UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 1031-i

House of COMMONS

MINUTES OF EVIDENCE

TAKEN BEFORE

TREASURY COMMITTEE

 

 

THE 2007 PRE-BUDGET REPORT

 

 

Monday 15 October 2007

MR ROBERT CHOTE, MS BRIDGET ROSEWELL and DR MARTIN WEALE

MR ROBERT CHOTE, PROFESSOR COLIN TALBOT,

DR MARTIN WEALE and MR JOHN WHITING

Evidence heard in Public Questions 1 - 129

 

 

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Oral Evidence

Taken before the Treasury Committee

on Monday 15 October 2007

Members present

John McFall, in the Chair

Mr Graham Brady

Mr Colin Breed

Mr Philip Dunne

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

Mr George Mudie

John Thurso

Peter Viggers

________________

Memorandum submitted by Dr Martin Weale

 

Examination of Witnesses

Witnesses: Mr Robert Chote, Institute for Fiscal Studies, Ms Bridget Rosewell, Volterra Consulting, and Dr Martin Weale, National Institute of Economic & Social Research, gave evidence.

Q1 Chairman: Welcome to this, our first session on the PBR in this year. Can you introduce yourselves for the shorthand writer please?

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

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

Ms Rosewell: Bridget Rosewell from Volterra Consulting and PRI Economics.

Q2 Chairman: The Pre-Budget Report and the risks to economic growth over the next few years: does the PBR adequately reflect those risks, given the statements from the IMF and others?

Dr Weale: I think it is fair to say the commentary on the PBR gives an account of the sorts of things that could go wrong with the British economy. What is perhaps slightly less satisfactory is that the numerical presentation is simply the numerical ranges that reflect what might happen to the supply side and so there is no real quantification of the sorts of things that could go wrong with the British economy and that might therefore adversely affect public borrowing and the fiscal position.

Q3 Chairman: What about the credit crunch? Is that included in it, do you think? Have they given enough consideration to that and the possible implications of it?

Dr Weale: Again, my own expectation is that the impact of the credit crunch will not be terribly severe. My view of next year is slightly more pessimistic than that presented here but I would not say sharply more pessimistic. I am expecting GDP growth of about half a percentage point less but, of course, the Treasury uses a lower figure for public sets of projections anyway. Beyond that, in 2009, again they assume growth of 23/4%. I choose slightly slower growth, but yes, the credit crunch could turn out worse than they are expecting and I am expecting. We do not know.

Ms Rosewell: I am not sure it is so much just to do with the credit crunch. I agree very much with Martin that to have about two-thirds of the page on forecast issues and risks in Annex A is not really a very good appreciation of the riskiness of the current situation, particularly given financial disruption and the potential for change and some view as to how serious those risks are either on the up side or the down side, actually, because there are potential upside risks in the world economy for that matter - China and India continue to do very well - and I think some appreciation of the scope outside the relatively narrow central range that they have got in the project would have been very helpful. I am particularly concerned that the position from 2009 that they are forecasting is rather optimistic compared to what may happen in 2008. In 2008 we are already getting a slowdown in the economy and we have had interest rate increases. Forget the financial credit crunches and all of that and just think about the underlying pattern. We were all forecasting a slowdown in the economy, but again, never mind the financial crisis; this is a very small slowdown, you know, a small accident, not many dead as far as this forecast is concerned, and if you look at either inflation or output growth they have returned to business as usual very quickly. It is the reasons why that is going to happen which I do not think are very well explained. We get a lot about 2008 but not much about the period beyond and yet that matters quite a lot.

Q4 Chairman: Robert, in your IFS briefing you stated that the recent turmoil in international markets had "punched a 61/2 billion hole in the current budget balance" for 2008-09. Could you elaborate on that and do you agree with the Government's assessment of the size of this hole and the speed with which it is expected to close up?

Mr Chote: The key revisions to the tax figures for that year I think are a 4 billion loss of revenue from income tax and a 3 billion revenue loss from corporation tax, and clearly the particular difficulties of the financial sector are playing an important part there although, as the Treasury book makes clear, there are other factors going on as well. Given what my colleagues have said about the uncertainties about precisely what the outlook is for the financial sector and the economy more broadly, I think you have to wonder whether this temporary hole that the Treasury has identified in revenues is going to close up quite as quickly as they hope. Clearly, we think back to the period early in Labour's second term in which there was a particular problem in the financial sector, albeit different in nature. We were having a protracted period of falling stock markets then and that hole ended up being deeper than the Treasury thought and then it did not fill itself up as quickly as they had thought, so there must be a concern in the Treasury's mind that if things do evolve in that sort of direction the hit to revenue will be larger and will take longer to unwind than they currently anticipate.

Dr Weale: I think there is, as I say, a very real risk that the Treasury is underestimating the hit to revenue. If you look at what has happened in the first six months of this calendar year, revenues as a proportion of GDP have fallen by 0.4 percentage points; income tax and corporation tax revenues have fallen by 0.5 percentage points. The Treasury is assuming that total revenues as a proportion of GDP remain the same as last year but it seems to me that there is a very significant risk that they will turn out to be lower.

Q5 Mr Breed: Could we turn to the question of house prices, which is something which, for a variety of reasons, is on everybody's mind at the moment? The Pre-Budget Report stated, "House price inflation is expected to continue to ease over the coming year". Can I ask you if you agree with that assessment and do you think that the risk of a more rapid fall in house prices may have increased since the Budget earlier this year?

Dr Weale: Yes, I do broadly agree with that, for all sorts of reasons: higher interest rates, probably separately a greater reluctance of banks and building societies to lend. I do think perhaps the market will continue to slow down. There is obviously a risk of a sharper adjustment and in making that a core of one's predictions there is a standard problem that we can observe that house prices are very high relative to normal historical experience. We can think of reasons why that might in part be the case. With much lower interest rates than we have had but at the same time very high house prices there does seem to be a risk of a correction, but whether that is going to come next year, the year after or not at all is something I would not like to say.

Ms Rosewell: In terms of the question that you asked, has the risk of a sharper house price correction increased since the Budget, I am not sure that it has, actually. If you look at most bits of the housing market, unemployment is still low so people can finance their mortgages, and that is really what matters when it comes to sharp house price corrections. What matters to the general tenor, if you like, whether it is going to slow down and maybe not much movement at all, is how many people are out there doing transactions, so you have two different things going on here. In terms of the numbers of transactions, we are already seeing those declining quite sharply. I think there is going to be a bit of a hiatus but most financial institutions are well capable of issuing mortgages, and indeed are issuing mortgages, so some base level of activity is still going on; houses are still for sale. While that is happening we will continue to get wobbles in some individual parts of the market but I agree both with the proposition that it will continue to slow down and also I do not think there has been a really significant increase in the probability of a sharp correction, which is always possible, since the Budget.

Q6 Mr Breed: On that basis you believe therefore that consumer confidence and consumer spending, although maybe at a slightly lower level, is not going to be a particular problem in the next year or two?

Dr Weale: First of all, reported measures of consumer confidence I do not think are much use as indicators of future consumer spending. What they tell you I am not quite sure but they do not tell you what is going to happen to consumer spending. With regard to the issue of what I expect to happen here, we have to bear in mind that the savings ratio at present is extremely low by any historical measure, so although disposable income may do better next year than it has done this year, at the same time consumers are likely to want to raise their saving and growth in consumption is likely to be at below trend rate, but I do not see consumption growth falling to rates that would provoke a recession.

Q7 Mr Breed: Does anybody disagree with that?

Ms Rosewell: No, I think that is right, though I think it is much more to do with the level of unemployment and wages and so on than it is to do with house prices, which I think is probably the same thing as Martin is saying.

Q8 Peter Viggers: The Chancellor of the Exchequer has said that he would like to encourage longer-term mortgages in suitable circumstances. What could he do to encourage longer-term mortgages and what should he do?

Ms Rosewell: I am not sure he should do anything. People have begun to issue longer term mortgages but the willingness of consumers to take them up is distinctly limited because they themselves do not want to lock themselves into a long-term rate which can only be maintained if there are exit penalties, and they fear that the interest rates will move in ways which will make these mortgages not something that they want in five or ten or 15 or 20 years' time, so they want the ability to get out of those mortgages. That is the experience that exists in quite a lot of places where long-term mortgages have been offered in the past, that eventually people want to get out of them, so I am not even sure that it is a good thing.

Q9 Peter Viggers: If I may ask a similar question in a different way, the Government is investigating whether the Debt Management Office could issue derivatives which might help mortgage lenders to hedge longer-term fixed-rate deals. Do you think that would be a worthwhile and useful step?

Dr Weale: I think I share Bridge's view that if people buy a house and take out a 30-year mortgage and then decide they want to move in five years' time, the costs and trouble associated with that are likely to be greater than if they have a mortgage of much shorter maturity. I also think that, of course, if everyone did take out long-term mortgages monetary policy almost certainly would not work in the way that it has. Whether we would think that would be a good thing or a bad thing is perhaps a separate issue but it would fundamentally change the way in which the economy works and I am not sure that it would help the management of the economy.

Q10 Peter Viggers: Switching to business investment, which has gone up and then down again, the Pre-Budget Report 2007 states that "with evidence that the cost of capital has risen since Budget time" business investment is forecast to slow in 2008 to a level of between 31/4% and 33/4%. Do you think that is a reasonable assessment given the current difficulties in the capital markets?

Ms Rosewell: Of course, investment depends on a lot more than just the cost of capital; that is the first proposition. The cost of capital does have a role to play but it is as much to do with the kind of security that your lender wants and the term over which they give you a loan or the state of the Stock Market as well. The Stock Market, of course, has recovered quite strongly, so if you are a quoted company the ability to finance investment has probably increased because you have got more collateral based on those shares. If you are in a small business or some such then it may become rather more difficult, not just in terms of how much you are going to have to pay but also in terms of the sort of collateral that you are being forced to offer and so on because the whole attitude to risk has tightened quite considerably over the last few months, and so while I think that the credit crunch may not make a difference to consumers I think it may well make a difference to businesses.

Q11 Peter Viggers: So what are the aspects of availability of capital which would impact on business?

Ms Rosewell: Just the sheer ability to get a loan. You go along to your friendly bank manager. Is he going to be willing to finance your investment or not? In a world where they have become more uncertain, more cautious about the risks that they are willing to take, they will either charge you more or ask for better security or they will not give it to you at all.

Dr Weale: Yes, we may find - it is unclear - that what happened in Germany three or four years ago will happen here where, although official rates of interest were respectably low, the rates that the banks were charging to their commercial customers and particularly their small customers looked extremely high. That said, I do find the Treasury's projection perfectly reasonable for business investment.

Q12 Peter Viggers: This Committee has in the past queried why business investment has not been as strong as might have been expected and the Government has produced a working paper on intangible investment. Does that help explain the slight unexpected weakness in business investment?

Dr Weale: In part, yes. I think the paper that the Government produced, and indeed the work underlying it, is rather unhelpful in that it focuses on gross investment and not net investment. The intangible investment that is identified is subject to very rapid depreciation rates compared with buildings and even vehicles and plant and machinery, so it is easy to get too excited, but my own back-of-the-envelope calculations from the figures that are in this report suggest that intangible investment, net investment, could be about a third of reported corporate net investment. If it is a third now it may have been a sixth 15 years ago, so there is something there but, even when you take account of that, business investment is low given how high profits are and how high profits have been for such a long time.

Q13 Peter Viggers: How supportive would you be of the Government using some measure of intangible investment?

Dr Weale: I would be supportive of them using it as an additional source of information. I think at the moment the way in which it would be worked out probably needs further consideration. I think at this stage the first thing they should do is to introduce it as an experimental statistic. This is something that the Office for National Statistics has been doing for several years and it is a valuable way of airing data, letting people get used to them and letting statisticians identify what might not be working quite as well as we had hoped with them, but if they do that I would stress once again that we need to look at net figures as well as gross figures and not simply say, as they seem to, "Gross intangible investment is 13% of GDP. Is this not a lot compared with reported corporate gross investment?".

Ms Rosewell: I agree very much that this is an important area and it needs more consideration, more investigation, and therefore publishing these sorts of numbers on a continuing basis for several years is important so that you can not only see what the levels look like but also how they are developing and changing on a year-to-year basis for several years before you have got to use them as more than an indicator of what you think is going on.

Q14 Mr Brady: The PBR identifies the unexpected rise in interest rates as one of the determinants in slowing growth. If commodity prices remain high how constrained will the Bank of England be in lowering rates in response to a drop-off in demand from current financial market difficulties?

Ms Rosewell: It is not a question of whether they remain high; it is a question of whether they continue to increase that is the issue. The projection in the PBR I think takes $68 a barrel. That is an awful lot higher than we were a couple of years ago but then it is flat thereafter, so you do not get further increases. Therefore, a lot depends on whether you think we are going to go back to $80 or $90 or even higher level of oil prices. Certainly my projection would be that it will go up and down a bit but it will probably fluctuate in that kind of range, so we are not looking at major further pressures on commodity prices such as we have seen over the last couple of years, in which case it comes out in the wash, as it were.

Dr Weale: I think I largely agree with Bridget. I suspect that a modest reduction in interest rates at some point in the next six months or so will be perfectly compatible with achieving the inflation target. I think it is fair to say that inflation has fallen from the 3.1% peak that we had in the spring faster and further than certainly we were expecting, and I think people generally were expecting, so I suspect that the Bank of England will have some room for manoeuvre, but at the same time I think we have to bear in mind that lower interest rates nationally and internationally got us into the sort of situation that we are in and in that sense you do actually wonder whether more low interest rates are a sensible cure.

Q15 Mr Brady: So any risk of inflation is adequately reflected in the PBR?

Ms Rosewell: No risk of inflation is reflected in the PBR because they have got it coming back very quickly.

Q16 Mr Brady: So they have got that right in that case?

Ms Rosewell: It seems to me to be policy-based forecasting. It is assuming that the policy will work and that the policy can be achieved by whatever means the Bank of England have. That is really saying that whatever those risks are the Bank can manage them. We do not yet know whether that is the case and I am sure that if the Governor were here in front of you he would be talking about all the uncertainties involved in that because that is what he generally does.

Q17 Mr Brady: Can I turn to the service sector? Obviously, service sector output growth is very important to the UK economy, especially given the size of the financial sector. Given the recent trouble in credit markets, how likely do you think it is that the financial sector will recover as fast as it has previously, following the problems in 1998 and 2001?

Dr Weale: My own view is that the financial sector has shown itself to be remarkably innovative in thinking of new things to do. Once one area of business does not develop quite as hoped it is remarkably innovative at thinking of new things to do and I expect it will go on doing that. We have recently seen very rapid growth in the financial sector in the first few months of this year. I suppose I would not expect that to be maintained on the same sort of basis and, as with all the service sectors, there are always questions about how well you are measuring what they are doing, but unless the financial markets take a substantial turn for the worse I would expect us to continue to have a fairly active financial sector in the British economy.

Ms Rosewell: If you look at the pattern of interest rates you certainly see a bigger risk spread than you did in the summer, or indeed in the spring, but some of the more standard relationships, like the relationship between the LIBOR and bank rate, have come back into much more normal balance, and I agree very much with Martin about the ability of the City, "If this does not work we will try something else". I think the big risk, therefore, is the international capital flows, that these are not disrupted by, for example, political changes in the Far East or indeed a US recession, which often we cannot control, so I would see those international risks as being a much bigger problem than recent credit disruptions.

Q18 Mr Breed: Going on from that, what effect would a greater than anticipated slowdown in the US economy have on the forecasts that were presented in the Pre-Budget Report?

Ms Rosewell: They would go down.

Q19 Mr Breed: Can it link?

Ms Rosewell: Yes, potentially.

Dr Weale: It is, I am afraid, difficult to give a satisfactory answer to that. It would depend partly on what happened to the exchange rates. Arguably, if the United States economy were to weaken and its external position were therefore to improve, possibly some of the strength of the European currencies might be reversed and, yes, obviously, the immediate response of weaker growth or a recession in the United States is less demand for United Kingdom and European exports and therefore a weaker overall economy, but at the same time we have to remember that the contribution of China and the Far Eastern economies to world growth is much bigger than it was and in that sense the world economy is perhaps in better shape to cope with weakness in the United States than it was at the turn of the millennium.

Ms Rosewell: I think what really means is that if the US goes into recession, before all the moves to greater globalisation or diversity of global growth there was probably a 100% chance we would go into recession and now there is only a 70-80% chance of going into a recession.

Dr Weale: Could I point out that the United States had a recession in 2001, was it, and the British economy slowed slightly but -----

Ms Rosewell: The private sector went into recession, Martin. We spent a lot of Government money to stop that infecting the UK economy.

Q20 Mr Breed: But this time we have got the combined effect of the disruption in the capital markets and the rather differing response of the US Fed to that and to our own central bank with the Fed putting in a lot of money. Do you think that the US response to that disruption in the capital markets might just have increased the risk of future financial crises?

Dr Weale: No, and this is a comment that one could make going back over several years. The United States, I think, has been a bit too keen on easy money and cheap money, the Greenspan put, now possibly the Bernanke put, and if you encourage people in markets to believe that they have got a one-way bet they react accordingly, so they do think that the policy of saying clearly that there are other things to do than worry about the health of financial markets is a much more sensible way to manage an economy.

Q21 Mr Breed: Yes, I would agree with that.

Ms Rosewell: On the other hand you can get away with it for quite a long time.

Q22 Mr Breed: You reckon?

Ms Rosewell: Yes.

Q23 Mr Dunne: We have touched on the low and declining savings ratio to, I think, record lows as predicted in the PBR. This is coming at a time when household debt is at historically high levels also. With inflation looking to trend down more rapidly than perhaps commentators had thought and interest rates, partly as a result of the dislocation in the credit markets, really just very gently rising, what impact could that have on the forecasts for economic growth?

Dr Weale: These are factors that one can take into account. Yes, obviously, debt worries observers and it worries people who have debt, but actually what is striking about the British household sector is just how much growth it has acquired as a result of 20 years of rising land prices and it is very hard to account for its wealth holdings in terms of financing old age, wanting to leave money to children and so on, and relatively small fluctuations do not have much impact on that so we do have a substantial cushion of excess wealth. Yes, interest rates might be slightly higher, some people will be squeezed, but although I can see the consumer household sector wanting to rebuild its savings rate I cannot see a sharp fall in consumption growth coming.

Q24 Mr Dunne: What about the corporate level? We have touched on the Government's ability to forecast its receipts accurately or inaccurately. Do you see the level of debt within the corporate sector, given the higher real interest rates, having an impact on Government revenues from corporation tax and VAT?

Ms Rosewell: I do not have enough detailed knowledge to be able to answer that one. I do not know if Robert does.

Mr Chote: No.

Ms Rosewell: It is really hard because there are so many different detailed bits and pieces according to what company you are talking about and what their underlying situation is, so I am not sure that is a question I can answer.

Q25 Mr Dunne: Can I break it down into a simpler question then? Is the Treasury good at forecasting its corporation tax revenue?

Dr Weale: I think the answer to that is that there have been periods in the past, and I think we are in another one, where I certainly regard corporation tax projections as optimistic and Bridget talked about a policy-driven forecast. I find that comment less true about the projections for the whole of the economy than I do for the projections of the Government's tax revenues and that is not only because of what I said about the position in the current year but also because, looking three or four years ahead, they project the gap that has opened up now closing.

Q26 Mr Dunne: I think that in answer to the Chairman you suggested there was a vulnerability there.

Dr Weale: Yes.

Q27 Mr Dunne: Which you are confirming?

Dr Weale: Yes, absolutely.

Q28 Mr Dunne: At what point is the Government able to estimate how far it has got it wrong, because corporation tax is levied on an ongoing basis, is it not? The corporates make estimates from quarter to quarter on how much they should be paying. If, for example, as a result of higher interest rates or slower economic activity corporate activity is lower, is that not going to have a disproportionate effect on the payments made, looking ahead quarter by quarter?

Ms Rosewell: But it is more complicated than that, is it not, because you have only got to wait for the final settlement and make a payment on that basis -----

Q29 Mr Dunne: On account, yes.

Ms Rosewell: ----- on account, but what is due may take years to settle, and indeed one of the things in here is that some of the changes in the current year are due to there being greater repayments from previous years than they had anticipated, which means that when they finally got round to trying to settle individual corporates' tax bills they have to go back five, six, even seven years, obviously, before these things are sorted out. That is one of the reasons why the actual cash may be very hard.

Mr Chote: The swing in corporation tax is relatively difficult to forecast, not least because the swings are much more pronounced than are the taxes on income, for example, or on spending. The other issue is that, again, coming back to the relative reliance of the UK economy on the financial sector, the Treasury has based its medium-term corporation tax forecasts in the past on projections, for example, of it seeing there being a trend rise in the share of GDP accounted for by financial sector profits. Therefore, working out, as it were, the steady states which you are getting to and therefore what is short-term oscillation versus the trend that the Treasury believes we are returning to is part of the problem. Indeed, one of the issues in the second term when we were talking about the over-optimism of the corporation tax forecast was really down to the over-optimism of that medium term trend. It is very difficult for anybody to forecast accurately the swings in the short term, I think.

Q30 Mr Dunne: Can I take this onto a slightly different tack to do with accuracy of data, and that is the question of the larger than normal revisions in the Blue Book this year, according to changes in National Accounts data? How important do you think these revisions could prove in understanding the current economy?

Ms Rosewell: I think it is as much to do with whatever future revisions there will be. There are always continuous revisions and they are quite often different or larger or sometimes smaller than what you had previously expected. That is in the nature of the black box, if you like. I think on some occasions you can get revisions going back ten years which change the entire trend of what it was that you were looking at. It is an occupational hazard.

Q31 Mr Dunne: Do you think the current set of revisions might, for example, lead to the Chancellor concluding that the cycle had suddenly ended?

Dr Weale: I think the position on cycle is clearly represented by the chart on page 141 and this seems to me a very clear example of the analysis being driven by the policy. At the moment the Pre-Budget Report says that we cannot be sure whether the cycle has ended or not. The difficulty that the Treasury is having is that the 2004 peak at the moment is possibly slightly higher than the 2007 peak. If the 2004 peak is raised further by a revision then it would be difficult to avoid the conclusion that the cycle had ended in 2004-05, which would, of course, mean that in the current cycle the golden rule has not been met. Data revisions can move cycles around and this is well known. There has been substantial academic literature on this. They can move cycles around for quite long periods, so my response to that is that it demonstrates why the current policy structure is not usable as a way of assessing the Government's fiscal performance.

Mr Chote: I certainly agree with that. We have discussed many times before at these meetings the problems of trying to base policy on being able to identify when cycles start and end, and this is looking more and more like pin the tail on the donkey as time goes by. That two year mini-cycle, which seems to be 2007-08 and 2008-08, if things evolve like this presumably the flat line will be less flat than it was but is that two year period going to be added to the previous cycle, counted as a cycle in its own right or counted as the start of the next one? All of those would have different implications for by how much the golden rule was met or missed over different periods. The idea that we should be basing medium-term planning of fiscal policy on those sorts of uncertainties seems potty.

Q32 Mr Dunne: Would any of you like to comment on whether the golden rule is currently breached?

Dr Weale: There are two issues with the golden rule. First of all, the arithmetic is specific to the Treasury and not the way in which anyone else would work out their borrowings. If you were to use standard arithmetic I think you would find that the golden rule was broken. Looking at the way the Treasury do the calculations, even if you look at the cumulated surplus or deficit from 1997 then, because I have a gloomier view about the current financial year and the next financial year, I expect it to be breached. I would say it is more likely than not.

Ms Rosewell: I would agree with that.

Mr Chote: But looking over a 10-12 year period current spending is roughly equal to current revenue, there is very little economic significance to a breach by a few billion either way, which is what I think we will be talking about using the Treasury's own definition.

Mr Dunne: You are not a politician, Robert! Thank you, Chairman.

Q33 Ms Keeble: Perhaps to Martin first of all. Would you expect the Government's public finances to be in a stronger position than they are given that output growth has been close to or above trend in recent years?

Dr Weale: Well, I think one would hope that at this stage in the cycle the public finances would be in a stronger position than they actually are. That the Government is borrowing to invest seems to me fine, that is a policy decision. How far we are short of public sector capital is a matter for political judgment but a perfectly appropriate thing for politicians to be judging about. It is the state of the current deficit which I think is more indicative of fiscal weakness. Here I would go back to the issues which arose before the 2005 General Election when a number of commentators were saying that there was a shortfall of perhaps 15 billion to 20 billion in the public finances. At the time the Government denied there was any shortfall but after the General Election we saw tax increases and spending cuts. We are now seeing tax increases and further spending cuts. My guess is that what we are still trying to do is fill that 15 billion to 20 billion black hole.

Q34 Ms Keeble: Robert and Bridget, do you broadly agree with that assessment?

Ms Rosewell: Yes, I would.

Q35 Ms Keeble: Robert, do you?

Mr Chote: Yes. Collectively we were pointing out the fact that the forecasts were over-optimistic on the current budget side pretty much from 2002 onwards. Clearly the Government did start to address that, as Martin said, with a combination of tax increases and the pencilling in of the reduction in spending. We are now seeing spending plans where the forecasts for improvement in borrowing in the further term rely on spending continuing to grow less quickly than GDP beyond CSR 2007. That is still being pencilled in there to make the recovery look as good as it does in the out years.

Q36 Ms Keeble: Bridget, you said in response to an earlier question that in 2001 you saw it as the private sector in recession and the government spending money to prevent that from spreading across.

Ms Rosewell: I am not sure whether that was the aim and object of the policy, but certainly if you look at the numbers, and I think I put that in a note on some earlier occasion, if you strip out the mainly government sectors and look just at the output of the remaining sectors then they did actually go into recession in the 2001-02 period, but because there was strong growth in the public sector the overall picture for the economy was much better. The difficulty, as Robert has just pointed out, is that the current Spending Review has got much more constrained growth and the scope to do that again is strictly limited; in fact, non-existent.

Q37 Ms Keeble: Do you see there being a risk there given that there is less scope for using public sector spending in that way and there are risks around to the economy?

Ms Rosewell: I do not think spending was being used in that way, it happened to be the occasion when ---

Q38 Ms Keeble: The result was that.

Ms Rosewell: --- increases in public spending could be fitted into the strategy. I think the Government has rightly tried not to use fiscal policy to fine-tune the economy, it is an extremely hard thing to do, and relies instead on the Bank of England to do that. Having said that, of course, there are always occasions when it is being flexed, but if you look at the charts it is very clear that the substantial growth in public spending as a percentage of GDP from 2001 is a straight line through to 2004-05 and has got nothing really to do with the state of the underlying economy at that time.

Mr Chote: The Bank of England takes the outlook for public spending as given, so if there had not been that volume of public spending the monetary policy would presumably have been looser. In a sense, what the Government decides on public expenditure is going to affect the monetary fiscal mix with which we end up aiming at the inflation target. The Bank is going to set the interest rates that it believes are appropriate to hit the inflation target given the fiscal package it has been handed by the Treasury.

Ms Rosewell: Indeed. All through that period the Bank of England Inflation Report was talking about the resource take of the public sector and how big was this and how was it growing and being concerned about that issue.

Mr Chote: Ultimately it is not the Bank's job to decide that.

Ms Rosewell: No, absolutely not. It is not the Bank's job.

Mr Chote: That is for the Government.

Q39 Ms Keeble: Martin, you referred to the current fiscal position compared with other countries. Would you like to just give an assessment as to where you think the UK sits there?

Dr Weale: The likely overall deficit on the public sector I expect to be something like 2.9% of GDP, that is an overall position. That is likely to be worse than most other European countries with the exception of France and Portugal. France is doing its best to maintain a high level of public borrowing. Portugal has had problems. Apart from those two, among the old European countries we are likely to have the largest fiscal deficit as a proportion of income next year.

Q40 Ms Keeble: Thanks. If I could just turn to Government spending. How realistic do you think it is to keep growth to just 2.1% per annum?

Dr Weale: Could I say on that, that the real growth figures the Government presents are calculated relative to the price index for the economy as a whole, the GDP deflator. If you look at what happened to the actual cost of Government consumption from 1997-2006, that rose 1.7 percentage points faster than the GDP deflator, so if that sort of progress is repeated we will not get 2.1% real growth, we will get 0.4% real growth and that means in terms of the resources actually deployed in the public sector, the number of nurses, the number of teachers and so on. I think we have a much tighter straitjacket than the 2.1% number suggests.

Q41 Ms Keeble: I was going to ask how realistic you think it is to actually achieve that and which would be the biggest pressure points. I think they are fairly obvious but it would be helpful if you could set them out. Perhaps Robert and Bridget might also have views on that.

Mr Chote: One point to make is that the overall spending growth is expected to slow, as Martin said, to 2.1% from 4% during the so-called "years of plenty". Looking at departmental expenditure limits, the slow-down is actually rather sharper because on the 4% growth in total spending, because in Annually Managed Expenditure things like social security benefits and debt interests were growing less quickly actually departments were seeing an increase of almost 5%. So the slow-down in departments' growth is 5:2 or thereabouts. Obviously you can look back at previous Spending Reviews and say, "What did the Treasury say initially was going to be spent here and what has happened subsequently" and in most of those cases, except for Spending Review 2004, they were topped up. That was partly because the Annually Managed Expenditure was coming in relatively slowly and, therefore, there seemed to be money around to do that. Obvious pressure points I guess would include is it realistic to see the local government settlement sticking as low as it has without the Government coming under pressure to provide more money centrally to stop council tax bills going up more quickly; is the Government serious about its objectives for child poverty because it is not clear that they found the money to make progress on the sort of path they need to do to get there for 2010. That is just to name a couple. Then you have the usual trade-off of what quality of public services do you want in areas like health and education. We are now having a settlement for health which is less than Derek Wanless recommended as what you could get away with on the most optimistic path and he does not believe that optimistic path in terms of individual behaviour health service achievement will be deliverable anyway. There are clearly pressures across there.

Ms Rosewell: There are two more things that are worth mentioning. One is wages. We are already seeing considerable industrial discomfort, the Fire Service for example, and that is going to continue and will intensify under these circumstances. The other one is we have already said it is a very stable outlook on which this is predicated, so if there are more instabilities, even if the average performance of the economy is as predicted here, as there are wobbles around that, and it is impossible to believe it is going to be a flat line, then that also increases the pressure and makes it harder to plan, to organise, make cuts, increase efficiency, et cetera, et cetera, when things are changing. So the more uncertainty there is and the more variability is in those numbers, the harder it is to make those gains.

Q42 Mr Love: Picking up that point you just made, the Government has said in the Report that it wants a 2% pay norm, not just for this year but for the whole of this Spending Review. How critically important is that to the delivery both of the inflation target and, indeed, all of the things that go into their projections for the coming years?

Dr Weale: I think it is critically important for delivering an increase in the volume of services. I do not think in itself it is terribly important for the inflation target because, of course, public sector output does not enter into the inflation target. Now, if public sector workers were getting increases of 5, 6, 7% then that might create upward pressure in the private sector, but if public sector workers were to get 31/2% rather than 2% that would be unlikely to have a major impact on the aspirations of the private sector. I think it is important for your second point but not very important for your first point.

Ms Rosewell: Agreed.

Q43 Mr Love: Mr Chote, how about some of those objectives that the Government have that you are finding difficulty in believing they can be delivered? If we want to live up to this 2% pay norm, would that really make it so much more difficult to achieve them?

Mr Chote: As Martin was clearly implying, to some extent it shows up in the quality of services in a particular area. If you end up deciding that you are going to increase the amount of spending within, say, health in order to accommodate faster than you had anticipated pay increases then that would clearly mean you would have less money to devote to something like child poverty, et cetera. It depends on whether you want to take the hit in terms of the quality and volume of health service output but to keep the cash budget for health as it was. It depends on how far you want to ring-fence that problem or let it spill over into taking resources elsewhere.

Q44 Mr Love: Can I go back to the growth forecast that we talked about at the beginning because I just want to press you on that. Dr Weale, you said in one comment made slightly later on that you had a gloomier view of the economy than perhaps is expressed in these figures and I would like to push a little bit on that. You all agreed that business investment of a 33/4% increase was a reasonable estimate but I think you recognised that the re-pricing of risk that is going on may provide some dark clouds to those figures. We have not talked about net trade but, as I understand it, included within the figures here is a very small improvement or a very small reduction in the negative aspect of net trade. We have talked about government expenditure and I take the point you made, Ms Rosewell, about scope for that making up for the other parts of net demand, and of course the whole thing hinges, as always, on consumer expenditure and the relationship between consumer expenditure and house prices. The point I want to make to you, and I start with Dr Weale, is are the forecasts that are in this interim forecasts and what do you think the probability is that they may come under some stress as we go into the middle of next year?

Dr Weale: First of all, could I possibly correct something I said right at the start. I mentioned expecting GDP growth perhaps up to half a percentage point lower than the Treasury's numbers, that comment should relate to 2009 and not 2008. Are these interim numbers which are likely to come under stress, well forecasts are always subject to ---

Q45 Mr Love: I was thinking more than normal. We all understand that they will come under stress but we are talking about scenarios if house prices do not continue to rise and the impact of that and if America has a much more difficult adjustment process as a result of the sub-prime situation. I can tell you that I was there recently and there is a great deal more concern about sub-prime in Washington than there is on Wall Street and I think that should worry everybody.

Mr Chote: Could I say here as a statistician that it is easy to think about the sorts of things that could go wrong. With almost every forecast you can think of particularly gloomy things that could happen, and sometimes they do and sometimes they do not. I would be reluctant to say that the uncertainty surrounding this forecast is greater than normal. The factors may be different but there are always factors, they always seem specific to the occasion, and I am sure like all forecasts it will be revised. I find the numbers for both next and the year after perfectly plausible, although, as I say, for 2009 I have a gloomier view.

Q46 Mr Love: Can I ask the question in a slightly different way? What do you think the probabilities are that the forecasts will be revised up and how much down? Is it 100% they are likely to go down and 0% they will go up?

Dr Weale: No.

Q47 Mr Love: How much are we in a trend situation here and the trend is for growth to go down?

Ms Rosewell: There is one way of answering that. My central view is like Martin's, and I said this at the beginning, it is not so much 2008 but 2009. I do not see this kind of quick response. My central view, 50% view, is below that. There must be a higher probability that they are going to be revised down on that basis than they will be revised up. I am about half a point adrift as well, so then it depends what is the size of the range. I guess that probably increases that to 70% likely to be revised down and 30% up.

Q48 Mr Love: Would you demur from that?

Ms Rosewell: As a rule of thumb.

Dr Weale: Yes, I am afraid I am reluctant to give ---

Ms Rosewell: Coward!

Dr Weale: It is not a question of being a coward, it is a question of not having a basis for giving precise numbers. I certainly think that a downward revision is more likely than an upward revision.

Chairman: Can I thank you for your evidence. We will now go on to the second part of the evidence session. Thank you very much.


Memoranda submitted by Mr John Whiting and Dr Martin Weale

Examination of Witnesses

Witnesses: Mr Robert Chote, Institute for Fiscal Studies, Professor Colin Talbot, Manchester Business School, Dr Martin Weale, National Institute of Economic & Social Research, and Mr John Whiting, PricewaterhouseCoopers, gave evidence.

Q49 Chairman: Welcome. Could you introduce yourselves for the shorthand writer, please?

Mr Whiting: John Whiting, PricewaterhouseCoopers and Chartered Institute of Taxation.

Dr Weale: Martin Weale, National Institute of Economic & Social Research.

Mr Chote: Robert Chote, Institute of Fiscal Studies.

Professor Talbot: Colin Talbot, Manchester Business School.

Q50 Chairman: Good. John, there is a lot for you to get your maybe gloomy teeth into as a result of this PBR. Can you detect the Government's overarching strategy?

Mr Whiting: I am glad to say that is not my job.

Q51 Chairman: On tax.

Mr Whiting: There are some points coming through and, let us be clear, there are some welcome moves towards simplification in this, and that does need to be put very much on the credit side. A number of the other things do seem to be, shall we say, quick decisions and it remains to be seen how much we can get through in the detail of legislation as that is exposed to comment to make sure that the policy changes do work. Dare one say it, there may also be one or two things that there is need for a certain amount of rethinking on.

Q52 Chairman: That is what I was thinking of. Who are the winners and losers in the PBR tax policy?

Mr Whiting: It depends, of course, which bits you are looking at. If you are looking at inheritance tax then there are winners there with a lot of ordinary people, particularly those whose sole asset is their house. It makes life and, dare one say it, death much easier. Capital gains tax is clearly the main focus and there is a range of winners and losers there. The winners do seem to be those with second homes, other assets that rank for capital gains tax, quoted shareholdings, providing they are not losing out too much when indexation is abolished. The losers are clearly those who are seeing their tax rate climbing, which can include entrepreneurs, small businesses who also feel a bit blooded with the Arctic Systems agenda, employee shareholders who in some cases will see their tax rate will go up from 5% to 18%. There is quite a range of losers. Then, of course, one has the residence and domicile issues that, like a number of things, we have still got to try and evaluate but there is concern amongst some employers that they may be faced with additional costs to keep the ex-patriots on the payroll who they wish to keep employing.

Q53 Chairman: On the issue of climate change, following the Stern Review, what about the environmental measures announced in the PBR? Do you see them contributing towards a coherent climate change policy?

Mr Whiting: I think there is a contribution. I am not sure we have yet got to the really clear policy and I think business in particular would still like to understand what is the overall, overarching policy of the way environmental taxes and duties are going as we follow the Stern Review. Some measures, for example a switch in Air Passenger Duty is a good contributor in that direction and, of course, particularly welcome that it comes with quite a long lead time to make sure the changeover can be managed efficiently.

Q54 Mr Dunne: I would like to focus on the capital gains tax reforms specifically. John, were you, as an experienced practitioner, aware of any consultation taking place on potential changes to capital gains tax before the PBR was announced?

Mr Whiting: There has been a series of long running consultations on details because capital gains tax has been widely recognised as an extremely complex tax with lots of anomalies, for example in the way taper relief operates, therefore there has been a long running discussion on how can we simplify, but in terms of consultation about such radical changes as we have seen, no, I am not aware that there has been consultation on that.

Q55 Mr Dunne: It is my understanding that the consultation generally was focused around trying to address perceived anomalies in the private equity industry. Was there any suggestion that a measure to try to tackle that particular anomaly should be replaced by such a wide-ranging change without consultation with business groups, for example?

Mr Whiting: Not that I am aware of. I would say that the consultation was wider than just private equity because, for example, there have been many discussions about how to streamline the anomalies within the taper relief system which causes lots of difficulties and clearly what we have is one way of solving all the difficulties by getting rid of them all.

Q56 Mr Dunne: I would like to remind the Committee of my interests in the Register in relation to private equity. What do you expect to be the key consequence of the new regime on the larger buy-out end of the market?

Mr Whiting: Clearly over the next few months there are going to be an awful lot of decisions taken as to whether deals should be accelerated or deferred depending on the impact of the new changes. The impact on the large buy-out, and could I just clarify, do you have private equity particularly in mind?

Q57 Mr Dunne: I do.

Mr Whiting: Then I think in many ways the rate chosen, the 18% rate, is quite shrewd because clearly the industry was expecting a change, expecting some change, and the speculation as to what changes there should be were many and wide-ranging. What we seem to have is a rate that is reasonably competitive internationally and obviously the industry is very aware of international competition, so all being well, particularly if the signal is clearly put out and clearly understood that this is it, there are no more changes, then I think the industry will absorb it and carry on.

Q58 Mr Dunne: Would you expect to see a rash of divestitures, and you touched on it earlier, ahead of this change coming into force, particularly by those businesses that currently benefit from 10% rates, the entrepreneurial end of the spectrum, the smaller companies?

Mr Whiting: I think there will be a certain amount of acceleration. I hope that there will not be too many contrived disposals of businesses that were not going to be disposed of in the next year or two, but clearly if you have somebody, a small business, an entrepreneur, who was thinking of selling his or her business in the next year or two, then it could make every sense to bring that sale forward to get a 10% rate rather than 18% providing, of course, it does not lead to much lower proceeds.

Q59 Mr Dunne: Who do you see as the main winners and losers from this new regime? I think you touched on the second homeowners as being major gainers.

Mr Whiting: Clearly they are one of the gainers, subject in some cases, as I say, to the fact that people will lose out with the abolition of indexation and in some cases they may be losers. Other gainers can be investors in the main market, and it has got a bit of a swing here between AIM and the main quoted stock market, and those who invest in assets such as antiques, art, whatever, which would not count as business assets. There are undoubtedly some winners and, let us be clear, if I can come back to it, some of the winners are people generally who will find capital gains tax easier to understand because I would not discount the advantages of having a nice, simple flat rate system.

Q60 Mr Dunne: Perhaps we should ask the economists this question. Would you anticipate that the Treasury estimate of a 900 million gain to the Exchequer from these changes to be broadly right? Is it too early to tell whether they have got this forecast correct?

Dr Weale: At least from my position, it is too early to tell. I am sure they have looked at the tax base from which they expect to collect this tax. Of course, what is not really known is how much the tax base changes as a consequence of the change in the tax rate and we do not really have any helpful historical evidence to go on. There is a substantial element of uncertainty there.

Q61 Mr Dunne: Do you think there is a major risk that the tax advisory industry will now move from focusing on securing a 10% tax rate for business assets to focusing on what they used to do, which was to shift income into capital?

Dr Weale: Yes, I do. This goes back to the question about an overarching strategy. One can perfectly reasonably ask is there a case for taxing capital gains at a rate different from the tax rate on income from capital or should we go back to the sort of arrangement that was in place until 1997 when effectively, apart from indexation relief, capital gains were abrogated with income. What actually is the strategy, beyond a sort of compromise so as not to upset everyone too much, I do not think I know but I certainly think tax advisers will be looking at how to convert income into capital gains.

Q62 Mr Dunne: So there is some threat to the government revenues from a switch from income into capital? Do you think that has been taken into account in coming up with these figures?

Dr Weale: I think that would be a question for the Treasury. I am sure that in part the response will be that anti-avoidance measures are much stronger than they were ten years ago so, therefore, the scope for doing that has been reduced. How important that is numerically I am afraid I do not know.

Mr Whiting: If I can just comment. I am sure that has been taken into account. The question of capital versus revenue has been a long running one. There are many anti-avoidance measures and the Treasury has already indicated that there is the disclosure regime which would allow them to police quickly any new devices that arose.

Q63 Mr Dunne: In terms of looking for an overarching strategy in this report, one of the longstanding strategies of the Government has been to promote entrepreneurship and investment by businesses to stimulate early stage companies. Do you think that by scrapping taper relief that strategy has now been abandoned and we are looking at a reversion to what the Government might call short-term investment?

Mr Whiting: I cannot comment as to whether the policy has happened but certainly the perception from talking to businesses small and large is that a relief that was brought in to encourage entrepreneurship and, indeed, to encourage long-term planning has gone, so is this a signal that we are not supposed to do it. I think we would say that business is asking the question. Another thing that particularly small businesses are saying is, "We used to have something called retirement relief. That was there to allow us to build up on a long-term basis in effect a retirement pot with our businesses before we sold out. That went and in exchange we got taper relief. Now taper relief has gone, where is the reciprocal? Should we have retirement relief back?"

Q64 Peter Viggers: One commentator on the inheritance tax proposals said that the Government was merely giving people what they already have. Is there very much new in these proposals, Mr Whiting?

Mr Whiting: I understand the comment because if you took advice and arranged your affairs in a certain way then you could make sure husband and wife, or civil partners, could take advantage of both nil rate bands. I am sure the Committee is well aware of nil rate band discretionary will trusts, which has been the typical route to follow. However, it is well said that many will not take advantage of that, many did not like to, particularly as it involved splitting the ownership of the family house in many circumstances. So although the route was there, many thousands of couples would not take that route, and I am certainly aware of that from my own practice and discussions in many forums, therefore what has come through with this proposal is a much simpler route that obviates the need for doing complex planning and, therefore, although theoretically, in a sense, there is no change, in practice this is a very good step forward.

Q65 Peter Viggers: I would like to ask each of the witnesses what their view is of the estimated costs of this measure because the Treasury has projected the changes through to 2010-11 and the figures are minus 100, minus 1,000, minus 1,200 and minus 1,400 million, these large figures. How robust do you think those figures are?

Mr Chote: The short answer is certainly I do not have the sort of information that you would need from the Revenue, if the Revenue have it, to judge the sort of question that John was saying, which is to what extent is there a group of people who would like to do this and did not want to do it through the complex route and will therefore take advantage of it. If the commentator to whom you are referring may be right, that anybody who really wants to take advantage of this will already have done so, then it is going to cost, I presume, considerably less than the 1.4 billion by 2010-11. In a sense, I think it would be wise to probe the Treasury or the Revenue on what assumptions they are making about the proportion of people who would be in a position to benefit from this sort of arrangement but are not doing so simply because they do not want to go through the planning. I have to say that just because you could do it through a complex process of planning, it is still a desirable feature to enable people to do things simply through the tax system that they could otherwise do in a complicated way. How much there is a demand to do that crucially affects how big that number ends up being.

Dr Weale: Could I just make the point that since wills are public documents it is perfectly possible for the Treasury to explore how far this has been done by the people who died in the last year. They may say that it is only, what, a billion pounds or so and that is not very much money by some people's standards, but it is the sort of situation where one could look at what people actually have done and plan on the basis of that. You could certainly ask them whether they have done that, how widespread the trusts that delivered what has now been made available to everyone actually were.

Q66 Peter Viggers: Colin, have you looked at this?

Professor Talbot: No.

Mr Whiting: I would just add, do bear in mind that the yield of inheritance tax is going up quite steadily bearing in mind a relatively small base, so saying that this is going to cost a billion a year is possibly against a yardstick that there would be a half billion or so rise a year anyway.

Q67 Peter Viggers: Have any of you considered what complications might arise in cases of divorces or annulments of civil partnerships?

Mr Whiting: Yes. To be fair to the Revenue, they have also been into it. At the moment they have simply put a line in the sand that says if you die married then potentially your unused nil rate band can go to your surviving spouse; if you divorce and die the next day, well that is unlucky, that is tough, it does not then go.

Q68 Peter Viggers: Turning to the rules on non-domiciled and the 30,000 charge, it has been alleged that the 30,000 charge will scare off entrepreneurs and successful businessmen. Have you a view on this?

Dr Weale: As an economist, I understand the argument that you should have higher taxes on sources of revenue that will not be scared off and, therefore, you might worry about scaring off successful business and so on. On the other hand, I can actually see a rather strong political argument that if you levy taxes disproportionately on the people who, for want of a better phrase, are loyal to Queen and country then they may start to think there is something wrong with your tax system. Yes, there is a risk people will be scared off but we have to live with that.

Mr Whiting: Like a lot of things, it is a bit too early to say how this will go but inevitably we have already had a lot of people asking what the implications are. It is clear a lot of people are already thinking. At one end of the spectrum you will have a great volume of non-domiciled people who will not be affected by this, they are in for a relatively short period, so to that extent I think the seven year limit is quite well chosen, so potentially they will be gone. At the other end of the spectrum there is a small cadre of very wealthy non-domiciled people who will undoubtedly pay the 30,000 and think it is a very small amount. In the middle, and in many ways these are the ones that we care about, is a proportion who have significant interests abroad but will look at 30,000 and say, "This is actually quite a substantial fee" and they will also think it is 30,000 now but could it go up in the future because one of the concerns that this sends is that the UK is trying to make more money out of the non-domiciled person. Of course, it is a balance and how on earth do we strike that balance. A bit like capital gains tax that we were talking about earlier, one of the things is to say, "This is our system. This is what you can rely on and how it will operate. We encourage you to make use of the system as it stands, we are not going to change it and you can plan on that basis". It is that middle cadre of people that we are unclear on of whether a lot will go off to somewhere like Switzerland, who will just do a deal, or who will stay.

Q69 Peter Viggers: Given the complexity of the proposals and their intended retrospective effect, how workable do you think this scheme will be in that middle class you have been talking about?

Mr Whiting: You are right to point to the retrospective effect because clearly as of 6 April next year a number of people will find themselves in the new system and to that end it is disappointing we have not got some draft legislation which we can start working on the practicalities of, but it is to be hoped we will see that very soon. It would be an interesting question to put to HMRC as to how well they think they are prepared in terms of policing this because clearly there are a lot of non-domiciled people who will have to be managed into this new system.

Q70 Peter Viggers: Are you concerned about the legality of this charge taking account the ruling in the Al-Fayed case and the nature of the charge as a "payment not to tax" or a "ring-fence"?

Mr Whiting: I would not say I am concerned about the legality of it. I would say that I am concerned about the status. I am sorry, perhaps I sound as if I am splitting hairs but one immediate concern is, is this payment actually income tax that would rank within our double tax treaties as income tax creditable against somebody's tax liability abroad, is it something that the EU might conceivably say is not allowed under particular EU aid rules. Again, I am sure that HMRC have thought about that and looked at the issues, but those are some of the technicalities that we need to clarify and be clear on as we move towards 6 April.

Q71 Mr Mudie: Going back to capital gains tax and the overarching strategy, apart from simplification and dealing with the question of private equity, what other reasons would you think there were for the Chancellor introducing this reform? I am thinking it cannot have been money in the short-term because it only makes 350 million next year and you have already raised genuine doubts, which we already share, about the long-term projections in here.

Dr Weale: One answer might be that he thought the current system was too generous to the people who were getting the full business taper relief and relative to the overall structure of taxation that is an argument that I could see some force for. It is essentially a related point to that I made earlier that arguably relative to the taxes we collect on income, the rate of tax on capital gains is still too low and should one think more about how they fit together. It might be an argument like that we had for abolishing the very low rates of corporation tax that actually they were too generous to the people they were helping relative to everyone else who had in some sense to make up for the missing tax revenue.

Dr Weale: I think in many ways you hit the nail on the head by saying simplification and get a reasonable rate for private equity. The attraction then of saying, "Let's do it all the same", in many ways if you are starting with a clean sheet it might be quite a reasonable answer, but we are moving from a situation where some people benefited from rates as low as 5% if they were a basic ratepayer, and that is quite a shift. I do not think it has been well explained as to why that is appropriate for small business and entrepreneurs.

Mr Chote: Presumably in coming up with this reform there were a number of questions that the Government had to ask itself. One was do we want taper relief or not, do we want differential treatment of business and non-business assets, and then if you answer both of those, "No, we are happy with a stable, single rate" then what should that rate be. Clearly it is 18% in part because they want to raise the 500 million or so after three years. If they wanted to make this a revenue neutral reform presumably the rate would be 15 or 16 pence, but then it is the other two questions as well we might ask looking at it, does it make sense to treat business and non-business assets differently and does taper relief have the sort of beneficial effects claimed for entrepreneurship that Mr Dunne was talking about earlier, and conceivably the Government concluded that perhaps we ought to let the market decide that assets should be in the hands of those people who value them most highly and the Government should not try to persuade people to keep them longer than they would otherwise wish to do. There may have been other considerations in their minds at the time.

Q72 Mr Mudie: That is an economist's answer. Can the Chancellor still have his cake and eat it? Can he make changes that avoid what he said was trying to avoid, the law of unintended consequences? Can he bring the small businesses et cetera back into the fold? Can he do anything with taper relief that would allow the entrepreneurs to have 5, 6, 7 years in the business? Can he do this or is it back to scratch if he cannot?

Mr Whiting: Clearly he could leave taper relief in places for defined taxpayers, although that then starts to create its own complexities and boundary issues if you are still running the taper relief system. It is difficult to say, "I want a flat, simple system but I want some exceptions". I go back to the one idea I gave to Mr Dunne earlier that we might have to consider going back to a system of retirement relief to at least allow the small business to get out with a tax free gain. It is not a perfect way of mitigating the change but it is one possibility.

Q73 Mr Mudie: This is described in the book by the Treasury as a major reform and although you said in response to Peter that there were bits of consultation, we were all amazed because months ago when we were dealing with private equity the Chancellor said he would do nothing rash, it all had to be thought out. On the basis that there is only 350 million estimated in next year's Budget, would there be a downside to the Chancellor saying, "Look, I'll tell you what I'll do, I will not run it from this April but the following April and in the meantime I am open to consultation"? What would be the downside of doing that?

Mr Whiting: I suspect that the Treasury's response would be they would be worried about pre-emptive action to more people buying or selling either side of the change.

Q74 Mr Mudie: They can do that now, can they not, they have got six months to do it.

Mr Whiting: Indeed.

Q75 Mr Mudie: They will be starting yesterday, I suppose. Apart from that, what is the downside of just saying, "Maybe there has not been consultation but I have been listening and as it is not a great financial amount, it is revenue inspired, I will push it forward to the following year and I will listen"?

Mr Whiting: I think there would be every advantage in that, not least because not only would that be a technical consultation as to the problem but also allow him to talk to the business groups and, if appropriate, explain in advance why this is under consideration.

Q76 Mr Mudie: Robert, do you see a downside to a listening Chancellor? He did listen on inheritance tax, did he not?

Mr Chote: I am not sure that was the group he was thinking of consulting or he will be thinking of consulting on this example. As both you and Mr Whiting have indicated, the fact that we have this period now until April, during which time there is going to be this flurry presumably of people thinking about whether they should be accelerating disposals, the idea that we could not have had any consultation around it seems a rather hard argument to sustain. I am afraid this is probably another example where this is a Pre-Budget Report which is always supposed to be about consultation and laying out potential areas of direction but just ends up looking more like a mini-Budget with two bites of the cherry in any year.

Q77 Mr Mudie: You do not see any downside, Martin?

Dr Weale: No. This is something I think the Chancellor could still do although it would create extra uncertainty to form a view on the appropriate taxation of capital gains relative to the rest of the tax system.

Q78 John Thurso: Who would most like to give advice on aviation taxation? A rash of volunteers! Can I start with you perhaps, Professor Talbot. The change from Air Passenger Duty to an Aeroplane Tax, will this succeed in the primary goal of helping to reduce carbon emissions through aviation?

Professor Talbot: I am not sure I can answer that. There are some obvious administrative advantages. It is an awful lot easier to administer a tax which is simply on movements of aircraft than it is on movements of individuals, so from that point of view it will remove some burdens. In terms of its incentive effect, I do not think we know and I do not think we will know until we see the tax in operation.

Mr Chote: The environmental targeting should be better as the emissions do not depend enormously on the number of passengers involved. As your party has discussed, there are other possibilities of making a system more precise at targeting environmental objectives by looking at the issues of distance travelled or the emissions from different sorts of aircraft, et cetera and there, of course, the trade-off is that the more precisely targeted it becomes the more complicated the tax becomes, so you have a trade-off to be negotiated.

Dr Weale: Can I just say that I am not convinced that the more precisely targeted the more complicated the tax becomes. My starting point with wanting to address carbon emissions is that you have a tax on carbon emissions, ie on fuel use. The sort of question that we keep skirting around is why, instead of adopting that basic starting point, we have all these fancy alternatives. The Treasury produces good reasons for them, but taxes on fuel use would be precisely targeted to carbon emissions and in my view would be the best sort of fiscal intervention there could be to reduce carbon emissions.

Q79 John Thurso: The difficulty being that we can only put duty on domestic aviation without international agreement, therefore if the Chancellor wants to do something now that instrument is not available to him whereas this, as a departure tax on aeroplanes, brings all of the freight planes in and is as straightforward and as close as you can get without having to go through all the international treaties.

Dr Weale: That is perfectly true, but what is the Chancellor or the Government doing about promoting a coherent international regime. Maybe they have concluded that it is too difficult and cannot be done but it is creating substantial second best issues.

Mr Whiting: Just one point. I would certainly echo the point Colin made about this potentially being a simpler tax or a simpler basis to manage. One point I did notice was in the press notice which talks about this it talks about the tax in due course raising 520 million a year, which is interesting as Air Passenger Duty currently raises about 2 billion a year.

Q80 John Thurso: In the table it has got plus 520. Is that meant to be on top of what is already there?

Mr Whiting: That is how I interpreted it.

Q81 John Thurso: Otherwise it would be a failure.

Mr Whiting: It did seem to be a slightly curious way of expressing it, which therefore suggests that they are anticipating this will raise more, probably by raising it on cargo flights as well.

Professor Talbot: If it is raising more one could argue that it clearly is not working.

Q82 John Thurso: Explain that to my simple mind.

Professor Talbot: If the intention is to reduce carbon output and reduce aircraft miles flown, if it is raising more revenue then presumably it means there are more aircraft miles being flown.

Q83 John Thurso: Presumably it is because it is bringing in freight aircraft which is not included in anything and, therefore, by getting all of the aircraft it goes up but it provides the incentive to start flying aeroplanes that do not produce so much so it starts to go down thereafter.

Professor Talbot: That is the point I was trying to make. The long-term trend has to be for it to go down and one would hope that is what they have been projecting rather than increases.

Q84 John Thurso: Greenpeace have said that the Government's financial commitment to the Environmental Transformation Fund could only lead to failure since only 370 million was allotted to be spent in the UK. To what extent is this new money and how significant is this sum? Has anybody got any thoughts on that? Supreme indifference, right. We will rapidly move on to my last question and see if I get any further with that! The Government has revised downwards its estimates of the potential for carbon savings that might be made through road transport biofuels. The King Report warns against the "wider environmental and social impacts of increasing demand for biofuels". Is this, therefore, really the right time to be introducing a biofuel incentive, such as the Renewable Transport Fuel Obligation? You may have an equally quick answer for me!

Professor Talbot: I fear we are going to disappoint you with that.

Q85 Chairman: Anyone?

Mr Whiting: Not our area.

John Thurso: Two of the best questions I have ever asked!

Chairman: Very cogent responses, thank you.

Mr Mudie: Ask them a third and see if you can get a hat trick!

Q86 Chairman: John, tax protection plans. Are there any tax protection plans that have caught your eye in terms of being innovative or problematic?

Mr Whiting: Are you referring to anti-avoidance measures in particular, Chairman?

Q87 Chairman: Yes.

Mr Whiting: I think a lot of the anti-avoidance measures that have come in are perfectly sensible and understandable moves. Many, of course, come about through disclosures through the disclosure regime. One that I would just draw attention to is the adjustment on pension spreading. This is where an employer makes a substantial contribution to the pension fund and because it is above a certain limit it is spread over a number of years by way of deduction. There have been routes worked up to sidestep that and get an immediate deduction and that sidestepping is now blocked, which you can understand although it does one cause one to question why we have to have a spreading of pension contributions anyway because these are amounts that the employer has put into the pension fund to make up a shortfall. The fact that it is a big contribution, they are actually putting the money there, one feels they are being penalised for making up that shortfall. What it does is perhaps it highlights a question as to whether the overriding policy is correct.

Q88 Chairman: The PBR proposed draft legislation to prevent so-called income duty. The Government intends that proposals will affect "only arrangements intended to reduce tax rather than commercial arrangements", but in practice how easy will it be for HMRC to ascertain the purpose for which income shifting takes place?

Mr Whiting: This is one of the biggest worries with this drive to police something that is enormously difficult to define. We seem to be aiming squarely at husband and wife companies, although that is not firmly defined. We seem to be aiming at certain circumstances and not others, but that is not terribly well defined. All right, the one good thing is that there is a commitment to discuss this at length and to consult because at the end of the day what we have got to have is rules that can be applied on a self-assessment basis by ordinary taxpayers and their advisers. There seems to be a goal in mind to police a cadre of offenders and it is very difficult to get a clear articulation as to who they are.

Q89 Chairman: George was asking the question is this a rushed policy to the Arctic Systems case? Maybe there is a need for consultation.

Mr Whiting: It struck most of us as a very knee-jerk sore loser reaction to the Arctic Systems case which in any event seemed to be litigation that was pursued, dare one say it, almost slightly vindictively without really thinking through what the overall policy was.

Chairman: That is clear to us.

Q90 Ms Keeble: I wanted to ask about the PSAs. The Government has replaced the former 410 with 30, what is your assessment of them and in particular do you think the desirability or otherwise of having them work across government rather than by department has been a major factor in the selection of them?

Professor Talbot: The first thing to say is they cannot count. The original PSAs in 2004, depending on how you counted them, were about 145 because a number of them were multiple indicators wrapped up in terribly long, convoluted sentences which covered half a dozen different things. Actually, this time around it is in some ways not that different. There are 30 Public Service Agreements and there are also Departmental Strategic Objectives listed in the report, which adds up to 127, which is not that different from last time, and more or less the same proportions in the sense that about 20% of PSAs in 2004 were cross-cutting PSAs and about 80% of them were departmental and this time it is 25/75. They have been renamed Departmental Strategic Objectives but actually most of them look remarkably similar to the sort of PSA statements that appeared last time around. Can I just add to that. Underneath that there is an enormous range of indicators and measures. There are 156 indicators listed in the report for the 30 PSAs. The Committee has seen information from the Treasury and if you look at the Treasury's Departmental Strategic Objectives there are 27 indicators below the two DSOs they have got there. If that was generalised across all of the DSOs there would be about 1,400 indicators to measure the 97 Departmental Strategic Objectives. There has been a wonderful bit of spin around this of saying, "We have reduced the number of targets to 30", but actually, broadly speaking, it is the same picture as we had last time.

Q91 Ms Keeble: I think that having some sort of targets like this is important provided you get them right and you do not create more bureaucracy than existed to deliver the services in the first place. Do you think that the interdepartmental workings and structures that have been developed over the past period are sufficient to deliver this new set of targets? Obviously the cross-cutting ones are the ones I am particularly interested in.

Professor Talbot: I would slightly reframe that in the sense that the first question to ask is what is going to drive this performance management framework. It is clearly in the document here that the Treasury believes it is going to be the PSAs which are going to drive the whole new system. I have to say that the view from quite a few departments appears to be that it is not, it is going to be the Departmental Strategic Objectives because that is what they are going to be held accountable for, that is what they will get called up in front of the PAC for and the accounting officers will have to account for rather than the PSA system. There is an argument going on about which of these two systems is going to drive performance management in the department.

Q92 Ms Keeble: I understand that you can look at different things and say which ones are people going to think are more important, but have they got the structures in place to be able to deliver targets across government?

Professor Talbot: They have certainly attempted to beef up the structures in terms of putting in place Cabinet committees around the PSAs, that is certainly the case. Whether or not they are able to do it remains to be seen. The cross-cutting PSAs under the first four rounds of PSAs from 1998 onwards have had a fairly chequered history; some of them seem to have worked reasonably well and some of them have not worked at all. There seems to be a clear drive from Treasury, and presumably from the Cabinet Office as well, to try and make this work this time around and make the PSAs the focus of priorities, but again I raise the issue that it is not at all clear to me what is actually going to drive the system, whether it is the DSOs or the PSAs or both, and how do they fit together. The analysis that we have done so far and we have only looked at the Treasury's because we have only got the Treasury's DSO indicators, is that there is some overlap but not a great deal of overlap and integration between the indicators underpinning the two sets of systems. It is very unclear to me what is going to drive it.

Q93 Ms Keeble: You said that there had been some good ones and some not so good ones which had been developed. Could you give an example of what has worked and what has not so we can get an idea?

Professor Talbot: I think some of the criminal just cross-cutting indicators seem to ---

Q94 Ms Keeble: Which ones?

Professor Talbot: I cannot remember off the top of my head. I can send you a note on it if you would like. Anecdotally it seems to have been suggested that there have been improvements in those areas. In some of the other areas it is less clear.

Q95 Ms Keeble: Are you clear as to why some have worked and some have not, because sometimes things are easier to work because they are easier to measure or some might work because they have got the right organisational structures. Why have some worked and some have not?

Professor Talbot: I am not aware of any research on this to give a definitive answer to that question. I doubt it is the case that it is simply having cross-cutting PSAs that has driven a better joining up of services across different departments and between departments and the rest of the public service outside of Whitehall. It is more to do with there being an impetus from those organisations to do something about it, and I think PSAs have probably helped in some circumstances but they are not the sole factor.

Q96 Ms Keeble: In previous Spending Reviews there was supposed to have been a linkage between resources and the targets. The new Delivery Agreements do not provide much information about this. Do you think that the Government has abandoned the linkage between spending settlements and PSAs?

Professor Talbot: The question implies there ever was one, and I think this Committee has asked the previous Chancellor on a number of occasions to give evidence of where resource decisions in previous Spending Reviews have been affected by performance outturns in relation to PSAs, and I do not think you have ever had an answer to that.

Chairman: We have tried for five years.

Q97 Ms Keeble: Do you think there is an issue here because there is enormous public scepticism about targets and most frequently expressed around the Department of Health at present? What do you think the Government should be doing to get effective ways of monitoring spend such that it can convince the outside world as well that public money is being spent on the things that the public wants to see happen and are supposed to happen, which is really the core of all of this, is it not?

Professor Talbot: It is. First of all, I would make a clear distinction between publishing and measurement of what is actually changing and what is being delivered in public services and setting central targets against those measures, and they are two distinct things. On the latter, the Government itself now says that it did too much target setting and not enough just simply measuring or publishing information. I have to say, I am not terribly encouraged by the situation that we have got, which you have not asked about, around the issue of efficiency and value for money because the efficiency report which was published alongside the Spending Review, which is this rather flimsy document which is about five pages which accounts for 20 billion worth of efficiency savings supposedly, is all that was published. The value for money Delivery Agreement which was supposed to be published alongside this, I would have thought they have had plenty of time to produce it as it is three years and three months since the Gershon Review was published, but it has not appeared and I understand is not going to appear before Christmas or around about then. We have got a target for 30 billion worth of efficiency savings in here but no notion of how that is actually going to be delivered.

Q98 Mr Brady: The view is that 30 billion of savings is clearly not identified as to where it is going to come from.

Professor Talbot: Yes. Maybe I am not very good at mathematics but I cannot understand how you get a 3% efficiency target to add up to 30 billion based on Total Managed Expenditure at the end of this period. If it was 3% on TME, which is the entire public sector budget, then it would be about 20 billion. I am not sure where this 30 billion a year at the end of the period comes from and certainly have no evidence in here as to where it is going to come from. I wait with great interest to see the Delivery Agreement on value for money.

Q99 Mr Brady: Everybody else agrees with that as well, do they? The value for money Delivery Agreements that are also due, what information would you want to see in those Agreements? What do you need to see in them to have an improved reporting framework?

Professor Talbot: First of all, can I just raise the issue about terminology. It is a bit unfortunate that the Treasury has now started talking about these as value for money rather than efficiency. In their own definition, as set out in the joint publication which they negotiated with the ONS, National Audit Office, the Audit Commission and the Cabinet Office about five years ago, they defined efficiency as being the relationship between inputs and outputs, which is what previous efficiency targets have largely been about, and value for money as being about the relationship between inputs and outcomes. As I understand it, most of the targets for efficiency savings, the 30 billion worth of efficiency savings, are actually efficiency savings, they are not value for money in the sense that they do not directly relate to outcomes. That is the first point about the terminology. Second, I would be very interested to see what the spread of potential savings is across different government departments because last time around, although we had this 21/2% target, it varied from 1.7% over three years for the Cabinet Office up to 171/2% for the Department of Work and Pensions, so there was huge variation. It will be interesting to see whether that is the same this time around, whether there is a big variation across departments. It will be interesting to see how they identify exactly in which work streams in the terminology of the Gershon Review they are expecting to make this 30 billion from. It is an extremely ambitious target, particularly in a situation where in real terms the budgets in some areas, like local government, are only increasing by 1% a year and are going to be heavily reliant on maintaining service levels to making large scale efficiency savings and it is difficult to see how they are going to do that.

Q100 Mr Brady: What level of savings might be more realistically achievable?

Professor Talbot: I do not know. The Government is now claiming that it is more or less on target to make the 21.5 billion and they are claiming 20 billion here. As you know, both the PAC and the National Audit office have been extremely sceptical about that. I would guess that there is somewhere between 50% and 60% of those that are real savings, but that is only a guestimate based on the sort of analysis that we have had on the reliability of data that has been published. Those efficiency savings last time around were based on, roughly speaking, 60% of it being cashable savings and 40% non-cashable; this time it is supposed to be all cashable and 3%, so effectively it has doubled the target in terms of cashable savings and that is extremely ambitious.

Q101 Mr Brady: The workforce reduction targets seem to have been replaced now by a 5% annual real reduction in administration budgets across departments. Is that an improvement?

Professor Talbot: I certainly think it is much more sensible to target administration budgets insofar as it is easy to define what they are, and there is an interesting issue about exactly how they do define what is counted as being an administration budget and what is not. We do not have sufficient information about that. I have certainly raised the criticism with the Committee a number of times that workforce targets per se are pretty meaningless and actually potentially damaging because it may be the case, for example, in education and health that it is much more efficient to employ more people if they are employed as Community Support Officers in the police or nursing assistants in health or teaching assistants in education than it is to just cut headcount numbers which may be potentially damaging.

Q102 Mr Brady: How achievable are reductions in administration budgets of their 5% order?

Professor Talbot: Again, it depends exactly what they are defining as administration budgets and that is difficult to tell. In some cases it certainly appears to me that you would only be getting the sort of level of reductions that they are talking about if you were including things that I would define as operational budgets that were actually involved in delivering services.

Q103 Mr Brady: Such as?

Professor Talbot: Well, if you take somewhere like the Ministry of Justice, their principal financial activity, their biggest area of activity now is prisons. What do you define in the Prison Service as an administrative budget and what do you define as being programme expenditure in terms of keeping people in prisons? It is a very difficult area to draw a line in and there is a real danger that you actually end up cutting back on the services you are providing rather than overheads.

Q104 Mr Mudie: I am on child poverty. It is in the brief and confirmed in the book that they reckon they will take more children out of poverty by two methods: increase the minimum wage plus child tax credits. They have put 30 million as the cost. Robert, I think it is you who reckons that it would take 4 billion to actually allow them to meet their targets. Does that include the minimum wage part? Also, does it include any other tactics rather than a strategy to actually get there?

Mr Chote: The latest figure we have, as you say, is 3.8 billion would be the most cost-effective way of achieving that, which is essentially to stick it into the child element of the child tax credit. That was based on a baseline forecast of where you think child poverty would go in the absence of those sorts of policies. There are some assumptions in there about what happens to employment and what happens to wage growth through the income distribution. Of the measures that we had announced in the PBR there was additional money for the child element of the child tax credit, the announcement on more maintenance payments being ignored in terms of income for means-tested benefits and also a rolling out of the scheme of back to work payments for lone parents. That lot together costs about 600 million, but is clearly not all the most cost-effective areas as we would have defined them, so you might think that would take rather less than 600 million away from the 3.8 billion figure to tell you how much you have left still to do. Another way of looking at it is to say that on our forecast the Government would fall about 800,000 children short of meeting its target. The Chancellor himself said that he thought the measures announced on PBR day would take 100,000 out, so if that is right that still leaves you 700,000 short which gives you some sense of where further you need to go in the remaining Budgets and Pre-Budget Reports.

Q105 Mr Mudie: This is a daft question and if it is you can pour scorn on me. If it is only 30,000 plus the minimum wage costs, but they do not fall on Government, to take 1,000 out, why do you have a bigger figure? If he could do this amount and take that number out, why can he not just multiply up and do it very cheaply? Is that a daft question?

Mr Chote: If it is costing 600 million to take 100,000 out and if you say he needed to take 800,000 out you could multiply 8 by 6.

Q106 Mr Mudie: I misunderstood your answer.

Mr Chote: Then the number is different.

Q107 Mr Mudie: Is there any explanation as to why the number of working households in poverty has increased despite the increases in minimum wage? That figure is actually going up and it is that element where the number is falling. They have always said work is the way to get children out of poverty, get families out of poverty, and yet the figures we have been provided with suggest the number of children in poverty in those families is increasing.

Mr Chote: The Government is clearly relying both on getting more households to have one or more people in work and to make people better off both in workless and non-workless households as well, so you are operating on two different tracks at the same time. In our analysis which got to the 3.8 billion figure we certainly did not think that the Government was going to be successful in meeting the sorts of targets for lone parent employment and other employment that would make a huge difference. Child poverty is not very sensitive to the lone parent employment rate, so even if you had a very successful effort to get more lone parents into work it would not be enough to get you very far towards the target.

Q108 Mr Mudie: Okay. Some of my colleagues will be coming back on that, I think, but I would like to finish my question on this section. Do you share my concern about the small growth put in for social care as opposed to hospital care in view of the Wanless/King's Fund Report which spelt out, as we all know and we are all aware in our communities, how many people are being deprived of the services because the money is being used only for the more serious. Wanless said you had to bite the bullet and agree to spend a tremendous amount of money as well as agree a strategy. With 1% it does not seem to me that the Chancellor has accepted in the Comprehensive Spending Review that if he is going to adopt the King's Fund strategy or the Wanless strategy on social care it is not going to be in the period of this Comprehensive Spending Review.

Mr Chote: I would not claim to be an expert in that area but he is clearly not doing what Wanless would say was necessary for health either. We are seeing health spending overall dropping from around 7% to 3.7% across the UK as a whole. Wanless said 4.4% minimum would be necessary over this period and he said in his subsequent report for the King's Fund that he does not believe the changes in NHS efficiency and individual behaviour that would allow you to get away with as little as 4.4% will be there, so that has been squeezed.

Q109 Mr Mudie: I am forced to ask you, before members of the Opposition do, did he get to the 4% by adding in the 2 that he took out in previous years in terms of capital spending, or is it a genuine 4%?

Mr Chote: The 4% is NHS England, so the main difference between the 3.7 number that we are using and that is the fact that this is Health UK versus NHS England. There is then the separate issue of was the money spent somewhere else at the time of the Budget when it was removed. The money is fungible, so it is hard to say one way or another. The main difference is NHS England versus Health UK.

Q110 Ms Keeble: You mentioned just now, Robert Chote, that the employment rate amongst lone parents did not play a very substantial role or did not have a very substantial impact on the number of children in poverty. Could you just give some figures around that?

Mr Chote: I do not have those to hand. We did a report with the Joseph Rowntree Foundation which was where the original 4 billion number came up and that was subsequently revised to 3.8 billion in the light of what was announced at the time of the Budget. There was a report as part of that by Paul Gregg at Bristol, which I think looked at lone parent employment and came up with different scenarios for employment relative to the sorts of targets which had been set out, so there may be figures in that. We took those employment forecasts as a given in coming up with our analysis of how much tax credit spending was needed.

Q111 Ms Keeble: Thank you. Colin, do you want to add to that?

Professor Talbot: Yes, and this relates to Mr Mudie's question earlier as well. Indicator 3 in the Delivery Agreement on child poverty is children in relative low income households and material deprivation. The important thing to point out here is if you look at the list of questions that were asked in the survey about material deprivation, a number of them have very little to do with the economic status of families. For example, having friends or family around for a drink or a meal once a month I suspect has more to do with social norms and behaviour than it does with material deprivation levels. You have to look through this fairly carefully because there are a number of things in here which have got nothing to do with the material status of the family.

Q112 Ms Keeble: It would be helpful to have any further information about those figures. It has always been my assumption that part of ending the cycle of deprivation which you can see on some of the big estates here is getting people into work, including lone parents. Would you accept that even if it does not immediately produce a big increase in the number of children living in poverty, which almost by definition is the case if you have a generous benefits system, it nonetheless has an important role in breaking the cycle of poverty as it affects people longer term?

Mr Chote: It is a very important question in the sense of has the setting of the target for 2010 put pressure on the Government to go down the quickest cost-effective route of getting there, which is to increase transfer payments and, until recently, the increase in the child element of the child tax credit, whereas if you were trying to get to where you want to be by 2020 maybe you should not be doing that in the short-term accepting a higher probability that you miss the short-term target and invest in other longer term social investments instead.

Dr Weale: I just wanted to agree with you. I would have thought that in some ways the main benefit is getting children used to an environment where going out to work is normal and what they expect to do and obviously you are then talking about breaking the cycle of deprivation in terms of the adult experiences of those who are currently children. It is very important but I think it is a slightly different issue from whether it has an immediate impact on a child in poverty.

Q113 Ms Keeble: Yes, I agree. Robert, you mentioned the issue about the increase in the childcare element of the child tax credit. Amongst the voluminous lot of papers that we got there was a little bit somewhere that said all elements of the tax credits are being increased and then it had in brackets, "except the childcare element".

Mr Chote: I was referring to the per child element as distinct from the family element of the child tax credit.

Q114 Ms Keeble: You have got the childcare element which is the one that lets women go out to work because that is the one that pays for their childcare costs. It used to be called the childcare tax credit and now it is just the childcare element, is it not, of whichever tax credit?

Mr Chote: Of the working tax credit, yes.

Q115 Ms Keeble: John, do you know what has happened to that this year?

Mr Whiting: My observation is simply that there was a substantial increase last year, including the percentage of childcare costs that was covered by that. My understanding is that has been seen as enough to carry it through for a year or two. As I understand it, that is why there is not an increase built into the childcare element this year.

Q116 Ms Keeble: I just wondered if you had done any projection because there has also been a debate about childcare costs and the difficulty for people on low incomes paying some of the very high childcare costs. I wondered if there had been any work done around looking at the impact of not having an inflation proofing increase in the childcare element as to the effect that would have on the ability of lone parents to go out to work but also on the financial viability of some of the childcare providers.

Mr Whiting: Certainly from evidence we have with our low income tax reform group hat on, we know that the covering of childcare costs is very important. To what extent this is going to be a factor because it has not been uprated it is too early to say. As I said, what we have had is effectively quite an increase in the amount of childcare costs that can be covered by the working tax credit and that is arguably still working into the system and people are taking decisions accordingly. I think this is something we will need to keep under review.

Q117 Peter Viggers: The Government has set tough new targets for local services, recycling for instance, composting, they have instructed local authorities to improve services for children in care, families in need, old and vulnerable people, and they have given a settlement of 1% per year in real terms in the next three years and told local government that it should be able to keep council tax rises substantially below the 5%, and so far so good, but if you then read on local government is expected to find savings of 4.9 billion a year, which is some 2.8 from smarter procurement, some 1.8 from new collaboration of voluntary groups and businesses, and 300 million from better management. How achievable are those targets and how sensitive will local government rate increases, council tax increases, be to achieving those?

Professor Talbot: The comments that I made earlier about the efficiency targets would apply to this even more so. You are talking about extremely large efficiency savings for local government. Local government apparently did very well in the previous efficiency round, probably better than central Government, certainly initially, but even so these are extremely tight targets. We are talking about a 1% increase in real terms and that does not take account of the demand side on local authorities, not just targets set by central Government about improving services but changing demand from a body about quality of services for the public, so it is putting a very, very stiff challenge to the local government.

Mr Chote: I will add no more than I noted earlier that the local government settlement had been more generous in 2004 and did not prove enough to withstand the political pressure, so there clearly has to be some question mark over whether the Government will be finding itself under pressure to top this up later. Getting comparable figures on what the extent of topping up of the local government settlement was during Spending Review 2004 would be quite helpful because looking at the numbers in here we could not get a match up with the local government figures in here and the local government figures in the Spending Review 2004 document. If you can prise that out of the Treasury I am sure that would make us all wiser.

Q118 Peter Viggers: Any other questions to ask, Martin?

Dr Weale: I just wanted to add that there is a long history of relying on local authority taxation as a way of raising tax revenue without the central Government figures looking quite as bad as they might. I expect that process to continue. I do think the Government is being optimistic in talking about the ways that money can be saved.

Q119 Peter Viggers: Any comment, John?

Mr Whiting: No.

Q120 Mr Love: Can I go back to child poverty and I will ask the same question which my two colleagues have asked which I do not think has been answered. It goes right to the heart of Government policy about making work pay. According to the IPPR there has been an increase in the number of working households in child poverty. Can anybody explain to me why that has happened? Mr Chote, this is an area that you have focused on particularly.

Mr Chote: The increase in the proportion would presumably be that the growth rate of incomes at that level of the income distribution has been growing less quickly than in the median. You are measuring how far people are falling behind the middle. The success in terms of how people in work towards the bottom of the income distribution are doing relative to the median is not only a function of how much incomes are right at the bottom but what the target is and effectively are they having to run to stand still.

Q121 Mr Love: I understand that. Let me come to Dr Weale. The Government tells us that the combination of the minimum wage, which is going up, and tax credits, which have been going up as well, should be enough to counter that economic effect. Why is that not working?

Dr Weale: I think we have had an element of downward pressure on wages at the low end of the distribution from a combination of international trade competition from low wage economies and also probably from migration. There are also questions of how full-time some of the people who are working are actually working. Indeed, there have to be questions about how many hours a week they are actually working. We have seen a general widening of the income distribution, partly at the top but also downward pressure at the lower part of the distribution and that does have implications for people who work.

Q122 Mr Love: Absolutely. This is an international effect. Would you agree with that?

Professor Talbot: I have not looked at the IPPR material but one of the issues is what is it that you are measuring because we are assuming in this conversation that you are simply measuring the financial status of households and children relative to other households and the point I was trying to make earlier is that is not actually how it is measured, there are a whole range of different things which go into the measurement system. I am not sure on what basis IPPR was measuring relative deprivation, but if you include the list there are 21 questions in the survey here used to establish the level of material deprivation, very few of which actually have anything to do with the financial status of the household directly. If you are measuring those things then that is very different from looking purely at the financial situation.

Q123 Mr Love: I am sure we can ask Treasury officials exactly that question about what it is they are measuring.

Mr Chote: Essentially there are three targets running in parallel, that is the key. There is the material deprivation one that Colin is talking about, do you have access to goods and services that you would expect et cetera, then there is a relative poverty measure which is the one we typically focus on and then there is an absolute poverty measure which typically is easier to hit anyway, hence the focus mostly still being on the relative income measure although the Government would like to see more emphasis on the material deprivation scores that Colin mentioned.

Q124 Mr Love: We will no doubt come back to that. Can I just be clear. You suggested this figure of 3.8 billion which could be raised through a child tax credit increase. Are you sceptical about all the other issues that the Government raises as mechanisms for reducing child poverty, about greater employment rates, the possible rises in wages, although one has to take into account that 2% is the norm and we are expecting incomes at the lower end of the scale not to rise very much?

Mr Chote: There is certainly nothing from the likely path of employment trends, et cetera, that would lead you to believe that 3.8 billion minus whatever effect we take out of the 600 here through the child tax credit would be the sort of benchmark you are aiming at to give you a 50/50 chance of hitting the target. This is a sample and there are uncertainties in any year in the measurement. Certainly we had this discussion at Budget time that the sorts of things the Government was talking about in terms of what would be a boost to employment would not be enough to make a material difference to that sort of figure, so they still need to be finding much more proportionately than they have found in this PBR to get there.

Q125 Mr Love: There has been a suggestion that by increasing part-time employment and changing how the benefit system works, particularly the 16 hour rule, that may be a way of increasing the number of people you can take. This was especially focused on single parents, that if you change the benefit system this may be a way of taking people out of the poverty of their children.

Mr Chote: There is also the more general issue of whether you ---

Q126 Mr Love: Is there any merit to that argument?

Mr Chote: Well, how much material difference it would make to meeting the short-term child poverty target I do not know, but certainly the issue about whether you could do more through the structure of the benefit system to encourage many jobs in terms of that relatively small number of hours in the hope that that would lead people to have greater attachment to the labour market looking forward is certainly a good thing to do. I do not think you would say it is the most cost-effective way of getting to the 2010 target to spend money in that way but it does not mean that it is not desirable. As I say, you have got short and long-term investments to make.

Q127 Mr Love: Apologies, Chairman, for going back but I just want to be absolutely clear when we interview Treasury officials tomorrow. I have two questions. The first question is related to inheritance tax. The Treasury told us last year that 6% of estates were hit by inheritance tax. The indications from the limited research that has been done in this area is that with house prices going up, especially in London and the South East, there are very much larger numbers of people. What you would be getting in effect is inheritance tax not being a tax on the so-called wealthy but a tax, if you like, on the middle class. Since the middle class do not undertake to use some of the mechanisms, like setting up trusts and others, to anything like the same propensity as the wealthy, have the Government made an assumption that far higher numbers of those people who have now been taken out of the tax would not have used the mechanisms and, therefore, it is a real benefit to the vast majority of people who would have been hit by this inheritance tax if it had not been increased? Would that be a reasonable assumption to make?

Mr Whiting: I think that would be a very reasonable assumption to make, Mr Love, yes. That is very much the basis, that the change that we are seeing coming through on inheritance tax will particularly benefit the couple with the typical 300,000 to 600,000 house and very little else, which clearly is a lot of value, but in London and the South East and many other parts of the country it is a relatively ordinary property and it is those who have little other assets who cannot do a lot with planning.

Q128 Mr Love: The Halifax Building Society - they are no longer a building society - told me that 20% of households in my constituency would be hit in this way, and I can assure you that some of them were knocking on my door. Not all 20% but a considerable number of them! If I could ask my final question and it goes back to the issue of taper relief. My understanding, Mr Chote, is that you are sympathetic to the argument that we need to simplify the task. I wanted to come back to this issue, and I know how difficult this area is to get any quantifiable evidence on, but is there any quantifiable evidence that taper relief actively incentivised what it was intended to incentivise, that is the longer term holding of assets in particular of this thing called entrepreneurship, although how the hell you would define that I have no idea? Did it lead to people holding assets for longer? Is there any evidence to suggest that happened?

Mr Whiting: I am not aware of it. Martin, do you know?

Dr Weale: I do not know. Because people do respond to the tax system I would expect it did have an impact. How sensible is it for people's behaviour to be distorted by the tax system in terms of it promoting entrepreneurship, I think it is much less likely that it did that. If people have good business ideas and good businesses to run will they really be put off because the tax rate is 18% rather than 5% on the capital gains that they make, quite honestly I doubt that.

Mr Whiting: My own firm has done a survey on the impact of such incentives and we found only moderate take-up of them and only moderate influence by them. Certainly taper relief is probably at the top of incentives that businesses are aware of, or towards the top below capital allowances, but the extent to which it changes behaviour is unclear. When all is said and done, where we are now is you only have to hold the asset for two years so that is hardly long-term holding.

Mr Love: No, but that will be changed. Can I ask one final question, Chairman?

Chairman: This is your third final question!

Mr Love: I shan't ask it now. I shall ask it tomorrow.

Q129 Chairman: Can I ask Andy's final question. Robert, this is for you. Over the CSR period, Annually Managed Expenditure is forecast to rise at an average of 2.1% a year in real terms. How cautious and realistic are the Government's forecasts of AME?

Mr Chote: That was roughly the sort of figure that we pencilled in based on the growth rate of AME in recent years. The key thing there is obviously that the Government has not put aside any extra money to go into that to make progress towards the child poverty target. On the fact of it, there are lots of uncertainties, outlook for unemployment being not the least amongst them, but it does not look a particularly outrageous estimate.

Chairman: Can I thank you very much. Andy, you will get the chance of being first next time if you want. Thank you very much for your time.