Examination of Witnesses (Questions 120
- 139)
WEDNESDAY 7 DECEMBER 2005
MR JON
CUNLIFFE, MR
DAVE RAMSDEN,
MR TONY
ORHNIAL, MR
JOHN KINGMAN
AND MS
MRIDUL BRIVATI
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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