House of COMMONS













Evidence heard in Public Questions 130 - 267





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Oral Evidence

Taken before the Treasury Committee

on Wednesday 17 October 2007

Members present

Rt Hon John McFall, in the Chair

Mr Graham Brady

Jim Cousins

Mr Philip Dunne

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

Mr George Mudie

John Thurso

Peter Viggers


Witnesses: Mr Nicholas Macpherson, Permanent Secretary, Mr Mark Neale, Managing Director, Budget, Tax and Welfare, Mr Dave Ramsden, Managing Director, Macroeconomic and Fiscal Policy, Mr Clive Maxwell, Director, Financial Services, and Mr Richard Hughes, Team Leader, Comprehensive Spending Review, HM Treasury, gave evidence.

Q130 Chairman: Mr Macpherson, we welcome you and your colleagues to this hearing on the Pre-Budget Report. Perhaps you would introduce yourselves for the shorthand writer.

Mr Macpherson: On my right is Mark Neale, managing director of budget tax and welfare; on my left is Dave Ramsden, managing director of macroeconomic and fiscal policy and also the Treasury's chief economist; on my further left is Richard Hughes, head of the spending review team; and on my furthest left is Clive Maxwell, director of financial services.

Q131 Chairman: The Chancellor may have left for other fields, but you have brought along the same volume of books and reports and I hope they are of use to you this afternoon. If I may start by referring to the IMF report on the world economy, is there now a higher level of uncertainty about the economy than at the time of the Budget?

Mr Macpherson: It is always a tradition in budget and pre-budget documents to say there is a heightened level of uncertainty about the future, but this time I think there is more uncertainty than for several years. We are in an interesting economic conjunction with a lot of momentum in the economy. The economy has been growing rapidly quarter after quarter at about 0.8%, that is, 3% plus a year. On the face of it, there is still considerable momentum. The surveys confirm a reasonable amount of economic activity. If one looks at financial indicators like the stock market, as of this morning the FTSE100 is pretty close to record levels. Against that, we had the financial events in August which themselves were triggered by concerns about the US. Everybody tries to anticipate what the effect of those financial events may be. There is real uncertainty about that. Yesterday I looked back at some of the forecasts made in 1998 when there was a crisis about hedge funds and long-term capital markets in the States. There was then a concern that there would be a big slow-down. All the surveys suggested that growth would be slower, but that did not turn out. Our forecast has tried to anticipate some effect from the credit events, but there is uncertainty. Inevitably, both the downside and upside risks are higher around our central forecast than they were at budget time.

Q132 Chairman: Are you doing anything to counter the increase in the level of future uncertainty?

Mr Macpherson: Within the economic forecasts all one can do in these situations is take a view on what the fiscal events may be and try to anticipate them. We try to make provision for some of the fiscal effects in the tax forecast, for example. We seek to put a slightly bigger contingency reserve in the spending plans. This is all about ensuring that fiscal policy is ready to weather any potential storms.

Mr Ramsden: We do not publish confidence intervals around our forecasts, so in that respect we are different from the bank. We have stuck to the same forecast ranges as we have used in the past, but try to highlight in the text of the document, both in chapter 2 and chapter A, the increased uncertainties we face looking ahead. In various parts of the fiscal forecast we have made allowance. I apologise that I have already made a factual error in that "LTCM" stands for long-term credit management.

Q133 Chairman: I note that you have reduced your forecast for GDP growth in 2008 from 21/2% to 3% to 2% to 2.1/2%. What element of the forecast has led to this downgrade?

Mr Ramsden: Typically, in PBR forecasts we have quite a lot of data that has come in since the Budget at the beginning of the year. If one looks at recent PBR forecasts, in 2005 we revised down our assessment of the current year but revised up future years; in 2006 we revised up our assessment of the current year 2006 given the momentum in the economy. This year it is rather different. If one looks at the data, in 2007 we are in a position where the economy still grows robustly. That is very well picked up in the MPC minutes published this morning. Most people expect growth again of about .75% in Q3, so there is nothing in terms of recent momentum to lead us to change our forecasts; indeed, we have not changed our forecast for 2007. But, looking ahead to 2008, we have to consider how to take account of the shock which is happening in real time. How do we factor it into our assessment of the economy going forward? We think we have made a cautious assessment of its impact in 2008 by revising down our range for growth for 2008 from 2.5% to 3%, which was what we had at budget time, to 2% to 2.5%. It is interesting that you mention the IMF forecasts published just a few minutes ago. For the UK they are 2.3% for 2008, so they are right in the middle of our forecast range. What we have tried to assess is whether the shock that has hit us will be permanent or temporary. Our assessment is that it will be a shock with a temporary impact in 2008 and we see good reasons for expecting growth to strengthen in 2009 back to trend. We can tell the Committee more about that if it is interested.

Q134 John Thurso: I want to ask about house prices. To what extent is the forecast dependent upon reasonable stability within the housing market?

Mr Ramsden: The forecast for house prices is not that dissimilar from our forecasts in recent years, in that the growth in house prices is forecast to slow from the double-digit rates we have been experiencing until recently to a growth rate in prices much more closely in line with incomes. It will be much more round about the 4% to 5% range than the double-digit rates we have seen recently. As I have explained to the Committee in the past, although in terms of the range of outside forecasters we have been towards the optimistic end on house prices we have never expected a fall in the market. House prices have continued to exceed even our expectations. We forecast that they will slow down. For the first time in this PBR we have some evidence that they are beginning to slow down. The problem with house price data is that every index tells a different story. I will not run through all the different indices, but the Halifax is down on the latest month and Nationwide is still slightly up. Other wider indicators of the housing market suggest that the kind of soft landing we have been forecasting for housing for some time may be beginning to emerge, but it is early days. To come back to your original point, we certainly do not expect a disorderly correction in the housing market or house prices, although we must acknowledge that there will be regional differences.

Q135 John Thurso: There is something of the order of ₤1.1 trillion of personal debt the vast bulk of which is secured by way of mortgages, and that is a clear distinction. If we had a situation where excessive lending in the capital markets translated through to more prudent lending and a slow down that could become a rapidly descending cycle similar to the meltdown in the capital markets earlier this year. Have you looked at the consequences of a more rapid deterioration, or perhaps stable house prices with no rise or even slight drops, and what it may do to the economic forecasts for next year? Is that as critical as some forecasters indicate?

Mr Ramsden: That is quite an involved question which has several parts to it. I shall try to deal with each in turn. When we try to analyse what is going to happen in the housing market we look at the potential transmission mechanism between the market and the wider economy. We look at the past experience of the UK economy, but we also look at the differences and similarities with other countries. Our analysis must take account of all these different elements. Within each of those elements we think about the scenarios you have mapped out, including one where house prices do not particularly slow down. What goes to the essence of your question is that if one looks at the UK's position versus the position in the US the size of our sub-prime sector, which is really the big issue for the US, is much smaller; most estimates put it at about .6% or .7% rather than the double-digit size in the US. If one looks at housing supply in the UK, that is a long-standing issue that the Committee has looked at following things like the Government-sponsored Barker review. Housing supply is much more elastic in the US which means that potentially one gets a much greater effect in terms of quantity and price. The other comment in terms of the scenarios is that if one looks at the underlying fundamentals in the past when there has been a closer link between house prices and consumption it is usually because something else is going on, for example how the labour market is performing or household finances. If one looks at the labour market, it is pretty strong. Unemployment is still falling and employment is at record levels. Therefore, the link that one saw sometimes in the past between house prices and consumption might be more to do with wider economic and labour market conditions and instability in the economy. We do not really have any of that at the moment. Therefore, whilst we can do the kind of scenario analysis that you suggest we do not see it as being anywhere near our main case which is that there will be just an orderly soft landing in the housing market. Our recent forecasting record on this matter plays into that. Although we have been at the optimistic end of the range, housing has exceeded even our expectations. Other commentators who have been forecasting for many years that there will be the kind of correction about which you speak have been proven incorrect. My final comment is linked to the point of wider stability. The estimates which suggest that the equilibrium of house price to earnings ratio is much lower than at present are based on very long runs of data which include all this instability and much higher long-term interest rates which are a critical factor in all of this. As you identify, there have been problems with short-term interest rates in regard to liquidity and credit markets, but long-term interest rates are still very low. Of late they are a bit higher than their absolute troughs, but they are very low compared with historical conditions. That gives us real reassurance about our forecast for the housing market but also more generally.

Q136 Mr Fallon: I should like turn to the public finances in table B2 in your report. The table shows that we finally move into surplus in the year 2009-10, does it not?

Mr Macpherson: That is correct.

Q137 Mr Fallon: Am I also correct in saying that in Budget 2003 you said we would be in surplus by 2005-06, that in PBR 2003 and Budget 2004 you said that we would be in surplus by 2006-07 and that in PBR 2004 and 2005 you also said that we would be in surplus by 2006-07? In PBR 2005 and Budget 2006 you said that we would be in surplus during the current year. We are not. In PBR last year and the Budget you said that we would be in surplus next year. Is that correct?

Mr Macpherson: What you are identifying is that once one gets to the tipping point in moving from deficit to surplus one is usually dealing with quite small numbers. Given the uncertainty around the forecasting of public finances, it is not totally surprising that the outturns have come out as you describe. I do not disagree with your description, but for completeness it is striking, for example, that the forecast we made of the current deficit in Budget 2006-07 was ₤9.5 billion and it came in at ₤4.7 billion.

Q138 Mr Fallon: To be clear about this, you have been telling the world and this Committee year after year that finally we would get into surplus. For the past nine projections going back over five years each time you have missed it. Why should we believe the tenth projection?

Mr Macpherson: Why do we make these projections? We do it in part to demonstrate whether or not the Government is meeting its fiscal rules. Even with the outturns you describe the Government is hitting its fiscal rules over the cycle, which we believe ended in 2006-07, and we project that we shall hit them over the next cycle. Clearly, of late there are issues around forecasting and you have identified the recent outturns, but the numbers are small. It is not that we have had outturns which are massively big deficits; they are pretty close to zero, especially in terms of the percentage of GDP. But you are right that the deficit has been persistent.

Q130 Mr Fallon: I note that the outturn for last year was minus ₤15 billion when you said we would finally be in surplus by ₤2 billion. Whether or not they are small, the fact is that they have always been on the wrong side. Every time you have said that the budget will finally be in surplus in two years' time, or whatever, by the time we have got there you have been wrong.

Mr Macpherson: The outturn for last year was ₤4.7 billion.

Q131 Mr Fallon: In 2005-06 you said that we would be in surplus by ₤2 billion and there was a deficit of ₤15 billion. Can you answer the point? Why should we believe the tenth of these projections when every single one of the previous nine has been wrong? What faith can we have that we will be in surplus in 2009-10?

Mr Macpherson: Over the cycle we have been in surplus, and our estimate of the surplus over the cycle is higher than it was at budget time largely because in the case of 2006-07 the deficit came in lower than our forecast. I recognise the point you make, but we are dealing with quite small numbers given the relative size of revenues and spending. Each time we seek to learn further from our forecasting record to improve our performance. If one takes a long view, our forecasting performance has improved of late. We may not have quite hit the relevant numbers, but we are getting very much closer to them. Mr Ramsden is an expert in fiscal forecasting and he will explain that in a bit more detail.

Mr Ramsden: Perhaps I may add one point that is relevant to Mr Fallon's question. As the Committee has highlighted before, there seems to be a pro-cyclicality in our forecasting record, so during the late 1990s when the economy was growing very strongly our receipts forecasts were consistently over-pessimistic. Table 2 in the Committee's report on the 2007 Budget draws this out very well. We had very big positive errors up until 2001-02 and then went through five years when, as your account describes, we had errors in our borrowing forecasts driven largely by errors on receipts. But, as the bottom line of your table shows, in 2006-07 we broke that five-year trend and the receipts forecast for 2006-07 at Budget 2006 was exceeded by the outturn. Therefore, Mr Macpherson's point that we are working on our forecasts to try to reduce the size of the errors comes through very clearly in your table. We have been hit by the shock in 2007-08 which has led us to revise up our borrowing forecast.

Q132 Mr Fallon: But all of these errors have been in the same direction. The Budget has never been in the surplus that you originally forecast. Before sending out your Chancellor and publishing a document like this should there not be a footnote from the permanent secretary saying that none of the previous projections have been right and nobody should take this very seriously?

Mr Ramsden: Every year we publish an end-of-year fiscal report which fully accounts for our forecast errors, whether positive or negative, for the previous two years. That is a hugely important part of the transparency with which we account for our forecasts. You have all of them on record, which is why you are able to hold us to account. We do not hide these changes in our forecasts at all.

Q133 Mr Fallon: Permanent Secretary, can you guarantee that we shall be in surplus in 2009-10?

Mr Macpherson: Certainly, we will plan to be in surplus in 2009-10, but economic forecasting is extraordinarily difficult. The Treasury's record has not been bad, and I think this Committee will acknowledge that on the whole on matters like the gross domestic product outside forecasters always think that there is about to be some big slow-down and there has not been. The fiscal aspect is a challenge. Forecasting revenues in a global economy is difficult. We seek to learn from our experience and we are confident that these forecasts are realistic.

Q134 Mr Fallon: You have been at the top for 10 years now and you are not very good at it, are you?

Mr Macpherson: We are hitting the fiscal rules and the errors are getting smaller.

Q135 Mr Brady: Given that the predicted increase in public sector current expenditure at 2.1% per annum over the spending review period is so much lower than the previous period, how realistic is it that you will achieve that?

Mr Macpherson: I think it is perfectly realistic. I worked in the Treasury in the 1980s and 1990s and there were years when public spending grew a lot more slowly than that and over quite a long period. To be confident that one can continue to improve services whilst planning for growth of that nature there are two matters I would highlight. One needs to have a sensible approach to public sector pay and, alongside that, to continue to drive a value-for-money efficiency agenda. The experience of recent years with the Gershon agenda on efficiency suggests to me that the public sector is now seriously pursuing that agenda and driving out value-for-money improvements. I am reasonably confident that that rate of growth is both deliverable and consistent with improving public services.

Q136 Mr Brady: Other than the efficiency regime to which I will turn in a moment, are there other factors that may cause you to overshoot the expenditure targets?

Mr Macpherson: There are some elements of public spending which you can plan effectively by constraining departments' expenditure limits. There are other areas of spending, for example social security, which are demand-led and sometimes those can grow faster or more slowly than you expect, but I am confident that the projections we make are prudent, sensible and consistent with recent trends in social security, for example.

Q137 Mr Brady: But the projections are heavily reliant on the achievement of the efficiency savings to which you refer?

Mr Macpherson: No. Over the years the Treasury has become progressively better at controlling public spending. I think the issue you raise is: assuming the Treasury can do its part and control public spending, what will be the implication for public services? I argue that provided departments operate a sensible approach to driving out value for money on a broad front that settlement is consistent with improving public services.

Q138 Mr Brady: On Monday we took evidence from some academics. One of the issues we looked at was the question of efficiency savings. There was broad scepticism about the Government's ability to reach the ₤30 billion savings target. To quote Professor Talbot, he simply was not sure where the ₤30 billion saving would come from at the end of the period. Certainly, there is no evidence in the report as to where it will come from. Can you shed some light on where you see that coming from?

Mr Macpherson: It has become fashionable to dispute the Government's and Treasury's claims on efficiency improvements. I have been quite closely involved in the Gershon programme latterly and I believe there have been substantial improvements. The National Audit Office has tended to confirm that. Within the Civil Service, which I recognise is only a small part of the public sector, the numbers are now on a definite downward trajectory. In the case of key departments like Work and Pensions and Her Majesty's Revenue and Customs there is every indication that service quality is being maintained or even improved. Efficiency is a dynamic issue. There is quite a lot of investment going on which will drive out further improvements in particular in relation to IT. If one looks at the channel strategies being pursued by some of the big service departments in terms of delivering services there are grounds for optimism. Therefore, I believe that ₤30 billion is a perfectly sensible number. Mr Hughes, who knows even more about this than I do, may be able to give further detail.

Mr Hughes: Each departmental chapter at the back of the document gave both the target for savings over the spending review period and examples of where it expected those savings to come from. By the end of this calendar year we expect all departments to publish value-for-money delivery plans saying how they intend those savings to be achieved. Now they have their planned expenditure they will be able to do that, and they will also be doing it in advance of the beginning of the financial year. We will know where they plan to find those savings and we and the Select Committee will expect to hold them to account for finding them.

Q139 Mr Brady: We also heard evidence that lurking behind the previous set of efficiency savings was the fact that 60% approximately were cashable savings and 40% were not, whereas in the current projection all of the savings are expected to be cashable and a higher level of savings of 3% is also targeted. Effectively, this means that the targeted saving is double what it was in the previous round. Is that realistic?

Mr Hughes: It is a more ambitious programme and we think that it is realistic. Departments have a lot more experience with the Gershon programme. The decision to make all the savings cashable and to push departments to make them is a reflection of feedback we have had from both the NAO and this Committee about ensuring that the savings are things that can be recycled to meet pressures elsewhere in their departments, so it increases their financial flexibility. We have also changed the way in which these savings are measured so that they are net of upfront costs. The previous Gershon savings were measured gross, so they are a genuine reflection of what we think is the extra financial flexibility a department has over the spending in the year. If one looks at particular areas of the public sector which have been ahead of the game on efficiency, for example local government, a much higher proportion of cashable savings is being delivered. One can see how they use them to meet pressures elsewhere. We have been preparing for the spending review for over two years and a big part of the first year was devoted to undertaking a series of reviews of departmental expenditure to see where they could find these savings. After 10 years of delivery and three years of learning from the Gershon programme there was quite a lot of experience out there in terms of where the opportunities lay and how they could be driven out over the three years to come.

Q140 Jim Cousins: I want to ask you about your forecasts of real disposable household income. In 2006 the outturn was 11/4% and in 2007 the forecast is 11/2%. Are there any sections of the population where real disposable household incomes are in decline?

Mr Ramsden: The forecasts we put together are at the macro level, so we do not do a forecast by decile of the population.

Mr Macpherson: I would be quite surprised if there were large sections of society which faced a declining income partly because the tax and benefit improvements at the lower end provide a support system to disposable income.

Q141 Jim Cousins: Personal tax revenues are less than forecast which is an indicator, is it not? It would be reasonable to expect increases in food and energy costs as a result of the global environment. Are you satisfied that real household disposable income can continue to advance against that background?

Mr Macpherson: We are, but what you highlight is that average earnings have perhaps risen slightly more slowly than we anticipated and that has fed through into income tax and National Insurance receipts. In one sense that is good for the functioning of the economy; it reflects a flexible labour market. On the other hand, clearly if real incomes come under pressure that is a matter for concern. What you highlight has been a temporary phenomenon associated with the uptake of inflation earlier this year. Inflation now seems to be coming down. This week the latest data confirms that it is edging down slightly. I am pretty confident that real incomes will continue to increase.

Q142 Jim Cousins: How important is the public sector incomes policy that in practical terms is now in place in achieving what you want to achieve? Does it imply that in the public sector there could be large numbers of low paid workers whose real incomes will decline?

Mr Macpherson: There are two issues. I would highlight the minimum wage which has continued to increase.

Q143 Jim Cousins: How many public sector workers do you believe depend on the minimum wage?

Mr Macpherson: I could not give an estimate, but what I shall do is try to find out whether or not we know the answer to that. Public sector wages continue to increase. It is easy to mis-describe what has been going on with public sector pay. What the Government has sought to do on public sector pay is ensure that wages rise in a way that is consistent with the inflation target of 2%. That does not mean it seeks to constrain wage growth absolutely to 2%; on the whole, it is trying to constrain settlements to about that level, but a settlement of 2% will generally result in public sector wages rising by about 31/2% a year which is still consistent with real income growth.

Q144 Jim Cousins: That principle often works out as meaning that the people who make the cuts get big increases and the people who experience them get rather smaller ones.

Mr Macpherson: I do not immediately recognise that. The public sector wage bill is driven by the big battalions of public sector workers, so one would expect average public sector pay to be consistent with the pay of nurses, teachers, people working in Jobcentres and local government workers. Those will ultimately drive public sector earnings. It is worth highlighting that the Government is sensitive to low pay. For example, the Armed Forces pay settlement last year delivered much bigger increases for the private soldier, so to speak, than the generals.

Q145 Ms Keeble: In the Pre-Budget Report you highlight the unexpected rise in interest rates as one of the determining factors in slowing growth. If commodity prices continue to increase, which is also one of the factors you have noted, how constrained will the Bank of England be in lowering rates in response to a drop in demand because of current financial market difficulties?

Mr Macpherson: I do not want to get into a debate about what the Bank of England should be doing next because the bank is independent and the Treasury should not comment on what it may do in future. You are right that at budget time we had a review of what would happen to interest rates over the period March and October. In the event, rates rose more than we expected because the inflation outlook deteriorated somewhat. Now inflation is very much back on track. Mr Ramsden can comment on our market rate assumption, but it is clear to me - it is tied to an earlier question about housing - that market expectations about interest rates certainly suggest a slightly more benign environment when it comes to interest rates than they were a couple of months back.

Mr Ramsden: We run off market expectations. At the time of the Budget those were factoring in one interest rate rise between then and October. There have been two rises which reflect that perhaps there was a bit more inflation in the system than had been expected at Budget time. The economy has been growing pretty much at the top end of the forecast range; it grew at 31/4% in the first half of the year. Now inflation is at 1.8% in September, the same as in August. Looking ahead, market expectations have changed. Up until the summer they were expecting the Bank of England to put up rates further but since the financial turbulence expectations have switched round. One must be careful because, given the impact the turbulence has had on the markets, it is quite difficult to extract the expectation of the policy rate. It appears that the markets are now expecting the next movement in interest rates to be down and we are running off that expectation. You saw the MPC minutes this morning and so you have a very up-do-date assessment of what it thinks about the economy.

Q146 Ms Keeble: You pointed out that in present circumstances it was hard to predict very closely or extract what might happen. Is that because we are in somewhat unprecedented conditions with turbulence in the market having an impact on demand at the same time as continuing increases in commodity prices?

Mr Macpherson: Where we are at present is very uncertain. What happened in August clearly had some effect on credit markets. In the first instance the effect was quite marked in terms of interbank lending and rates. Having said that, recent Bank of England surveys picked up some effect in terms of credit conditions in the corporate sector but not very much in the personal sector. One has a very strong stock market. As you identify, commodity prices are consistent with strong world demand. It is difficult to predict what will happen in the short and medium terms.

Mr Ramsden: The bank's latest data on effective interest rates paid by mortgage-payers has come down compared with August, so already there seems to be some improvement in the actual rates at which different types of mortgage are taken out. It is the kind of thing that you would probably expect an economist to say, but it is the case that no two shocks are the same. This shock is really unusual. There has been a very unusual impact in terms of liquidity. The big contrast with previous shocks is that meanwhile equity prices are very strong. Later this week we will be celebrating the 20th anniversary of Black Monday when equity prices fell by more than 20% in a single session.

Q147 Chairman: Celebrating?

Mr Ramsden: I meant "marking". We have very strong equity and commodity markets. In the past strong commodity prices and oil prices have had a real impact on the UK economy, but this time round they seem to be associated with strong world growth, so overall they are supportive of our UK forecasts.

Q148 Ms Keeble: One matter much in the news now is the impact of migration. Previously when we have asked about this a big factor in controlling wage inflation has been, bluntly, migration. Have you factored that into the equation? If so, how important will the availability of migrant labour be to the UK economy?

Mr Ramsden: As we have discussed with the Committee before, the way we go about our assessment of the economy is to assess the potential growth rate, how the economy is performing relative to that in the short term and whether there is potential for greater than trend growth or the economy needs to slow down. When we appeared before you a year ago a big issue was migration because then we had revised up our trend growth projection on the back of higher projections for net inward migration. At this PBR we have not changed those projections, but what we have had is the latest data from the ONS which is consistent with our projection. The ONS has also published its long-term population projections which we include in either chapter 2 or annex B. They now assume that migration will continue at 190,000 a year. That is consistent with the projections we discussed with you which informed our forecast. Therefore, migration is important in terms of assessing at what pace the economy can grow without generating inflationary pressures. Therefore, we paid a lot of attention to it. We have contributed to the new analysis of migration published yesterday by the Home Office and DWP which includes in one chapter an analysis of why it matters at the macroeconomic level. It plays a very important part.

Q149 Ms Keeble: In these more uncertain times do you think that given the particular scenarios at present it will be more or less important?

Mr Ramsden: I believe that it will be as important. If anything, for us the uncertainty of migration in the short term has declined a little. Last year the projection we made was higher than the ONS's long-term projection. Our projection was around 190,000 and at that time the ONS said it was 145,000. Some of the witnesses from whom the Committee took evidence said that maybe the Treasury in its migration assumption had gone for quite a high projection. The ONS has now said that it will be 190,000 so, if anything, in a world of projections it gives us a bit more certainty about them.

Q150 Ms Keeble: On the financial sector in particular, given recent trouble in the credit markets do you expect it to recover quickly as it did following previous pressures?

Mr Ramsden: Yes, we do.

Q151 Ms Keeble: What evidence do you have for that?

Mr Ramsden: The fact that it has in the past which counts as evidence, although the shocks have been different.

Q152 Ms Keeble: You have said that each shock is different?

Mr Ramsden: It is, but the resilience and responsiveness shown by the financial sector has been quite similar. On Monday one of your witnesses, Dr Martin Weale, spoke about the financial sector's ability to innovate and think of new ways in which both the retail sector but particularly the wholesale sector can be competitive. That is why particularly in the UK we have a financial sector that has a comparative advantage and has been growing much more strongly than the rest of the economy. We think there will be a short-term impact running through the rest of this year and into 2008, but we believe that it will bounce back. That is why we forecast a range of 21/2% to 3% for 2009 because we think that the financial sector will strengthen.

Q153 Ms Keeble: What do you expect to be the effect of the slow-down in the US economy? Are there other factors offsetting it?

Mr Ramsden: As with all our forecasts, we have tried to take a cautious approach. In the case of the US there is a range of views. The IMF this morning publishes 1.9%. The consensus is about 2.4% for 2008. We are somewhere in the middle. We believe that to be a reasonable forecast. When we were completing our forecast some of the data was quite encouraging, for example that to do with the labour market. We do not forecast a recession but a slow down in the US. As for 2009, we believe that because the US economy like the UK economy is pretty flexible it will grow more quickly back up towards trend rates of about 23/4%.

Q154 Mr Dunne: Either Mr Macpherson or Mr Ramsden referred earlier to transparency. Why do you not have an index to the 280-page Blue Book?

Mr Macpherson: The main reason is that historically budgets, PBRs and spending reviews are prepared under considerable pressure. Chancellors of the exchequer tends to want to come to the House of Commons and announce their proposals as soon as they have come together and therefore the time which we have to prepare an index is very limited. We try to have a fairly good contents page. We always listen to the Committee's suggestions on the matter. I am not a publisher, but I understand that the production of indices is quite time-consuming.

Q155 Mr Dunne: Perhaps I may encourage you to look at that more seriously for the Red Book and Budget?

Mr Macpherson: We will certainly do so.

Q156 Mr Dunne: From your answer do I take it that this particular Pre-Budget Report had a particularly large number of last-minute insertions?

Mr Macpherson: I have been involved in budget and pre-budget reports over quite a long period. I do not believe that this was different from any of the rest.

Q157 Mr Dunne: It contained a number of shock last-minutes changes in part by the Chancellor. I turn in particular to the capital gains tax proposals. How much consultation took place in relation to the standardised rate proposed by the Chancellor?

Mr Neale: We do not consult on tax rates in the normal course of events, but, as several of your external witnesses have said, capital gains tax has been the subject of continuing debate among those interested in the tax system, and the changes we have made are in large part a response to a strong feeling that capital gains tax was over-complicated.

Q158 Mr Dunne: Are you referring particularly to the private equity debate that has been going on?

Mr Neale: I am not referring to the private equity debates in particular. Mr Whiting who is very active in these fields said in his memorandum to you that there had been many representations about capital gains tax because it was a complex tax. What we have done is carry out a fairly fundamental reform that responds to that concern.

Q159 Mr Dunne: How do you respond to the open letter to the Chancellor published in the Financial Times on Monday? That letter was signed by the British Chamber of Commerce, the Federation of Small Businesses, the Confederation of British Industry and the Institute of Directors which are groups that do not often sign joint letters to the Chancellor. It said: "Your announcement came as a bolt out of the blue", and goes on to say that the Treasury did not "signal at any point that such a change was in prospect" in relation to the capital gains tax proposal.

Mr Neale: With respect, I do not think that those who are interested in reform of the tax system would see reform of capital gains tax as a bolt out of the blue but as a fairly natural development in the context of the Government's continuing reforms of the tax system.

Q160 Mr Dunne: These bodies represent both large and small British businesses and have made it clear that they did regard it as a bolt out of the blue. It suggests to me that you had no consultation with them at all?

Mr Neale: As I have said, there has been a very lively and continuing debate about capital gains tax among those interested in the tax system.

Q161 Mr Dunne: Are you aware that as of this morning over 10,000 people have signed a Downing Street petition to complain about the impact of these changes?

Mr Neale: I was not aware of that. Clearly, we have looked very carefully at the likely impact of the reform announced by the Chancellor.

Q162 Mr Dunne: How many small and medium size enterprises are there in this country?

Mr Neale: There are about four and a half million.

Q163 Mr Dunne: Is it the case that four and a half million potential taxpayers could face an 80% increase in their effective rate of capital gains tax on the sale of their businesses?

Mr Neale: I do not believe it is possible to say that at all. Capital gains tax is paid in any one year by only about 250,000; it is paid by people who sell businesses.

Q164 Mr Dunne: But for those transactions that are in excess of the threshold, which I accept may reduce the number, anybody who sells his business can expect to pay capital gains tax?

Mr Neale: I do not think you can look at this in terms of winners and losers because, as I have said, only 250,000 people dispose of assets and pay capital gains tax in any one year.

Q165 Mr Dunne: That means that over a five-year parliament one and a quarter million people will be affected by this change?

Mr Neale: By no means necessarily because many of those people may dispose of assets in successive years, so I do not think you can make that deduction.

Q166 Mr Dunne: How many employees participate in save-as-you-earn share schemes in this country?

Mr Neale: A very considerable number. There are four schemes and we look quite carefully at the potential impact on them of the changes we have made. Our analysis is that there will be very little impact. The great majority of them will be able to take advantage of the continuing exempt amount, which is ₤9,200 in 2007-08. They will continue to have the tax benefits that come with these schemes - income tax and NICs exemption - and when the assets come out of the scheme they are CGT-exempt, too. Therefore, our analysis is that very few people will be affected by it.

Q167 Mr Dunne: How many participate in the four separate schemes?

Mr Neale: In the share incentive plan there are about 3.6 million and in the save-as-you-earn scheme there are about 1.7 million. As for the two schemes aimed primarily at executives, in the company share option plan there are about 470,000 and in the enterprise management incentive scheme there are approximately 100,000.

Q168 Mr Dunne: That is just short of six million people. I assume that there will be some overlap. How many of those will expect to see the tax rate go up effectively from 5% to 18% as a result of this reform?

Mr Neale: Very few of them will dispose of shares that realise gains in excess of the ₤9,200 exempt amount.

Q169 Mr Dunne: Last year how many sold more than that value?

Mr Neale: I simply cannot tell you that, but it would be very few.

Mr Macpherson: The vast majority will face a zero rate because the gains they realise will be within their ₤9,000-plus annual exemption.

Q170 Mr Dunne: What assessment have you made of the impact that this increase in taxation of these employees will have on their propensity to save and acquire a stake in their business?

Mr Neale: They will be scarcely impacted at all by the reform.

Q171 Mr Dunne: If we turn to page 90 of the Blue Book and the justification in paragraph 5.79, there is a very slight explanation of why this change has been made. You use two phrases which strike me as surprising. First, you say that the changes in capital gains tax reform "are responding to the changing needs of investors"; second, you say that it will "help investors plan for the long term." How does the abolition of taper relief help investors to plan and invest for the long term? Surely, it encourages short-term investment.

Mr Neale: I do not think it does. It makes the capital gains tax system vastly simpler for investors and individuals to understand. They will know that, whatever asset they hold and for however long they hold it, they will pay 18% on the gain they have realised over and above the ₤9,200 exempt amount.

Q172 Mr Dunne: For the next six months there will be a very rapid acceleration in the number of people who seek to take advantage of the 10% effective tax rate rather than 18%?

Mr Neale: We have given people the opportunity to get their affairs in order before this is introduced in April 2008.

Q173 Mr Dunne: What impact have you assumed it will have on tax receipts for the next six months?

Mr Neale: The impact on tax receipts is set out in the table on page 11 of the PBR book.

Q174 Mr Dunne: Could you respond in the context of this particular measure? This is a one-off short-term additional sale. Have you made any assessment of the impact?

Mr Neale: We have certainly made an assessment of the impact which is reflected in the numbers given in the table on page 11. Clearly, some people will bring disposals forward to take advantage of the existing capital gains tax rules; others will probably choose to defer disposals because they are better off disposing of them under the new rules.

Q175 Mr Dunne: We will come back to the individual impact in a moment, but the second clear consequence of this change is that there will no longer be any active incentive in the tax regime for individuals to hold onto assets for any period of time. Is that something that the Government now seeks to encourage, ie no incentive and short-term gains on things like second homes, antiques, wines and all sorts of other asset classes?

Mr Neale: The reform is completely neutral between both assets and the time over which they are held, and that is one of the things which makes it very much easier and simpler for taxpayers to understand. When I tell you that now 75% of people need to hire an accountant to work out their capital gains tax liability you will see that this is a considerable simplification.

Q176 Mr Dunne: How many second home property owners are there in the country?

Mr Neale: I do not know the answer to that.

Q177 Mr Dunne: Does anybody know the answer to that? Have you considered the impact of individuals selling second homes in order to take advantage of the benefit of a reduction of more than half in the tax payable on their gains?

Mr Macpherson: Is there something intrinsically wrong in selling a second home insofar as it increases housing supply?

Q178 Mr Dunne: I was just interested in whether this Government wants to encourage people to invest in second homes?

Mr Macpherson: If it increases the housing supply or revenue everybody gains. I do not think there is anything intrinsically problematic about it.

Q179 Mr Dunne: Does the tax incentive to own second homes not mean that you will reduce the housing supply by encouraging more people to invest in property rather than financial assets?

Mr Neale: Under the new capital gains tax regime there is no incentive to hold one asset over another or to hold assets for particular periods of time. The new regime will be completely neutral in that respect.

Q180 Mr Dunne: To go back to the individual impact of these separate measures, can you quantify what proportion of the ₤2 billion extra tax that the Government anticipates it will receive from these changes over three years comes from the withdrawal of different measures, taper relief to start with?

Mr Neale: I cannot give you that analysis here and now. We can look to see whether the basis on which this measure was costed enables you to decompose it in that way.

Q181 Mr Dunne: Will you write to us about that?

Mr Neale: I will write to let the Committee know whether or not it is possible to decompose it in that way.

Q182 Mr Dunne: Similarly, could you decompose the impact of removing indexation allowance?

Mr Neale: We will see if we can do that.

Q183 Mr Dunne: Similarly, will you look at the impact of abolishing halving relief?

Mr Neale: Yes.

Q184 Mr Dunne: And simplification of the share identification rules?

Mr Neale: Yes.

Q185 Mr Dunne: And the abolition of the kink test for assets held as at March 1982?

Mr Neale: Yes.

Q186 Mr Dunne: And the impact, which is not set out in your note, of the potential shift from income to capital which you anticipate may occur with the differential in rates?

Mr Neale: I think I have the message that you would like an analysis of how the costing of this measure breaks down.

Q187 Mr Dunne: Will that cover your response to the Arctic decision and how you intend to deal with that?

Mr Macpherson: We will try to provide the Committee with this information, but it is notoriously difficult to decompose these measures simply because whichever component one starts with there is a different answer.

Q188 Jim Cousins: Mr Neale, the table on page 11 to which you have drawn our attention shows zero impact in the present financial year?

Mr Macpherson: That is because capital gains tax is paid with a lag, so for any gains you realise in 2007-08 the Government get them the following year.

Mr Neale: It is paid on a self-assessment basis.

Q189 Mr Mudie: I wondered why the Chancellor introduced this controversial measure, but he was obviously talked into it by you, Mr Neale. Do you realise that most Members of Parliament have a second home and how hurtful this measure is?

Mr Neale: We cannot take into account the propensity of Members of Parliament to have second homes.

Q190 Mr Mudie: We are above that sort of calculation, are we not? When Mr Dunne asked you how these figures arose you were not clear. You projected a gain next year of ₤350 million. If you cannot do the make-up how do you arrive at ₤350 million?

Mr Neale: HMRC provides the costings and they are based on macroeconomic rather than microeconomic assumptions; in other words, they look at the volume of disposals historically and changes in the values of assets like shares that are among those disposed of and arrive at an overall costing.

Q191 Mr Mudie: You told Mr Dunne that you would get these figures, so you will have to go to a man who has told you that this is the figure and ask him how he arrived at it?

Mr Neale: I am not totally clear that it will be possible to decompose these numbers, but we will certainly look into it.

Q192 Mr Mudie: That is fair enough. This morning I attended a seminar on tax at the John Smith Institute. One of the top speakers described how difficult the job was because there was a lack of information and time and a full explanation was never given. Here is the most controversial measure. I ask you how you to get to ₤350 million and you say that somebody from the Inland Revenue told you. When somebody gives me a figure and I am in deep hot water over it I really expect to be able to go back to him and say, "How did you calculate it?" so there is no doubt that somebody in the whole apparatus of government, in whatever cubbyhole, has come up with a figure that has some legitimacy. I would expect that. Would you not expect it?

Mr Macpherson: You would expect that, and we would expect to be able to give you the answer. My point is that you can cost out individual elements but if you then add them together some of the parts may be different from the individual components. We shall try to do it. We certainly aim to be able to get this sort of information.

Mr Neale: It may reassure the Committee to know that we subject these costings to a good deal of scrutiny before we put them into the PBR or Budget. We also look in retrospect to see whether or not the costings are right and, if they are wide of the mark, why.

Mr Macpherson: Consistently with Mr Fallon's strictures about out tax projections, we are trying to be even more cautious in terms of what we get in from tax proposals.

Q193 Mr Mudie: All your protestations only confirm that you will deliver the breakdown as requested. This is almost the total amount of the policy changes in the Budget, is it not? On a budget of ₤589 billion the policy changes amount to ₤385 million. That is just about what you will get from these proposals. How could the Inland Revenue tell you with such certainty that not just next year - because this is next year's figure - but for the next two years it would go up in steps? To point you in the direction of the answer I seek, is there a past capital gains tax document showing that sort of step up in which this can be sensibly explained?

Mr Neale: We have not reformed capital gains tax in the recent past, but we publish forecasts for CGT receipts which essentially are based on the one hand on historic information about the volumes of disposals and on the other on forecasts of the value of assets.

Q194 Mr Mudie: Earlier Mr Fallon asked Mr Macpherson about his forecasts. Therefore, hand on heart - we have it in the minutes - you stand by the ₤350 million and the subsequent two years?

Mr Neale: I certainly stand by them as the best possible forecast we can make.

Q195 Mr Mudie: Now you start to back away. What does "the best possible" mean?

Mr Neale: It means that they are forecasts previously arrived at on the basis of the evidence we have.

Q196 Mr Mudie: How much doubt do you want to put in them? Is there an error of 5% or 10% either way so that Mr Fallon can say that you have given some leeway?

Mr Neale: I do not want to cast doubt on them at all because I have explained that they are based on historic information about volumes of disposals and forecasts of asset prices. Neither of those things is a certainty looking forward.

Q197 Mr Mudie: I have an open mind on this. A lot of heat is generated after all budgets and pre-budgets. Interested parties who come off badly scream first and then the dust settles. What Mr Fallon did not say was that in all the consultations that took place the withdrawal of taper relief was never raised by the Treasury. Is that true?

Mr Neale: As I said, there has been a continuing debate about it.

Q198 Mr Mudie: I am asking you a specific question. We are trying to find out whether or not the business world is bluffing. They are going to the country and saying that there were consultations on capital gains tax but one thing never discussed with them as a possibility was the withdrawal of taper relief. Is that true?

Mr Neale: Mr John Whiting said to you that CGT was an immensely complex tax, particularly the anomalies within taper relief, and there have been many representations arguing the need for simplification.

Q199 Mr Mudie: I have read his evidence. That is not the answer to the question. The straightforward question I ask is: did you consult business over the total withdrawal of taper relief - yes or no?

Mr Neale: We do not consult on changes to tax rates. There has been considerable debate about capital gains tax as reflected in some of the evidence that witnesses have given the Committee.

Q200 Mr Mudie: If you will not answer the question it must mean "no". Therefore, in the consultations that took place the withdrawal of taper relief was not raised by the Government or discussed with industry?

Mr Neale: We do not consult in advance on changes in tax rates.

Q201 Mr Mudie: You were involved in consultations over the reform of capital gains tax. One matter introduced eight years ago was taper relief. You went into consultation on the reform of capital gains tax and never bothered to ask what they would think of a change to taper relief?

Mr Neale: I seek to distinguish the Treasury formally consulting on changes to tax rates, which we do not do, and a debate out there in the country among people who are interested in the tax system and this particular tax where the issue about the complexity of taper relief has been a very live one, as your independent witnesses accept.

Q202 Mr Mudie: That is what I am coming to. What disturbs me is that the Chancellor said he would not make a knee-jerk response to our hearings on private equity given the law of unintended consequences. Is the withdrawal of taper relief an answer to the private equity carry-forward, or whatever it is, or the dispute that we have over the payment of taxation?

Mr Neale: That is not its primary motivation. Its primary motivation is to reform and simplify and apply a cap on a sustainable basis.

Q203 Mr Mudie: That is not the main objectives; you mean to say that it is one of the objectives. It deals with some of the problems we have had with the level of payment of private equity bosses.

Mr Neale: One of the effects of the reform will be that private equity managers and partners pay a higher rate on their capital gains when they dispose of them after two years.

Q204 Mr Mudie: I understand that. Do you not see why you have handed industry something with which it can hit you on the head? In dealing with one problem you have created anger and problems for people who run small businesses, that is, small venture capitalists, family businesses and small and medium size companies. That is the opinion of people in industry. Do you not think you should at least have floated it with those who would be affected by it?

Mr Neale: That goes to the question of the impact of these reforms on enterprise and entrepreneurship. Our analysis, which is also shared by outside experts, is that the regime as we shall reform it will remain very favourable. Entrepreneurs will retain 82% of the gain on the disposal of assets under the regime.

Q205 Mr Mudie: The Labour Government, not you personally, introduced something that was so well received that everybody with whom it discussed the measure - venture capitalists, industry and small businesses - said it was very much appreciated. It was introduced in 1998. Because there is then a difficulty with private equity you remove it completely without discussing it with them?

Mr Neale: Private equity was not the main motivation for introducing these reforms.

Q206 Mr Mudie: I know it was not the main motivation; it is the law of unintended consequences, is it not?

Mr Neale: It would be an unintended consequence if this was motivated by the private equity issue, but it is not.

Q207 Mr Mudie: It is one of the motivations.

Mr Neale: In considering the effect on enterprise we need to look at what the impact will be. Once the reforms are in place an entrepreneur selling his or her assets will still retain 82% of any gain over the exempt amount which internationally is very competitive.

Q208 Mr Mudie: Why is the withdrawal of the taper relief of benefit to small businesses including family businesses?

Mr Neale: There will be a significant benefit from simplification.

Q209 Mr Mudie: Again, you are not answering the question. Focusing just on taper relief, why is its withdrawal beneficial to small businesses including family business?

Mr Neale: The withdrawal of taper relief and the other reforms makes this a very much simpler tax and provides a clearer basis for businesses and individuals to decide in what to invest and when to dispose of their assets.

Q210 Mr Mudie: The seminar that I attended this morning dealt with that. Why tax? What are the considerations? Is the Government now going just for simplicity?

Mr Neale: Not just simplicity by any means, but it is a very important consideration, and in the process of simplifying capital gains tax we have put it on a much more sustainable basis which clarifies choices for individuals and businesses.

Q211 Mr Mudie: I accept that this is perhaps a difficult question. In the past couple of days officials met small businesses in the business community who must have played hell about it. If the Chancellor approached you as officials and told you to put taper relief back in what would be the financial effect? I am the Chancellor and I have had a hell of a time with industry. I ask why Mr Neale has talked me into it and I tell him not to take it out. What would you say to that? First, what would be the cost?

Mr Neale: If I may say so, that is a hypothetical question. The Chancellor's proposals are the Chancellor's proposals.

Q212 Mr Mudie: The question is: what is the financial cost and the effect on the reform if a simple decision is taken to put taper relief back in and deal with it when the private equity report comes in?

Mr Neale: Just as I cannot decompose the costing published in the PBR I cannot re-compose it off the top of my head.

Q213 Mr Mudie: But you cannot tell this Committee that it would have horrendous financial effects and it cannot be done?

Mr Neale: I cannot tell you exactly what financial effect it would have.

Q214 Mr Brady: I should like to take you quickly to a micro-example of this. One of my constituents has just written to me. His small business which he has owned for 10 years is valued at ₤62,000. If he sold it today the tax liability would be ₤2,520; if he did that after April it would be ₤9,504. Before the change he will get 75% relief after 10 years' ownership. Mr Macpherson looks very perplexed.

Mr Macpherson: Can you give me the figures again?

Q215 Mr Brady: He says that the business is valued at ₤62,000 and there is taper relief of 75%. He has a personal allowance of ₤9,200. He arrives at a tax bill on the sale of just over ₤2,500. Under the new proposals, having simply removed the ₤9,200 threshold with tax at 18% he will pay ₤9,500.

Mr Macpherson: Yes.

Q216 Mr Brady: Mr Neale looks very sceptically at Mr Macpherson. Clearly, there is a massive increase in taxation for a very small business. I suspect that you have already revealed the answer to the question before I ask it. Did the Treasury model the effect on a business of that sort prior to the announcement being made?

Mr Neale: We look very carefully at the impacts of any measure. I make two points. First, your constituent has the choice of whether to dispose of the business before or after April 2008. Second, the distinction I make is that in the example you have given before he will receive 90% and after he will receive 82% of the gain.

Q217 Mr Brady: But on the sale of a business valued at ₤62,000 the difference in tax take of ₤7,000 is very significant; it is a 377% increase in the tax payable.

Mr Neale: But, looking at investment and entrepreneurship, I think that to retain 82% of a gain in future remains a strong incentive.

Q218 Mr Love: From some of the responses given so far it sounds as if someone within the Treasury listened intently to the Committee's discussion with the academics on Monday. One of the discussions we had at that time related to a report by the IPPR which showed that the number of those in work who had children in poverty had gone up rather than down. This is not a question about the Comprehensive Spending Review, but let me pursue the point for a moment. When we questioned the academic experts on that matter the only reason they could give for that result was the very well known phenomenon both in this and other developed countries of the rate of income increases being much slower at the bottom end of the marketplace. To go back to the questions raised by Mr Cousins about the impact of a 2% pay norm in the public sector, many of those workers are very low paid. Accepting as the academic experts said that the minimum wage is perhaps not going up fast enough and tax credits do not have sufficient impact, will the 2% norm have a negative effect on the delivery of child poverty targets?

Mr Neale: One of the reasons why the proportion of families remaining below the 60% medium income but with an adult in work goes up is that we have been successful in moving people into work. Having said that, there is likely to be a number of factors that can explain the phenomenon you identify. One is that the working adult in some families is employed only part time; another may have to do with the number of children in the family. Large families are more at risk of poverty than small ones, though the disparity is now falling. Those may be factors to explain why there continue to be families in work who nevertheless have incomes below 60% of the medium.

Mr Macpherson: To pick up your point about the public sector, this is a matter that we would look at as part of wage negotiations and encourage relevant service departments to look at, because the public sector wants to be a good employer. We are alive to issues around earnings at the lower end.

Q219 Mr Love: You said that although it was 2% the average would work out at 31/2%, but I suspect that that phenomenon is much less effective at the lower end than at the top end?

Mr Macpherson: I do not know. The reason why one has that effect is that people move through wage scales. One sees from things like Agenda for Change in the health service that people do move up, so I am not convinced that it is a problem across every public service. There may be localised problems that we need to look at. In discussion with trades unions I hope that we would take that into account.

Q220 Mr Love: For all sorts of reasons the Institute for Fiscal Studies has great scepticism about all the other policies we are pursuing in relation to child poverty, in particular some of the ones relating to increasing employment and part-time employment. It produced a figure for us on Monday. It will cost ₤3.8 billion to deliver the target by 2010. That is related entirely to increases in tax credits. How do you counter the argument that that is really the only way to do it?

Mr Neale: I recall that we have discussed this issue in the past. The fact is that because our target on child poverty is based on relative income it is very sensitive to changes in income in the economy as a whole and to changes in employment rates. Therefore, we tend to look at this from each PBR to Budget to PBR and make incremental changes rather than make one big change. As you will have seen, in this PBR there are further measures to supplement those announced by the then Chancellor in the Budget to lift more children out of poverty.

Q221 Mr Love: To turn to capital gains tax, do you believe there is a problem of credibility? To explain what I mean by that, some years ago we started out with a scheme not dissimilar to what you propose. It was then decided that we had to sponsor and incentivise long-term investment. Originally, it was very complex and it talked about eight to 10 years' investment. It was then changed gradually; taper relief changed so it was only two years and now it is to be abolished. We have gone full circle effectively. Is there a credibility problem in that?

Mr Neale: We are now putting capital gains tax on a long-term sustainable basis and one that will be credible.

Mr Macpherson: The tax system evolves. If one looks at capital gains tax, there have been big changes since it was introduced in 1965, for example by Nigel Lawson in 1988 and Gordon Brown in 1997. This is a further evolution.

Q222 Mr Love: It seems to me that if you adopt simplification only because that is what people have asked for, as you seem to suggest, that is only half the equation. I asked the academics on Monday whether any research had been done into whether or not taper relief had ever sponsored long-term investment. Of course, they said that it was incredibly difficult to disaggregate it and find out. Have you done any research into it?

Mr Neale: Yes. We have looked at this very carefully. Our conclusion is that the introduction of taper relief did have a positive impact in signalling a new hospitality to entrepreneurship. This very often happens when one introduces an incentive into the tax system. It has a positive impact at the outset and one finds that it comes under pressure as others seek to take advantage of it and structure deals or their affairs to be within it rather than without it. That is why we are now taking this step both to simplify it and to put it on a long-term basis.

Q223 Mr Love: A couple of days ago I had a visit from PWC. They have done some research into small businesses in this particular area. I talked to them about all the taxation issues related to them. As you will appreciate, most small businesses do not really understand the taxation system that well and so their knowledge and experience in some of these areas is limited. One of the interesting findings of that research programme was that having tracked it over a number of years the knowledge of small businesses about taper relief has grown. We are beginning to see a net benefit to those businesses from the use of taper relief. Just at the time when small businesses begin to understand that there is such a thing as taper relief you abolish it. Is that a sensible way forward? I understand the formal position of the Treasury; it does not want to consult before it introduces tax changes, but should it not have found out how much awareness there was of taper relief and whether the proposals would impact negatively on that awareness?

Mr Neale: Our obligation is to look at the impact of this measure on enterprise and entrepreneurship. Our view is that the new regime we are putting in place will continue strongly to incentivise enterprise, because it assures the investor an 82% return on the gains that he or she makes when assets come to be disposed of.

Q224 Mr Love: I can probably find the exact reverse of that in previous statements made by Chancellors to the House of Commons, that is, that to incentivise enterprise there is a need to introduce taper relief. This is an issue that small business have to face up to. It was put to you that the 18% was a response to the private equity issue. You pretty much denied it. Can we be absolutely clear that this change has not been in response to the whole debate going on about private equity? To go even further, the implication of what you are saying is that it has absolutely nothing to do with private equity?

Mr Neale: We are reforming capital gains tax because of the intrinsic merits of reforming CGT in the way I described, not primarily because of any impact that it may have on private equity.

Q225 Chairman: Let us look at the Pre-Budget Report and the Comprehensive Spending Review. If we turn to page 63 we see a section there about maintaining international competitiveness. Private equity is squeezed right into the middle of that section in paragraph 4.57. Hey presto! When one turns to page 64 one finds paragraph 4.59 which says boldly that the reform of capital gains tax to a single rate of 18% establishes a system that is more sustainable, so private equity and capital gains tax are intertwined. Mr Neale, you say there is no connection; we say resoundingly that is a load of old fish?

Mr Neale: If you will forgive me, I did not say there was no connection.

Q226 Chairman: You have annoyed my two colleagues by saying that before I begin.

Mr Neale: One of the results of these reforms, as I explained earlier, is that private equity partners and managers will pay a higher rate of tax on their capital gains. The point I make is that that is not the main reason for these reforms.

Q227 Mr Fallon: Mr Neale, let us turn to inheritance tax. In the Budget you set out your inheritance tax plans for four years. At what point were these changed?

Mr Neale: The inheritance tax plans announced by the Chancellor are ones that the Treasury has had under analysis for many months before the Budget.

Q228 Mr Fallon: You announced the figures for four years running and then said, reading from your own press notice, that this was "to continue to provide a fair and targeted system with certainty for families". You gave the figures right up to 2010. Why did you suddenly revise the figures on 8 October in the PBR?

Mr Neale: I am sorry; I am not with you. In what sense do you think we have revised the figures?

Q229 Mr Fallon: You announced new changes; you said that married couples and partners could benefit from a double tax-free allowance. Therefore, the rate has increased.

Mr Macpherson: The Budget set out the allowances and they have not been changed.

Q230 Mr Fallon: No. In the Budget you said that you had a system with certainty for families. In the PBR effectively you doubled it.

Mr Neale: I apologise. I did not hear you say "Budget". What we have done has not changed the fundamental underpinnings of the system. The allowances remain the same, but what we have done is make it possible for those allowances to be transferable between partners.

Q231 Mr Fallon: We understand what you have done. The question to Mr Neale was: when did you decide to change it? You said in the Budget that you were providing a fair and targeted system with certainty for families. At what point between 21 March and 8 October did you change your mind and introduce this double tax-free allowance?

Mr Macpherson: The tax changes were announced in PBR's budgets and that was when the decisions were made. Over long periods all sorts of options are under consideration.

Q232 Mr Fallon: On 21 March you said there was certainty for families up to 2010-11. That is a period of three years. I want to know at what point you changed your mind?

Mr Neale: I do not think that constitutes a change of mind, if I may say so.

Q233 Mr Fallon: On 21 March you said it was certain and then you doubled the tax-free allowance on 8 October.

Mr Neale: The allowances are unchanged. I do not believe we have subtracted any certainty at all.

Q234 Mr Fallon: I quote from your own Blue Book: "The Government will therefore make the IHT system fairer", whereas on 21 March you said "to continue to provide a fair system". Therefore, at some point during the summer, or perhaps October, you decided to make a fair system fairer. On what date was that?

Mr Macpherson: The tax system continually evolves and, as you would expect, the Treasury is always looking at a range of options. In this case it is an option that I recall seeing over a long period. This does not represent a change. I do not quite understand the question.

Mr Fallon: If you had seen the option before March you must have rejected it because it is not in the Red Book and suddenly it pops out in the Blue Book. For example, were these inheritance tax proposals revised after 1 October?

Q235 Chairman: As a clue, think of Blackpool.

Mr Neale: I have already explained, and Mr Macpherson has confirmed, that this is an option that the Treasury has had under analysis for many months.

Q236 Mr Fallon: You will not answer my question as to whether these plans were revised after 1 October?

Mr Neale: It is an option that the Treasury has had under analysis for many months.

Q237 Mr Fallon: The Times reported on 11 October that officials had been hurriedly summoned to Whitehall on the Sunday before the Pre-Budget. Is that true?

Mr Neale: I have never experienced a budget or PBR in which Treasury officials have not been working over the preceding weekend.

Mr Macpherson: We do not want to seek your sympathy, but in the normal course the Treasury works before a PBR and it happened that there was a meeting at Number 11 Downing Street.

Q238 Mr Fallon: Therefore, this report is right because after the election was postponed you were summoned on Sunday morning?

Mr Macpherson: No.

Mr Neale: No.

Q239 Mr Fallon: You did not go in that Sunday morning?

Mr Neale: We always come in on Sundays at the time of a PBR.

Chairman: You come in voluntarily.

Mr Fallon: You happened to pick this particular Sunday to come in?

Q240 Mr Love: Are you paid overtime?

Mr Macpherson: No.

Jim Cousins: You have to work Sunday night to produce an index.

Mr Fallon: Mr Cousins will be glad to hear that junior officials can get overtired but senior officials do not. I think you have confirmed that the report was correct.

Q241 John Thurso: Who is the expert on aviation tax?

Mr Neale: I am the expert on aviation tax.

Q242 John Thurso: What is your estimate of the environmental costs of aviation?

Mr Neale: From memory, we have some numbers on the environmental costs of aviation. I do not have them with me, but I can certainly write to you about that.

Q243 John Thurso: The objective of the change in tax from passenger duty to airplane tax is to capture more of the environmental costs of aviation. How much more do you believe they will capture?

Mr Neale: It is to sharpen the environmental signal sent by aviation tax.

Q244 John Thurso: You estimate that you will get ₤500 million and the best that can be offered is that this is to sharpen the signal. Do you not think we ought to have a slightly better idea of the impact and how far it is likely to get us towards the objective of externalising the environmental costs of aviation?

Mr Neale: The per plane tax, because it sharpens the environmental signal, will certainly have some further impact on reducing emissions beyond what would have occurred without the tax. We can also let you have our assessment of that.

Q245 John Thurso: Do you include cargo planes in the new airplane tax?

Mr Neale: That is something on which we shall want to consult in designing the tax.

Q246 John Thurso: You have an airplane tax but you have not decided whether it is all aeroplanes or just some of them?

Mr Neale: We will want to look at the potential impact on freight of including cargo planes. It is clearly one of the issues that will be central to the consultations we shall shortly undertake.

Q247 John Thurso: I remember debating this matter with the current Chancellor when he was Secretary of State for Transport and I was a transport spokesman and he knew all the answers then. I find it rather odd that now he is in the Treasury he has forgotten all of it. This is a fairly straightforward issue. If one wants to make environmental tax work one of the key things is to include all of the aeroplanes that fly, which makes it fairer. That is why the airline industry, or some parts of it, are quite keen on it. I find it somewhat extraordinary that you do not seem to have a clue as to what the environmental costs are, who will be included and the extent of it. Given that lack, how on earth do you come up with ₤500 million over three years?

Mr Neale: We have quite a lot of information about the impact of taxation on emissions from aviation and we can let you have a note about that. We are in the process of designing a new tax. I think you would expect the Treasury to do that in consultation with the industry which will pay the tax and to take account of the economic impacts of various ways of designing the tax, including the economic impact and cargo flights within that tax.

Q248 John Thurso: You just spent 20 minutes explaining to three colleagues that that is the precise opposite of what you do with capital gains tax.

Mr Neale: If you will forgive me, we consult on the design of new taxes, not tax rates.

Q249 John Thurso: Therefore, you will consult on the design of the new tax as far as concern aeroplanes but not capital gains?

Mr Neale: What we have done with capital gains is a reform of an existing tax, not the introduction of a new one. This is an entirely new tax.

Q250 John Thurso: As aeroplane tax is a new tax, for the sake of completeness can you confirm that it will replace the passenger duty and not be additional to it?

Mr Neale: The proposal is that it should replace air passenger duty.

Q251 John Thurso: Basically, you cannot give me any reasonable estimate as to the external costs of aviation, which from memory is ₤1.5 billion, how much you are making from air passenger duty, which is about ₤900 million, and how much of the difference will be taken up by the new tax?

Mr Neale: We can give you our assessment of the environmental costs of aviation and we shall send it to you. I am afraid that I do not have the figures in front of me now.

Q252 John Thurso: A critical part of the case for a tax on aeroplanes and its effectiveness in going for environmental targets, as opposed simply to raising money, is the fact that it gives the operators an opportunity to be more effective. I do not think you dispute that. Everybody is also agreed that you have to bring in freight planes as well as passenger planes. Are you really telling me this is not something that the Treasury has considered?

Mr Neale: Of course we have considered it.

Q253 John Thurso: Or has a view upon it after considering it?

Mr Neale: The case you make is a very respectable one, but I think that in designing this tax we need to examine the economic implications of including cargo flights and consult the industry.

Q254 Mr Brady: I think there is a fairly widespread assumption, certainly in the aviation industry, that the increase in revenue of ₤500 million is predicated on the inclusion of freight aircraft. I am interested to hear that that is not the Treasury's assumption. Is it right to assume that if freight aircraft are included the increased revenue may be higher than ₤500 million, or is it more likely that the cost per passenger flight will be lower?

Mr Neale: The Chancellor's intention is to introduce a new plane tax that will raise the extra revenues set out in the table on page 11 of the PBR. Precisely how that tax is designed will be decided in the light of consultations with the industry and an economic appraisal of the options.

Q255 Mr Brady: Therefore, the cost per passenger flight will be higher or lower depending on whether freight flights are also included?

Mr Neale: Whether or not freight is included may very well affect the tax.

Q256 Jim Cousins: Are you confident that the tax changes on non-domiciles can produce the predicted revenue?

Mr Neale: Yes, we are.

Q257 Jim Cousins: How many people do you believe will pay the ₤30,000 charge?

Mr Neale: We estimate that there are about 20,000 non-domiciled citizens who are in the UK for more than seven years.

Q258 Jim Cousins: Seven years out of 10?

Mr Neale: Based on the information we have about their earnings we forecast that about 4,000 will have sufficient unremitted foreign income to make it worth their while paying the charge.

Q259 Jim Cousins: How does that produce ₤800 million a year?

Mr Neale: In a steady state it produces the numbers set out in the table on page 11.

Mr Macpherson: The proposals on domicile contain a number of measures, one of the most important of which relates to tax allowances.

Mr Neale: It includes measures to close loopholes and a measure to remove the personal allowance from non-domiciled taxpayers. All of those are in the numbers one sees in the table on page 11.

Q260 Jim Cousins: Could I trouble you at a later date to do a little more decomposition for the benefit of the Committee?

Mr Neale: We can let you have an analysis of the measures that are within that line.

Q261 Jim Cousins: You say that you will consult on a wider range of options, specifically an increased charge for longer than 10 years, as we see in paragraph 5.81 on page 91. When can we expect that consultation paper?

Mr Neale: Soon.

Q262 Jim Cousins: How soon? Can we decompose "soon"?

Mr Neale: As soon as we can produce it.

Q263 Mr Fallon: Mr Neale, at what point does one get the number of individuals declaring non-domiciled status for 2006-07?

Mr Neale: We base our costings on HMRC's numbers from self-assessment returns by non-domiciled taxpayers.

Q264 Mr Fallon: I know that, and we have them for 2005-06. The question is: when do we get the figures for 2006-07?

Mr Neale: Self-assessment tax returns for 2006-07 will be available in January, so it will not until mid-way through 2008.

Mr Macpherson: The numbers have been quite stable. I have a time series in front of me: for 2003-04 it was 111,000; for 2004-05 it was 115,000; and for 12005-06 it was 114,000. There has not been very great variation year by year.

Q265 Jim Cousins: Those are the totals. The charge is for seven out of 10 years. Do you have the tracking records for every individual to allow you readily to identify people who have been domiciled for seven out of 10 years?

Mr Neale: We know from the self-assessment tax returns submitted by non-domiciled taxpayers that only approximately 20% remain after seven years' residence.

Mr Macpherson: This is an area where there is quite a degree of uncertainty. Again, we have made our best estimates in the costings. As we have made clear, the knowledge base on this issue is limited.

Q266 Chairman: Mr Neale, the legality of the planned ₤30,000 charge has been called into question because it may count as both a ring fence, according to the words of the former Paymaster General, and a "payment not to tax" based on Lord Gill's ruling in the Al Fayed case. How confident are you that this is legal?

Mr Neale: Completely confident.

Q267 Chairman: What is the likelihood of a legal challenge to it?

Mr Neale: I cannot say what the likelihood of a legal challenge is, but we are very confident that we would win it.

Chairman: Thank you very much.