Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 120 - 139)



  Q120  Damian Green: One other factor that has been mentioned is the Governor of the Bank of England has said that high tax rates have contributed to the slowdown. Do you think he is right?

  Mr Cunliffe: The Bank said in their November Inflation Report, and I think the Governor said this, that what is contributing to the slowdown is the reduction in post-tax disposable income for households, real disposable income, and that is being affected by a number of different things. It is being affected by inflation, as I said, it is being affected particularly by inflationary costs where households cannot adjust quickly, and it is being affected by lower average earnings. The Governor also said that the increase in the tax to GPD ratio was as forecast by the Treasury, which was true, it is what was in the PBR last year and the Budget in April. A lot of that increase is fiscal drag, as I have explained to this Committee before, and also compositional effects where you get particularly strong growth in the financial sector that increases the tax take from the people at the very top paying income tax. It is difficult for me to see how taxation is a factor, there have been no tax increases, and, therefore, you would not have expected to see an impact. I think post-tax disposable income, yes, I would see an impact.

  Q121  Damian Green: Presumably you set tax rates and if you have a target for the GDP to tax ratio then the effects of fiscal drag and compositional effects will be included in the Treasury's calculations.

  Mr Cunliffe: We do not operate fiscal policy by targeting particular ratios; we operate fiscal policy by looking at the fiscal position over the cycle of the economy and adjusting that to meet the golden rule, the sustainable investment rule. There is not a policy decision there. Fiscal drag is something which I think has been happening, certainly since I joined the Civil Service, at about the same rate. Of course, the other effect is that more of the UK's tax base is accounted for by the financial sector, and when you get a strong year in financial sector growth and financial sector profits, which we may come on to later on, we normally do discuss that, you expect there to be a compositional change and, therefore, the tax to GDP ratio to go up. There are no new policy decisions on tax.

  Q122  Damian Green: Expanding from the financial sector, the Bank again has noted particular problems with growth measurement across the services sector and has asked for more resources to be devoted to understanding what is going on there. Is that happening?

  Mr Cunliffe: I suspect that is a question in the first instance for the Office of National Statistics. What I would say is the service sector is becoming an increasingly large part of the economy, it is now nearly four times as large as the manufacturing sector, say, but we have much better statistics for manufacturing. Part of that is historical because we have been collecting manufacturing statistics longer and part of that is it is just easier to measure when you are measuring physical things that have been produced and have physical inputs than measuring services. I think we agree, and the ONS agrees, that we need to improve the understanding of the service sector. It is also something which we have been pushing quite hard for in Europe and EUROSTAT to try and make it a priority for the European system of national accounts to measure the service sector actively better. I would agree with that. How it is being done statistically I would have to defer to the ONS.

  Q123  Damian Green: Do you have any feel for whether the fuzziness around the edges, which we all accept is there, is likely to be understating or overstating levels of growth?

  Mr Cunliffe: No, I do not think I can make a comment on that. I would just say that whatever the fuzziness is, it is becoming more important to deal with it because the share of services in the economy is growing and the share of services in trade is growing as well. In a number of areas it is important to understand it, but I could not say if there was a bias one way or the other.

  Q124  Damian Green: As you know, we had a panel of independent economists in this morning and I think it is fair to say that they were universally politely sceptical about your continued optimism on GDP growth looking further out to 2007-08. Why are you so optimistic?

  Mr Cunliffe: I would not say we were so optimistic. Our forecast and the way we forecast GDP is anchored around the cycle and the output gap and our starting assumption, which we then test in the forecast, is that the economy returns to its trend level. We had to put the end date of the cycle back from the end of this year to 2008-09 because of the slowdown in economic growth this year. The things that have caused the slowdown seem to be oil, seem to be exports and seem to be some of the effects on the labour market of immigration which are holding down earnings. As we see those effects coming out of the economy and as we now see there is a fair amount of spare capacity we would expect the economy to close that gap.

  Q125  Damian Green: If there is a considerable amount of spare capacity that seems to follow an output gap.

  Mr Cunliffe: Forecasting the output gap is an art, not a science. I would not claim one could be precise. I think we also make clear in this document that the indicators are particularly difficult to read at this time. It is very unusual to have a period in which the economy puts on 330,000 new jobs in a year, which is the strongest employment growth we have had for a couple of years, at the same time that the rate of output is dropping. What would normally happen is output would be dropping in the economy, firms would then be holding on to workers for a while perhaps and then reducing their headcounts. What one would not normally see is the rate of output dropping and the unemployment rising, those two effects going in different directions. It is difficult to know whether the employment effects of migration from what we call the A8 countries, the accession countries, minus Malta and Cyprus, is fairly stated. As explained in the document, it may well be understated. On the employment side, we are seeing stronger employment growth and the economy hiring people; on the output side we are seeing a fairly marked drop in the rate of growth. Those two things together are difficult to rationalise. If you take the figures at face value and you work from the last on trend point then there is a pretty sizeable output gap, possibly more sizeable than we have. If, on the other hand, you say these things may be revised down then you will see a smaller output gap. It is quite difficult to know where the trend rate of growth in the economy is running now.

  Q126  Damian Green: You use the phrase "sizeable negative output gap" in the document but it does not sound as if you are using that phrase with any tremendous degree of confidence.

  Mr Cunliffe: We have got the output gap at 1.4 and other forecasters have it in that area. The Bank of England has it somewhere around one, on the short side of one. The IMF, the EU and the OECD are around about 0.5%. What has changed between now and the Budget was at Budget time most outside forecasters were saying they did not think there was a negative output gap but I think everyone agrees there is a negative output gap. I think we are quite clear that it is sizeable, however the path of the supply trend rate of growth of the economy is difficult to estimate and some of the indicators point in different directions.

  Q127  Damian Green: So moving the end of the cycle seems as much an act of faith as anything else?

  Mr Cunliffe: No. I think it is a question of whether you have a methodology and you stick to it. There are different ways in which you can run fiscal policy. We operate fiscal policy on a cyclically adjusted view of the economy. We try and estimate where the economy is at any time against its potential level of output because that has a very big effect on public finances. We have a methodology for doing that which is about dating on trend points and then measuring the growth from the last on trend point against the trend rate of growth and seeing what that produces. That is the methodology we have operated fairly consistently—completely consistently—since the new framework was introduced. As a result of the ONS revisions that we just talked about, which revised the growth of output in 2004 quite heavily, and as a result of the output numbers for Q1, Q2 and Q3 this year, which averaged about 0.4, that opens up the output gap. It is not really an act of faith, it is taking the last trend point and leaving that unchanged. It is leaving unchanged our estimate of the trend rate of growth and it is putting in both the numbers from the ONS revisions from the Blue Book in the middle of last year and putting in the growth numbers for the last three quarters, and that is what we term as the output gap. If you like, it is the very opposite of an act of faith. We could say, "That is what our methodology produces, that is what is consistent with everything we publish from Budget to PBR, but we think the ONS figures will be revised or we think the output numbers are understated or the supply side of the economy is greater than we think and, therefore, we are changing all those things and we are putting a judgment overlay on top of that which suggests that the economy is actually doing better than it is, or will grow better than it is", but we do not do that, we operate the components of the approach very much as we have laid out in the past and said we would operate them, and that is what produces the delay at the end of the cycle.

  Q128  Peter Viggers: How many of the jobs that you referred to that have been created recently were in the public sector and how many in the private sector?

  Mr Cunliffe: I have not got the exact figures to mind. I think it is about half and half.

  Q129  Peter Viggers: I know a number of health authorities seriously overspent in the period before the election and are now having to retrench and lay off staff. Consumer spending is growing at close to its weakest level for ten years and you have referred to the reasons for this. When the Governor addressed this issue in the November Inflation Report he named two reasons: one was the ratio of taxes to disposable income had gone up by two percentage points and the other was people were spending more on so-called boring items like rent, housing, utilities and so on. Both of those areas are areas of governmental responsibility and yet in the Pre-Budget Report three different reasons were given. Can you reconcile those two?

  Mr Cunliffe: This was the point I was making before, maybe I did not make it clearly. What the Bank said in the Inflation Report was that they continued to believe that the slowing of house price inflation and activity played a role in the recent slowing of consumption, then they say "The slowing of consumption is probably reflected in a range of factors, including weaker growth in post-tax novel income, higher consumer price inflation, past increases in interest rates and a cooling housing market". The higher consumer price inflation is in effect the oil impact that I was talking about. The boring items, like heating, fuel, petrol, have gone up and housing has not been able to substitute away from that. Then more indirectly a number of other costs have gone up: air travel and the like. I think the Bank and the Treasury have been quite consistent, it is just explained in a different way. The slower growth in post-tax income is in our view due to the fact that at the end of last year average earnings were growing at 4.5% a year, which is below their sustainable rate when the economy was growing quite fast, and this year growth in average earnings has dropped for the third quarter to 3.9%. There has been a quite strong drop back in average earnings and you can explain that in a number of different ways. It is consistent with a large output gap but, of course, that has an impact on households.

  Q130  Peter Viggers: Can you explain why the Pre-Budget Report did not refer to the sharp rise in the ratio of taxes to household disposable income?

  Mr Cunliffe: The tax to GDP ratio has been rising for a number of years. The rise is not due to any tax policy decisions, it is not as if taxes have been increased, the rise is due to fiscal drag. The rise is also due, as to some extent we forecast, to a higher proportion of higher rate taxpayers getting a higher proportion of the pay increases and that is how that comes back to the financial sector. That is one of the reasons why income tax has held up more robustly than we would have expected it to do with economic growth at a slower rate. It is difficult for me to see that there has been anything there that would have impacted on households generally. To a large extent, this is people at the top end paying a higher effective rate of tax because they are earning more. To my mind, the thing to concentrate on is what has happened to household income. We do not see it as a taxation effect.

  Q131  Damian Green: I think some of my constituents would feel if there has been a sharp rise in the ratio of taxes to household disposable income that this could be a responsibility of the Chancellor of the Exchequer.

  Mr Cunliffe: Sorry, taxation is the responsibility of the Chancellor of the Exchequer.

  Q132  Peter Viggers: The increase.

  Mr Cunliffe: The point I was trying to make was there are no policy measures that are leading to a large increase in taxation on households. What we are looking at is the normal operation of fiscal drag which I think has been operating on the tax system for as long as I can remember. If you are asking me has the ratio of tax to GDP increased as forecast, yes. If you are saying has there been policy action on taxation which may have hit consumption, no. I do not think that increase in tax to GDP ratio has had this particular sharp effect on consumption. Fiscal drag has been going on at this rate for a number of years and it has not had that effect, it is difficult to think why it should have that effect now. I can see a drop in average earnings having an effect, I can see an increase in households' heating bills and fuel bills having an effect, but that is another issue.

  Q133  Peter Viggers: The Pre-Budget Report notes: "increasing evidence that the housing market is undergoing an orderly adjustment with little prospect of a sustained fall in house prices." How do you reconcile that with the OECD's comment that it regards house prices in the United Kingdom as "significantly overvalued"?

  Mr Cunliffe: The OECD will have to speak for themselves. It is very difficult to know that there is a right value for houses in the UK expressed as a percentage. Normally we look at the house price to earnings ratio. In a number of countries there is no steady relationship between house prices and earnings over the years. There was in the UK a relationship that held until the early 1990s but it does not seem to have held through the late 1990s when house prices rose quite quickly, but we did not see the sorts of strains appear in the economy that have appeared in the house price collapses of the 1980s and 1990s. If you simply draw a line on a graph and say, "Where is the house price to earnings ratio now? Where was it 10 years ago? Where was it 20 years ago? What happened in the past at a certain value must happen in the future at a certain value, and there is in the economy a right level of house prices", then I think maybe you could make the judgment that house prices are too high. If, on the other hand, you think with the structure of society house prices change and think that household wealth has increased quite considerably over the last eight or so years, and if you look at what happened when house prices went up and the way in which they have come down, it is not obvious to me that there is a right price. Is there still a risk from the housing market? Yes. The risk is less than it was a year ago, a year and a half ago. I guess what the PBR is saying is that the house price to earnings ratio has come down but it has come down not by house prices going down but simply by house prices growing less slowly than earnings. I think the risk as a result is less, but there is always a risk from the housing market as from any other asset price.

  Q134  Susan Kramer: A few moments ago you attributed much of the undershoot on growth to a rise in oil prices. I wonder if you could help me with that since other economies—the USA, Japan, major oil importers—do not seem to have seen that same dampening of their growth numbers. The Treasury's forecast for overall growth in the G7 is still 2.5%, the same as at the time of the Budget, despite the rise in oil prices. We took testimony this morning that the UK is virtually self-sustaining in oil, so can you explain to me why in your estimate the UK has been harder hit by oil prices than the G7?

  Mr Cunliffe: On the first point, I think when fuel bills go up and petrol prices go up, there is an impact on consumption. What that impact is depends on where consumption is, and there can be other factors driving consumption. Certainly in Europe we have seen quite a drop in consumption, particularly from the big European economies, and we have seen quite a drop in imports from the big European economies. One of the reasons why GDP growth has held up, for example, in places like Germany is because their export sector has performed extremely strongly. If you look at household demand in Germany it has been very weak for the last year and has not recovered in the way that it was forecast to recover. I think oil prices have had an effect on the consumer in Europe, they have had less of an effect on the consumer in the US. The second point is that in the UK this has come at the same time as interest rates were increasing and at the same time as house price growth was slowing and you have to look at the combination of effects on the consumer. We had a pessimistic forecast for the eurozone at Budget time; outside commentators had a higher forecast. Whether it has been flat or whether it has come down depends a little bit on your starting point. The eurozone economy has been growing somewhere between the low ones and one and a half up to two for some time. In the UK we have had much higher consumption. With a higher consumption level with interest rate increases and with households highly geared, personally I would expect to see a bigger effect. We are a slight net oil exporter and eventually all these things work through the system and the benefits to the UK of having an oil industry will feed back into the system. The oil sector is a separate part of the economy, so for the vast majority of British companies who are not engaged in oil exploration, production, oil is a higher input cost and that gets reflected in what wages they can pay, for example, and what prices they can charge. For a large number of UK consumers there is an international price for oil, it is not as if having our own oil and gas industry means that you pay a lower price, so the effect on the household is the effect of the international oil price. The fact that there is oil in the North Sea I do not think really affects the impact that an oil price increase has on household disposable income. Over a number of years I would expect the UK to be able to weather an oil price increase better than non-oil producers because having the benefit of an oil sector will feed back into the economy. When oil prices go up from about 40 at the Budget to 67 in six months, the fact that BP are out there in the North Sea does not seem to me to make much difference to the consumer.

  Susan Kramer: Many people would consider the consumer is restraining himself more because he has so heavily borrowed and that is an issue that really was not tackled in the Budget, rather than put it down to oil prices. You do not really mention that as an issue.

  Mr Cunliffe: I think we do mention that one of the reasons for the slowdown could be the interest rate increases on highly geared households. I think that is in the PBR document and I could find it for you if you would like. The point I make is we knew that at Budget time: "As expected, households continue to adjust to continued high levels of personal debt and the lagged effects of increases in interest rates between late 2003 and summer 2004". It is in there. The point I am making is I was asked to explain what has changed since the Budget. We knew about the interest rate increases and we were forecasting a house price change. What may have changed, as this goes on to say, is that those things happened but they had a bigger impact on the consumer than we were expecting, and that is what the Bank of England were referring to in their Inflation Report. I was also talking about new developments which we did not know about at Budget.

  Q135  Susan Kramer: In the various testimonies we have taken over the past few weeks, part of the explanation for the undershoot on growth has been attributed to unexpectedly low levels of business investment but nobody has been able to explain that with profits relatively high and interest rates low yet there is an undershoot. Can you give us any kind of explanation?

  Mr Cunliffe: I wish I could. I would say three things. We were forecasting at Budget time business investment to be 4.5%-5%, it has been 3% for 2005. We were not forecasting a huge increase but we were starting to see it climb back under the impact of the very high rates of return of profitability and very good financing conditions for businesses. I would explain it in a number of ways. This is an international phenomenon. Investment is lower at this stage in the cycle in most G7 economies. It has been lower in the US than they would expect for this level of growth. The IMF talked about this in their last World Economic Outlook. There is a general reluctance or change in company behaviour which means that with these levels of profitability and levels of economic growth where you would normally see investment come back, it has not come back to the same extent. I think it has been affected by oil. I think the oil price increases over the last year, year and a half, have just increased the degree of uncertainty for businesses and made businesses hold off on investment decisions. The third reason I would give for this—something that Alan Greenspan has talked about in the US and I think is true in the UK as well—the slowdown in 2000-01 was investment-led, companies over-invested, particularly in the IT sector but more generally, and there was a fair amount of nugatory investment that had to be worked out of the system and chief executives in boardrooms became quite risk averse about investment and you may see that effect coming through and the psychology. I have assembled the reasons but I do not think I can give you an iron cast explanation of why it has happened or what will happen in the future.

  Q136  Susan Kramer: What impact do you think the Pre-Budget will have on any of that?

  Mr Cunliffe: I do not think the Pre-Budget Report and the measures in it will have an impact, or should have any impact on investment. There may be an impact in the North Sea from increased capital allowances and the change in special corporation tax, and we can go into that if you would like.

  Susan Kramer: I think that will be picked up by someone else later.

  Q137  Kerry McCarthy: Can we turn to exports. The Bank of England has described UK export performance as "somewhat disappointing in recent years" given the expansion in world trade. What factors do you think could account for this disappointing performance?

  Mr Cunliffe: There are two parts to UK exports. One is what is happening to our export markets, and there you look at world trade and world imports but you then weight it to take account of different countries' importance to the UK. For example, we would give Ireland quite a high importance, higher than its economic weight would suggest, because a lot of UK exports go to Ireland. There we have seen UK export markets grow more slowly than world export markets. We were forecasting 7.5% at Budget time and it has been six. That is really to do with Europe. Over 50% of our exports, nearly 60, go to Europe and over 50 go to the eurozone. Weakness in the eurozone and weakness in particular in consumer demand has led to weakness of imports. That is one effect. The second is within those export markets the UK's share of what is there is growing or dropping. There we have seen our share in Europe decline, and decline quite strongly, in 2000, 2001 and 2002. That decline has now eased off a bit. There are a number of factors there. One is that our exports are still 2:1 goods to services and we have seen the effect of goods imports from the newly emerging economies, China in particular. That has been an effect across the world economy, and also we have the new countries that have joined the European Union. I would expect on the goods export side we are losing market share in the same way a number of other industrialised countries are simply because of the China effect and the effect from Eastern Europe. While service exports are growing from the UK, and we have higher service exports I think than any other G7 country, they are not making up for that. The other point is that our exports share in the newly emerging economies is holding constant but our exports in absolute terms are quite small. Our exports to China and India are about 1% of total exports, that is relatively small, and that means that needs to grow. I think it is a combination of our traditional export markets have grown slowly, we are facing competition there from emerging Asia and from Eastern Europe, we are doing better on service exports but they need to grow considerably faster and weak demand in the parts of the world which normally get reshuffled.

  Q138  Kerry McCarthy: What about the strength of sterling? Is overvaluation a problem in terms of exports?

  Mr Cunliffe: Recently sterling has come down a little bit and we have not seen a huge change in exports. I think the strength of sterling can make a difference temporarily but actually in the end it is our underlying competitiveness.

  Q139  Kerry McCarthy: You would not say it is a key factor in terms of manufacturing exports, for example?

  Mr Cunliffe: I would not. If you look at the difference in costs for textiles, say, or for toys between China and the UK, the exchange rate effect is not going to make much difference to our competitiveness in those sectors exporting into Belgium, say, or Italy.

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