June 2010 Budget - Treasury Contents


Examination of Witnesses (Questions 90-132)

MR ROGER BOOTLE, MR ROBERT CHOTE, MR RAY BARRELL, MR JOHN WHITING AND MR ALAN CLARKE

13 JULY 2010

  Q90 Chair: Thank you very much, all five of you, for coming today. I am sorry, as those of you who have given evidence before will know, that the evidence you are giving today is somewhat compressed. Can I begin by asking you, Robert Chote, whether you think this is a progressive Budget?

  Mr Chote: The Chancellor said in the Budget speech, "This is a progressive Budget". One issue is: what do you define as being `the Budget', ie, what set of measures do you include in making that judgment? The second question is: what do you mean by "progressive"? The Treasury has presented a set of analyses in the Red Book which is clearly rather more nuanced and precise in its definition in reaching the judgment that the Budget is progressive. It does, as these analyses typically do, look at the effect on the incomes of different households and divides them from the poorest 10th to the richest 10th. Essentially, they do reach the conclusion that it is progressive, it is harder or the richer households than the poorer ones, and a few points are worth bearing in mind here, that, first of all, this is mainly because of the reforms that had been announced by the previous Government that have been stuck to rather than the additional measures that were announced specifically there. It also looks more progressive because the Treasury is focusing on the position in 2012-13 and there are further changes, for example, on benefits that go beyond 2012-13 and you would expect those to hit poorer households proportionately more. In addition, the Treasury does not take account, and neither would we in an analysis because it is very difficult to allocate them to specific households, of the impact of things like cuts to housing benefit, disability living allowance and the in-year changes to tax credits, all of which, you might assume, would hit the poorer half of households harder than the rich. On the other hand, the Treasury analysis does not include capital gains tax changes, which you would expect to hit the rich harder than the poor, but those are relatively small. I think, taking all of that lot together, you would say that the overall impact of the additional measures that were announced in the Budget Statement are regressive if you look at—

  Q91  Chair: Are regressive?

  Mr Chote: Regressive, that is right.

  Q92  Chair: I am sure other colleagues will want to come back to this point in a moment, but I would like to go on to ask Roger Bootle one question, which comes out of a previous evidence session, which is: do you think that this Budget increased the risk of a double-dip recession?

  Mr Bootle: I think the answer is yes, but I would caution against overuse of this expression "double-dip". We heard Geoffrey Dicks say, "Are you assuming that this means two consecutive quarters of negative growth?" in which case it is not really particularly significant, it seems to me. It is possible to imagine an outturn in which there were two consecutive quarters of negative growth, but for the rest of the forecast period the economy is actually pretty strong. I think that media comment has focused excessively on this technical issue of: is it a double dip? I think the more meaningful thing is: is growth going to be significantly weaker or stronger than the forecasts over the period? I think the Budget has increased the chance that growth will be significantly weaker over the forecast period.

  Q93  Chair: By how much?

  Mr Bootle: You know there is no certainty in this, but, for the sake of argument, the emergency Budget forecast for next year suggests that the economy will grow by about 2.3%. My own forecast is more like 1.5%. It is difficult to be precise about how much the Budget itself has reduced growth prospects, not least because so much depends upon what happens to monetary policy and bond yields, and on that of course there can be umpteen different views.

  Q94  Chair: Just before we move on, what are your views on the long bond yield effect of these measures?

  Mr Bootle: This is a sense in which I think, although I adhere to the traditional Keynsian view of how the Budget will impact the economy, the Budget has gone down pretty well and, without a tough Budget, we would be looking at a more difficult situation. We reached a remarkable position under which the UK is regarded as something of a safe haven, or at least it has been recently. Government bond yields are really very low with a 10-year yield of the order of about 3.4% and at the beginning of the year not many people would give them much chance of that happening so, so far, that is looking good. Indeed, I think if short-term interest rates remain low for an extended period, there is even a significant chance that the 10-year yield will fall to 3% or below.

  Q95  Chair: Before I bring in John Mann, is there anybody else who wants to add anything to what has been said so far on that double dip point?

  Mr Clarke: I would agree with that as well. I shared Roger's pessimism on growth for this year and for 2011 particularly. Just to keep this in context, I am forecasting 1% growth, the OBR 2.3, and the most optimistic person in the consensus is looking for 3.2, so the OBR is in the middle of the road. The quarter on quarter path that the OBR is assuming barely has a bump in the road at the start of next year; it goes from 0.6 to 0.5 and then at 0.6 for ever. Now, for the economy to go about 2.3% and then almost 3% the year after that, the newspapers said this was going to be the most painful Budget in living memory. Well, 2.3% and then 3% is not painful at all. I think a quarter on quarter growth could get down to about zero, but then we recover from there. That is not a double dip, that is a soft patch.

  Q96  Chair: A soft patch?

  Mr Clarke: Yes.

  Q97  Chair: Mr Barrell?

  Mr Barrell: It is relatively clear that, if you look at the OBR forecasts, they think the world is uncertain. They are saying that there is 80% chance that next year growth will be somewhere between minus 0.5% and plus 5%, if you look at their chart. That seems to be a reasonable enough distribution, in my view.

  Q98  Chair: It is also reasonably wide enough to make sure you do not make a mistake! Why not make it minus 2 and plus 10?

  Mr Barrell: Well, it could be, but, if you look at forecast errors, which is what they have done, those are the sorts of numbers you get out of forecast errors from the past. In other words, it is a very uncertain process. If, in 2011, this Budget slows growth by 0.4 or 0.5, it means we are 80% certain growth will be somewhere between minus 1 and plus 4.5, so the distribution is very wide indeed, so the probability of a double-dip recession has risen by 4%, or some such number.

  Q99  Chair: So the width of the fan chart has increased, is what you are saying?

  Mr Barrell: No, not the width. The centre of the fan chart has shifted. If we had not had the Budget, the fan chart would have been higher and, therefore, less of it would have been below zero and more of it above 5%, so the whole thing is moving up and down. It is a terribly uncertain world we live in and it has got worse, I am afraid.

  Q100  John Mann: One certainty that the OBR is remarkably independently projecting is that inflation will be for three years, 2012 to 2015, 2%, 2% and 2%, that is, 2.0%, each year, which is a remarkably precise projection. The average earnings growth is 2.6, 3.8, 4.3 at the same time. How do those two figures marry together?

  Mr Clarke: Historically, theaverage earnings growth rate, to be consistent with the Bank of England's 2% inflation target, has been 4.5-4.75%, so I would not be too surprised if there is that gap, so you have got productivity growth which will account for that gap.

  Mr Barrell: The OBR's forecast obviously is different from other people's, but we can say that in the recent past about a third of the shock to labour input has been taken up on hours, that is, hours have dropped. Hours will rise again, so average earnings, which are not per hour but by person, will rise and we will also find the normal addition over the next few years of productivity growth, so average earnings growing at a bit over 2% in real terms from about three years' time is reasonable, maybe a bit high, but it is a reasonable assumption.

  Q101  John Mann: Growing by 2%?

  Mr Barrell: Yes, 2% or a bit more. My personal view is that the OBR is perhaps a little optimistic about the growth of real earnings three or four years out, but, if one thinks that the uncertainty bounds around our output forecast are as high as they are, the uncertainty bounds around the real income growth forecasts three years out are quite wide.

  Mr Bootle: Just briefly on the inflation part of your question, you comment on the fact that the inflation forecast is very precise and I can see that it does seem that way. In fact, this is just a convention that most forecasters would follow, that is to say, the Bank of England has got a target for inflation, we assume they are trying to hit it and over a run of years it seems, on average, that they will hit it. There is, however, an underlying uncertainty about how co-operative, as it were, the economy will be in producing that sort of inflation rate. I think the point is that, if it is not very co-operative, the implicit assumption in the OBR's document is that the Bank of England will take monetary policy action to bring inflation to the target, and that of course could make things very uncomfortable for the growth environment.

  Q102  John Mann: With a big increase in productivity, therefore, projected at a time of labour market flexibility, these new jobs that are coming in, what sectors would you expect them to be in?

  Mr Clarke: You are right to address that point, but I was talking about the gap, and 4% or so wage inflation does look a bit "go-ey" in the sense that demand for workers relative to supply, and my own view is that wage inflation should be lower. In what sectors will the jobs be coming? Manufacturing has done quite well for now, but a lot of the upstream indicators are turning down, so I do not think they will have such a good run over the next 12 months or so. The services sector has fared a little bit better, but I do not think there is going to be as much hiring as the OBR assumes because I do not think we will be growing in excess of the economy's trend growth and, when that is the case, you tend to have job losses.

  Q103  John Mann: So you think the projections on private sector job growth are overstated, the OBR's projections?

  Mr Clarke: They are fairly internally consistent given their optimistic growth forecast. Relative to my own view of where the economy is going to be, I am not as optimistic on hiring.

  Q104  John Mann: Any other comments?

  Mr Barrell: A similar comment, that in five years' time they have the output gap nearly closed and we might suggest it is not quite so closed as they think. The output gap closed means that unemployment is around about back to normal. Employment might be slightly slower than the OBR think, but again it is a very uncertain matter. We are liable to see employment growth, but we cannot always predict which sectors are going to grow because it depends upon who invents what where and who demands what where. One thing we can be reasonably clear on is that some of the growth will be export-related.

  Q105  John Mann: Mr Chote, on job losses in the public sector and the average earnings and average income tax take from those jobs and new growth in the private sector, what I have suggested earlier is a potential differential between the two, and that would have a negative impact on the forecasts on income tax take, possibly significantly so. In your Institute for Fiscal Studies, are these figures here on income tax take overly optimistic?

  Mr Chote: Well, I think that depends very much on the overall path of spending in the economy. The breakdown between the two is important, but essentially they are basing, and in a similar position other forecasters are basing, their income tax revenue forecasts on the overall wage bill in the economy. Now, you are assuming that there is obviously fiscal action taking place which takes demand out of the economy which takes workers out of the public sector, but essentially, as Roger was saying, we have an environment in which the Bank of England is essentially tasked with achieving an inflation target and, therefore, keeping the overall amount of nominal spending and activity in the economy where they think it should be in order to deliver the inflation target. Unless you think you are skewing the mix of that total nominal spending in the economy or total nominal income in the economy between the total amount that goes to wages and to other sources of income, it is not necessarily unrealistic that they should base the forecast off the aggregate wage bill.

  Q106  John Mann: If I am an employer of new employees, who am I going to employ if I am in one of the growth sectors, let us say, distribution or in retail, let us say, supermarkets, which has been a consistent growth sector in the economy in terms of jobs? If I am opening up a new supermarket, who am I going to employ? Am I going to employ a 45-year-old redundant public sector worker earning average public sector pay before, or am I going to employ a keen 20-year-old who is looking for work and just turned up from somewhere else within the European Union?

  Mr Chote: Well, we have not exhausted the supply of labour outside those being released from the public sector, so there will still be some people to go for there. Clearly, there is an issue about the people coming out of the public sector and some of those are going to be coming out with more transferable skills than others and that is presumably going to affect their relative employment chances, but, given the size of the output gap we have at the moment, the idea that there is no spare capacity in the labour market other than that which is going to be released as a result of the public spending cuts is probably not correct.

  Q107  John Mann: My final question is on this question of spare capacity because spare capacity in the labour market of course incorporates anybody who wishes to come here from within the European Union. Looking at what has happened over the last 10 years, is it not probable that a very large growth in private sector jobs in the short term in the economy in the UK will lead to, as we saw before, significant numbers of those jobs being taken up by young, relatively cheap, migrant workers coming from elsewhere in the European Union?

  Mr Barrell: Some of the work that people quote on migration and the Pre-Budget OBR Report quoted as well comes from the Department of Communities and Local Government's report on the effects of the recession on migration. I am probably one of the few people that has read it because I wrote it, so that is why I can give you a specific answer. We judge that perhaps the recession and the scar on output will reduce the stock of migrants in the UK by about 350,000, and that is a permanent shock and there are two reasons for that. Countries such as Poland, Australia and the Indian Sub-Continent have actually suffered less in this crisis than we have and people are less willing to come. Secondly, the Poles who have gone back, and it is the Poles in particular who are interesting, came here because we, the Irish and the Swedes were the only people who allowed them to work. When they start to come back as the whole of the European economy recovers, they will have the German, the French, the Italian and the other markets open to them, so they will not all come back here, so we are unlikely to see such a large rise in the number of migrants after the recession as we have seen beforehand, so I suspect a lot of those jobs will not be taken by Poles because they can earn more in Germany than they can in the UK and five years ago they were not allowed to go to Germany, so yes, there will be some inevitably, but we can say something about the numbers that there may be. There have obviously been changes in policy since then which would also change the number of migrants who come here, so I personally would revise my projection downwards and, if downwards, that is a larger impact on the stock of migrants than we previously thought.

  Q108  Stewart Hosie: You said that part of employment growth will be driven by exports, the export sector, and much of the growth forecasts are driven by an expectation of higher exports, but we have gone, since 1977, from a balance of trade effectively in balance, £1 billion surplus, to a £30-plus billion total deficit, an 80-plus deficit in the traded goods and a million lost manufacturing jobs associated with much of that before the recession. That is an incredibly deep trough to start from, so are you confident in terms of the Budget, the Finance Bill and forecasts that we can actually deliver this export-led growth that is intended?

  Mr Barrell: Well, over the next five years, probably yes. Over the next year or two, there are serious risks from our major market, the European Community. We have seen a major decline in the value of sterling against our competitors in the last two years and that will eventually feed through into stronger volumes, and I base that not on comparisons with previous recessions, but just on the standard statistical work we do all the time on the relationship between relative prices, the level of demand and the level of exports. Exports at some point or other will take off, but it could take two or three years for the effects to feed through, so it will happen slowly, we think.

  Q109  Stewart Hosie: I appreciate that there is a lag in these things, there always is, which is why we why we went from a £93 billion deficit in the traded goods up to a fantastic £82 billion deficit in the traded goods, but that was with a 25% reduction in sterling against the dollar and a 15% reduction in sterling against the euro over a pretty prolonged period. Now, if the forecasts from the eurozone are not great, if there are shocks to the euro which may be anticipated, if the stress-testing is adequate or if there is a loss of confidence there, then does that not damage those forecaster hopes even further?

  Mr Barrell: Any shocks on the downside would damage the prospects even further, but we have to remember that shocks can be on both sides. The stress test may, for instance, discover that there are no banks at risk in the euro area and suddenly we get a rebound in activity. I think that is rather unlikely, although normally the risks are distributed.

  Q110  Chair: Usual probability functions!

  Mr Barrell: That would be to discuss things I discuss with the FSA and the BIS in Basel, so I do not think I am in a position to do that!

  Q111  Stewart Hosie: Finally, in terms of the demand side, let us suppose the euro booms and people buy our goods and all that kind of good stuff, but in terms of the supply side, is there enough being done to ensure we have the service capacity and manufacturing capacity in order to meet the things we might want to sell, assuming we can design them properly and price them properly?

  Mr Barrell: One of the things that is clear in the UK is that over the last 10 to 15 years the economy has actually become more flexible, we have actually made the economy more efficient, and I think the conditions for that sort of growth are there. They have been put in place, not just by the previous Government, but by the last few years of the previous Conservative administration. That comment comes from a paper I did on accounting for UK growth for the European Commission and it was presented a few weeks ago, so it is not just a random thought, but there is a serious piece of research behind that. I think the UK economy's flexibility is sufficiently great that the market will work to produce those jobs and that capacity.

  Q112  Andrea Leadsom: I would like to talk to you a bit about the banks and the impact of, particularly, the bank levy, but also on the effect of the health of the banking system in terms of supporting our economic recovery. First of all, on bank lending, the OBR representatives earlier were suggesting that there is a lot of internal funding of expansion going on and that companies are actually now carrying a lot of cash in their balance sheets, so were not so dependent on bank lending to recover. Would you, as a panel, agree with those assumptions, or do you think that bank lending is absolutely key?

  Mr Barrell: There are two parts to the answer. It is relatively commonly agreed, and it is commented on in the Budget, that part of our problem in the run-up to the crisis is that we were borrowing too much. If we are borrowing too much, that means the banks are lending us too much, so perhaps we should hope to see an economy where banks lend rather less than they have been in the medium to long term. Now, in the short term, there can be some problems from the fact that banks are not lending enough, but one has to be very careful about that. Lending to consumers might stoke another house price boom and that would not necessarily be good. Lending to firms, well, firms do not report enormous problems with their borrowing and they do have internal resources, but we also have to recognise that this crisis has caused a reassessment of risk and, therefore, a reassessment of the equilibrium capital stock firms want, and they will want to invest less and that will mean they will want to borrow less, and that is part of what was in the forecast, that everybody's forecast has weak investment because of that scar and, therefore, weak borrowing because of that scar. I think we would be advised to worry less about the amount the banks are lending and worry more about what is happening in the real economy.

  Mr Bootle: I take a rather different view on that, I have to say. I think there is both a problem of the demand for bank finance and the supply of bank finance, and the OBR was surely right to stress that, on the whole, this is not a significant problem for large companies which have substantial internal resources. Also, of course large companies have access, in principle, to the bond markets and the equity markets. I think we are talking primarily about small- and medium-sized businesses which do not have that access and often do not have internal resources as well, and what I think has happened as a result of the crisis partly, as Ray Barrell was suggesting, may be that in equilibrium, as it were, they might want to borrow less because the future does not look so good and they should not be wanting to borrow for investment, but a lot of it, I think, is actually uncertainty and worry about continued access to finance and they have been frightened by what has happened in the crisis. The evidence is too plentiful to ignore, that the banks have tightened their terms extraordinarily and a lot of firms have felt this was very, very destabilising indeed and the reaction has been to say, "Well, we're just going to have to minimise our dependence on the banks because you can't trust them or depend on them". Equally, at the same time, it is not all a demand-side problem, but the banks, for reasons which I think are understandable under the pressures they are under, have become more risk-averse and, therefore, they have tightened the terms on which they are prepared to lend, and this is a factor, I think, which makes one, or me anyway, inclined to the view that investment, in particular, is going to struggle to recover at quite the pace that the OBR suggests.

  Q113  Andrea Leadsom: So, just turning to the bank levy, do you think that the banks have had an easy ride with this bank levy combined with the reduction in corporation tax, or do you think that this has done more damage to banks' ability to lend particularly to SMEs, which I think is the area that we are most concerned about?

  Mr Bootle: Well, it does not help in terms of taking resources from the banks, and it is very difficult, I think, to argue that banks should be lending more and at the same time asking them to hold more capital and/or imposing some sort of levy on them; these things are actually in contradiction. However, the amounts are not huge, I have to say, and I would regard this as more of a gesture, but in relation to the reaction of the banks, it is a gesture that does not help because all the time of course the banks are fearful of how the climate is developing with regard to their own activities, so many of them are worried that we are moving into a regime in which the political environment is very unfriendly to the activities that they wish to undertake, so they think about reducing the scale of those activities or even moving them elsewhere.

  Mr Whiting: As a comment from a tax point of view, you are absolutely right to link the bank levy with the reduction in corporation tax rates, because there is an element here for the profitable banks that the levy will claw back what would have otherwise been a bit of a bonus for the profitable banks with the reduction in corporation tax rates. There is, clearly, a lot of worry amongst the international banks that this levy will be matched by similar levies in other countries which then will not offset and it will all be cumulative. As Roger has alluded to, there is also a worry that this is also adding to the amount of extra regulation that is on the banks. Also that it is setting a bad atmosphere and it is not giving them the confidence to do the extra lending to, as has been said, the small- and medium-sized sector which, in many ways, is the one that is most wanting finance, so there is quite a lot of things swirling around. The good thing about the levy is that there is active discussion with the banking sector about its design to try to minimise the burdens, but what actually comes out remains to be seen.

  Q114  Andrea Leadsom: So do you think that it might push banks overseas? Obviously, banks are pretty international anyway, but do you think it might make them change their headquarters?

  Mr Bootle: I do not think the levy, as such, is significant enough to have that effect, would be my judgment. I think the way to see it is as just one of a whole series of things both already in place and mooted or threatened in the future which banks find uncomfortable. That is not to say of course that they should not necessarily be done, but, from the banks' point of view, the idea that they have got hanging over them a possible enforced break-up is, in my view, much more significant than this bank levy.

  Mr Whiting: I would agree with Roger. I do not think this is going to push banks overseas, particularly because they are looking and seeing a lot of other countries contemplating something similar. I think one of the things that this Government should be doing is actively engaging with other countries to try and co-ordinate the levies rather than have sort of everybody try and pick off their own. That is why we have double tax treaties to try and control interactions with general taxes; we want to make sure that there is not a significant doubling up of bank taxes.

  Q115  Mr Umunna: I would just like to probe a bit about the public spending cuts being imposed by the current coalition Government, and actually I will direct this to maybe Mr Bootle, given it was you, I think, who said a little earlier that the UK was being seen as somewhat of a safe haven now. Do you think it is absolutely necessary to be making the degree of cuts envisaged by the coalition Government within the four to five-year timeframe? Do you think there is any possibility that this could be done over maybe six to seven or seven to eight years? Do you think it is absolutely necessary for it to be done over four to five years?

  Mr Bootle: I do not think in this subject area that the word "necessary" is particularly helpful. I think of it as there being a spectrum essentially of possibilities.

  Q116  Mr Umunna: Well, maybe I should rephrase it. If it were to be done over a slightly longer period, do you think that would have a significant material impact on market confidence in the UK?

  Mr Bootle: I think this is where the political process intervenes because what the Government wanted to do was to eliminate the structural deficit within a Parliament. In straightforward economic terms, I am not sure it would make a great deal of difference if the adjustment were over a longer period, but we have to face the political reality of when parliaments change. Where, I think, there would be scope for the burden to have been distributed differently without adverse effect, I suspect, on the market is if more of the burden fell later in the period rather than earlier. As it is, I think that the programme is pretty good in this way because it does build up, the tightening builds up gradually over time, so the full thrust of the tightening comes later in the period. That is good, but it would have been possible to have designed it so that that happened even more so, but there are no free lunches in this area. To the extent that you do that, you also, to some extent, lessen the credibility because we all know, having observed governments over many, many years, that actually words are cheap and it is quite easy to make promises about what is going to happen in several years' time.

  Q117  Mr Umunna: In that regard actually, can I put this to you and also to Mr Chote. How plausible do you think it is that the Government, leaving aside the ring-fenced areas, leaving aside education and defence, are actually going to be able to make these spending cuts in the other departments of what we are talking, 33% and maybe more? Do you actually think it is feasible for them to be able to do that?

  Mr Chote: It is feasible if you are willing to take the consequences for the quality and quantity of public services you are able to deliver. Now, clearly, an additional choice before you get to the 33%, which, as you say, sort of falls out from assumptions you make about the areas you are protecting, is on what, if any, additional savings will be made on the welfare and social security budget because that is the other part of public spending where you can make savings in that way and loosen the restriction of public services, but that has different consequences.

  Q118  Mr Umunna: Realistically, what is the consensus amongst people in your industry as to what they are going to be able to do in terms of cuts in the non-ring-fenced, non-education and non-defence departments?

  Mr Chote: Well, I think you only have to look at the fact that, ignoring the ring-fencing, you are looking at a six-year period which implies the largest and most sustained real cut in public services spending at least since the Second World War, so it is not as though we have a great deal of historical precedent to say, "Well, the last time we tried spending cuts of this magnitude, it was able to be achieved there", so, in some senses, we are in the unknown there. As the previous session pointed out, we have had a fiscal consolidation of roughly this size before in the early 1990s, but, if you look at, for example, the Clarke and the Lamont budgets of 1993, the split between tax and spending, and it is hard to be precise about it because there was less information available then, it was roughly 50:50 between taxation and spending, whereas now you are looking at an overall consolidation that is roughly 75:25 by the end of the process, so more is being done on spending within a consolidation that is, arguably, not of unprecedented size.

  Q119  Mr Umunna: If they cannot achieve what they want in terms of cuts and they look towards reducing welfare expenditure, what is that actually going to look and feel like for my constituents?

  Mr Chote: Well, very painful for those affected and, for example, we had roughly, depending on which year you look at, an £11-12 billion discretionary cut in social security spending announced in the Budget. If you were to implement the same amount again at the time of the Spending Review, that would allow you to reduce the 33% squeeze in the unprotected departments to something like 25, so it is not as though doing the same amount again on welfare completely removes your need for tough decisions on the public services side either and, as you have seen with some of the consequences of the welfare decisions that were made in the Budget, making more of them would mean that more sacred cows would potentially be there for slaughter if you were to try to raise similar sums again.

  Q120  Mr Umunna: So the bottom line is that, if they are not able to achieve the spending cuts they want, they are going to have to slash welfare and, if they want to avoid doing that, they are going to have to look again at the period over which they look to make the reduction and wipe out the structural deficit. That is the bottom line and it seems to be one Mr Bootle and indeed yourself are telling me.

  Mr Chote: Yes, if you extend the period, you may still end up with the same eventual percentage cut in public services spending, but it is just going to be taking longer to do it. The other margin of course is that you can revisit the split between taxation and spending, so, if it looks unachievable on the spending side and you do not want to relax the fiscal targets, it is tax that has to move.

  Q121  Jesse Norman: Just to pick up on some of those issues for a second, Robert Chote. The IFS have done some excellent work in pointing out that you can view VAT either from an income or an expenditure standpoint, and each gives a different view as to whether you consider it to be progressive or not. Do you think it is a bit niggardly to call the Budget "regressive" on the back of assumptions already made, and accepting Labour's existing plans? Would not the fairer thing be to say that the whole package is progressive, in part, because of the original inheritance that has been taken over and adapted?

  Mr Chote: I think what we have done is pointed out that those are true and it depends on, as I say, what definition of "the Budget" you are using as to whether you are including the pre-announced measures. The Chancellor, in his Budget speech, said, "This Budget is progressive, I think", and I think most people would read that statement in isolation as meaning the newer measures announced in this Budget, rather than this Budget plus what was inherited from previous budgets, were progressive, but, if you look at the analysis that is in the Red Book, the Treasury is very clear and precise about what it means there in, as I say, focusing on 2012-13, focusing on a subset of the tax and benefit measures and those things which it has included and excluded, so the question in the Red Book is posed more precisely and answered correctly, whereas, inevitably, in a speech you cannot go into all of those details, but it is just worth pointing out why the pictures look different depending on how you are going to ask the question.

  Q122  Jesse Norman: In reference to the 80:20 balance that the Chancellor is expecting, I would just like to ask the panel where they come out on the wisdom of that balance, bearing in mind two things. One is, from an economic perspective, is it true that 80:20, as was suggested, was, as it were, the best economic balance to be struck between the two sides of spending cuts and tax rises, and the second is what about the glide path to 80:20. Because we end up with 77:23, I think it is, but we start at 60:40, much closer to the Lamont/Clarke era. Maybe other members of the panel could contribute as well?

  Mr Chote: It is clearly true that the total tax increase builds up pretty quick and is then static and you are doing more on spending in the longer term. I think that, given the way in which you plan public expenditure, that is not entirely surprising. Clearly, if you are looking to take the sorts of dramatic reductions in public services spending that you are talking about there, the idea of being able to do that very rapidly, clearly, it is very difficult doing it slowly and it is even more difficult doing it rapidly. With taxation, you are able to move more quickly and to get some of the job done earlier so, as Roger says, you are persuading people that you are on a relatively stable path with the consolidation as a whole. I think again though, if you go back to the early 1990s' consolidation, you had more pre-announcement and phasing in of the tax measures as well as the spending, so the tax measures took longer to build up in that consolidation than they do in this one, but that partly again comes down to the fact that you were looking at a very different mix of tax and spending in aggregate, so more of the job was being done on taxation in the early 1990s than it is now.

  Q123  Jesse Norman: Right, but the Chancellor is saying there is a specific technical point which was that the best economic advice available, in this kind of situation, recognising that they were very rare, was in favour of that kind of balance, that level of balance. Other economists went on about the technical point, but the question is what economic evidence supports that view.

  Mr Barrell: As I wrote something on it just before the Budget, may I comment. There are three things you can do when you have got a very large deficit that is caused by something. One is to cut public sector wages, and there is a strong case for doing that because private sector wages are adjusting to the scar to the economy we have got, so you can get rid of some of the deficit by adjusting public sector wages. Then you have got the options of either closing the problem that you might have with large deficits and a large debt stock by either raising taxes or cutting spending. It is quite clear that in the 1970s and 1980s and maybe even the early 1990s cutting spending was more effective than raising taxes because it involved more commitment. The recent research by the European Commission, who are very much spending-cutters rather than tax-risers, suggests that that balance of advantage has actually changed and that, although there may be some advantage to cutting spending, raising taxes with the right institutions in place, such as the Office for Budget Responsibility, might well be equally effective as cutting taxes, so there is a decision to be made. Does the economic evidence support the 80:20? If you look at the last 50 years, yes. If you look at the last 15 years, less so, although there might be a bias in that direction, but we also have to remember that things like ring-fencing certain types of spending and deciding on the size of the public sector can be a political decision as much as an economic decision. It is not for me, as an economist, to say what the optimal size of the public sector is; that is for the voters and the politicians to decide. Therefore, 80:20, there is some evidence for it, and 60:40, there is also some evidence for that.

  Mr Bootle: I do not think it is possible to defend, as it were, precisely 80:20 or 75:25 on the basis of the evidence, but there is quite a lot of evidence from a range of fiscal consolidations in the past ranging across Canada in the 1990s, Sweden, Finland, a whole series of examples which have been examined by a number of international bodies, and there were papers published in the UK on this to to suggest that it is more likely that your fiscal consolidation could be accompanied by sustained economic growth and it is preponderantly done with regard to spending cuts rather than taxation. I have to say, I do not find this altogether conclusive or persuasive and there is a considerable room here, I think, for political discussion and debate which, as an economist, I have got no role in. However, one point I would like to make is that one ought to make some reference to what has been happening recently before this fiscal crisis. Did we get to this position because taxes were cut to a considerable extent, or did we get to it because expenditure was increased to a considerable extent? When you think about what measures should be taken to address the fiscal crisis, you ought to look at the balance of the things that changed, and I think the evidence is pretty clear that in this country we have not been suffering from excessively low taxation and we perhaps have been suffering from excessively high public spending.

  Q124  David Rutley: The need for a stronger private sector-led recovery is implicit in the Budget, but I have been interested in your views particularly on the strength of the package of measures in the Budget that will help SMEs generate jobs, particularly in the regions.

  Mr Clarke: One particularly encouraging measure, I think, was the tax incentive to hire outside of the South East. If it is successful, yes, that was a very good idea. In terms of small- and medium-sized businesses, it is just coming back to the question of the banks and their lending. I am a bit worried by the latest Bank of England Credit Conditions Survey which is showing that the availability of lending that lenders expect over the next three months is going down. If the bank levy means that banks try to minimise the size of their balance sheets, they may lend less and it is not the big firms that are going to suffer most, it is the SMEs, so that would be a concern at the back of my mind.

  Mr Whiting: The national insurance holiday idea is certainly a worthwhile experiment for the small, new business with new employees. There are other things, no doubt, which could be done. There is a certain amount of concern about the reduction in the annual investment allowance, the 100% allowance, which is obviously of particular significance to small- and medium-sized businesses, although the proposed £25,000 limit will certainly cover an awful lot of small businesses. It is the medium business that perhaps falls into the potential £25,000-100,000 investment level in that there will be less allowances for them.

  Mr Chote: On the NICs holiday, it will obviously be interesting to see how that performs, an exemption from one year to the next, first 10 employees hired, first year of trading by businesses that have been set up in the last three years outside three particular regions of the country, up to a maximum of £5,000. I remember reading about simpler, flatter tax systems a while ago and that is not, I think, a move in that direction.

  Q125  David Rutley: So your concern is about complexity.

  Mr Chote: It is complex and it is estimated to cost less than £1 billion. If you are trying to protect employment, the case for providing support for start-ups relative to existing businesses that are feeling under pressure to let people go, it is not necessarily the best allocation of support.

  Q126  David Rutley: Do you think that it should have been capped to businesses of a certain size? What would your preference have been to take it forward?

  Mr Chote: You can push it in different areas if you want to make it more or less expensive. To what extent that sort of measure in terms of its size and magnitude is going to make a large material difference is unclear and depends a bit on what your actual objectives are for the policy to achieve. This may be a little too complicated to offer the best value for money.

  Mr Whiting: Yes. I view it as a bit of an experiment that needs evaluating after it has been in place for a little while.

  Q127  John Thurso: A quick question first to Roger Bootle, if I may. Did you hear the last session by any chance when I was asking about growth and pointing out that the historical judgment on this Budget will be if the growth is attained and the rebalancing happens? Geoffrey Dicks replied that the OBR merely applied the economic formula to what they saw and came out with a result and they did not look at any measures particularly. Do you think there are sufficient in the way of measures either being taken through the Budget or through the Business Department to actually achieve that or can we just rely on the application of the maths to arrive at those growth levels?

  Mr Bootle: I am not sure that there is a very great deal that can be done in an overall financial constraint to boost growth. After all, if you take some particular measures to boost growth then you are taking money within that constraint from some other area which prima facie you would imagine would reduce growth. There might be particular things that intelligently can be done which might boost growth. I do not think one could just pick these off the shelf, but there is a legitimate role here for Government to investigate these. Let us take, for instance, road pricing, which is an area that the Government has said it is not going to proceed with. If it were to embark on a policy of road pricing I think the structural consequences to the economy would be so big that I could imagine a whole series of private investment decisions that might follow from that. Another is the regime with regard to planning permission on residential property. If the planning regime were easier, and of course there are objections to this, this would not cost the Government any money but it could potentially lead to much greater private spending on residential investment. There are a series of things like that which the Budget does not seem to address or discuss where I think there is legitimate room for debate and discussion.

  Q128  John Thurso: Can I turn to the vexed subject of VAT. I am genuinely trying to decide for myself what the impact is on people and there seems to be a massive debate going on which sheds more dark than anything else. In your Green Budget in 2009 you had a wonderful section "Debunking Myth 2: VAT is a regressive form of taxation". It is obviously regressive on income and nobody is going to argue with that. In your analysis of the emergency Budget you had two slides which caught my eye, one as a proportion of income and the other as a proportion of expenditure, and the following slide which talks about hitting those with high expenditure the hardest, and so on. Can you give me a factual explanation? Is VAT ghastly and regressive and absolutely whacks the least well-off or is it actually, as others put it, a good way of raising money that does not impact on growth as much and therefore is fair? What is the real story?

  Mr Chote: If we take the regressive/progressive argument to begin with, it depends really on whether you are looking at its impact on people according to their living standards in a particular snapshot as measured by income or over a lifetime period. The reason that VAT looks particularly regressive if you do the standard comparison against income is that the poorest decile spend a relatively high amount relative to their income, you hit high spenders hardest and, therefore, not surprisingly that shows it to be regressive. If you take the alternative view, and as I say these are alternative views, there is not a right answer to this, and divide people up by the amount they spend, arguably what people are spending is a better indication, a better proxy for their lifetime living standards. For example, there will be some people on relatively low incomes who are consuming past savings. There will be some people in self-employment whose incomes are volatile and who may be at one end of the income distribution one year if you are doing the snapshot and a different point at the other. On balance, the consensus would be that total expenditure is probably a better guide to people's lifetime living standards and so that would give you a less regressive or a progressive pattern overall. In terms of whether it is the most efficient way to do it for the economy, there is an argument that says that increasing VAT you are taxing both incomes and past saving because it is on what people are spending and taxing past saving is less inefficient as you are taxing decisions people have already made rather than distorting decisions they are going to. That said, the way that VAT here is being increased by increasing the standard rate is widening the differential between the tax treatment of those items to which the standard rate is applied and the zero and reduced rates and to that extent it further distorts people's spending choices in a way that means they are getting fewer of the goods and services they want for every pound they are spending. In that efficiency sense there are arguments for saying that VAT is a relatively efficient way of raising money but this way of raising VAT actually makes the VAT system as a whole more distorting rather than less so. As ever there are arguments pointing in both directions on both the distribution and the efficiency side.

  Mr Clarke: Can I just add something quickly on timing. We thought it was quite skilful that the timing comes in early next year because if it is the low income groups that are hurt most by it it is coming very close to the time at which the personal allowance is starting to increase, so that does soften the blow somewhat. It is also skilful from a second standpoint, which is we saw from the June MPC Bank of England minutes some members of the Committee are sensitive to elevated inflation right now, so myself and a number of other forecasters thought it was perfectly plausible that could have gone up imminently which would have fanned those flames and maybe caused more people on the MPC to vote for interest rate hikes sooner rather than later. By doing it in January you are coinciding with base effects, ie the VAT hike a year ago, so you have minimised the impact on inflation, so the timing is quite good.

  Mr Chote: If you are concerned about double-dip in the short-term it does bring some spending forward from next year into this year but that depends on where you are worried about the double-dip.

  Mr Whiting: There is also a benefit for the lower income people with the increase in child tax credits. I was slightly surprised that the Chancellor did not explicitly make the point that the increase in child tax credits, which is above inflation, is not some sort of compensation for the VAT increase because, again along with the personal allowance increase, it is obviously geared at the lower paid and is some compensation for the general reduction in the tax credits. Coming back to Mr Umunna's point, there are already some quite significant reductions in tax credits around. VAT is an efficient tax and it is at least a tax we know and quite easy to collect—

  Q129  John Thurso: If you looked at a balanced comment on it, it is not that fair but it is not screamingly unfair and taken in the round with everything else it all comes out in the wash. That seems to be what you are saying.

  Mr Whiting: If you want to raise the money from somewhere it is at least known. It is in line with European rates. Our rate will still be relatively modest but, as people have said, it does highlight even more the differentials between 20% and the 5% or 0% rates. There are arguments that it gives a boost to the hidden economy rather than anything else because it increases that incentive. As the Low Incomes Tax Reform Group has said, it exposes many of the anomalies around things like the disabled welfare bits where there are some very odd boundary issues between what is taxed and what is not.

  Chair: Andy Love, you wanted to ask one quick question.

  Q130  Mr Love: It is one question in two parts. I want to ask the economists amongst the panel whether they accept that lower growth than forecast will increase the proportion of the Budget deficit that we could call structural?

  Mr Chote: It is not so much lower growth but lower potential growth. The main reason why the hole in the public finances looks a bit bigger than it did in Alistair Darling's final Budget is the fact that the OBR has taken a more pessimistic view of the future path of trend GDP, ie how far the economy can grow to get back to a Goldilocks state. If there is less scope for it to grow then there is less scope for the deficit to come down automatically so more of it looks structural.

  Q131  Mr Love: I am talking where trend growth stays the same. If growth going forward is lower does that increase the structural deficit? I am not getting much response from our economists.

  Mr Barrell: If we look at the structural deficit at this point in time or in 2011 if fiscal policy has slowed growth, which it probably has, that has not changed the structural deficit. If growth which in the long run will be driven by the trend rate of growth in the economy is slower then again the structural deficit may look bigger. Judging the structural deficit now, which is much more important than going forward, we have to make the judgment on how much this crisis has caused the scar to output. There are different estimates of the structural deficit at the minute that range from 10% to 0% of GDP depending on how much we think the crisis has caused a permanent loss of output and a temporary loss of one. There are delicate judgments to be made. Slower growth next year does not change the structural deficit. Slower growth over the medium term with no change in spending plans would worsen the structural deficit.

  Q132  Mr Love: I should have known that. Let me pose what I was trying to get at. If trend growth stays the same then growth going forward reduces and the structural deficit increases. On the basis that we have got to wipe out that structural deficit within a fixed timescale, does that then force us into a straitjacket of tax increases or cuts in expenditure? That is the question. What is the answer? Mr Bootle is being very coy about responding to this.

  Mr Chote: The fact you have a target for what you want to do, the structural part of the current Budget balance is not affected by how strong actual growth is over that period, so the contrast will be with the previous government which had a target for the actual level of the deficit in 2013-14, as I recall, which did have the odd characteristic that despite its espousal of Keynesian policy if you took it literally and you had weaker growth and the cyclical component and the deficit was higher you would have had to cut spending or increase taxes to do that. This is less perversely anti-Keynesian than the rule that was in the Fiscal Responsibility Act.

  Chair: I am going to bring this session to an end for the time being and you can pursue it informally. We have got another group of witnesses about to come before us. Thank you very much all five of you for coming in. I hope this will not be the last time that we have the opportunity to hear what you have to say. What you have said will no doubt be reflected in our report on the Budget which is going to be produced as soon as possible. Thank you very much.


 
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