisely what ----

Q193 Chairman: We end up on another controversial note. On you go, just give us an answer.

Mr Orhnial: One could not predict precisely what would be attracted by this particular relief but, as John and I said earlier, we have replaced this with a more effective relief and in any case it was about to expire.

Q194 Chairman: We are not convinced, is that correct? We ain't convinced. Maybe you will grow into the job as you come before us more, Mr Orhnial. Best of luck with that and give us a better answer tomorrow if you are here. Thank you very much, we look forward to seeing you tomorrow.

Mr Cunliffe: Thank you very much, Chairman, for putting this session back.

Chairman: No problem. Thank you.