Evidence heard in Public

Questions 112 - 240



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Oral Evidence

Taken before the Treasury Committee

on Tuesday 27 March 2012

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Mr Andrew Love

Mr Pat McFadden

Mr George Mudie

Teresa Pearce

Mr David Ruffley

John Thurso

Examination of Witnesses

Witnesses: Roger Bootle, Managing Director, Capital Economics, Brian Hilliard, Chief Economist UK, Société Générale, Jens Larsen, Chief European Economist, RBC Capital Markets, and Jonathan Portes, Director, National Institute of Economic and Social Research, gave evidence.

Q112 Chair: Thank you very much for coming. This is a pretty intensive day for the Committee, necessitated by the structure of parliamentary business and decisions, the end of the parliamentary Session, and problems like that, which are all beyond our control. We have two newcomers to the sessions today-welcome aboard Jens Larsen and Brian Hilliard, and thank you very much for coming-and two old lags, whom we welcome.

I will begin with one of the new team. Mr Larsen, do you believe the OBR’s estimate, and therefore the Government’s estimate, of spare capacity, and, if you do, do you think the gap should be plugged by monetary policy-that is, the policy of monetary activism and fiscal conservatism?

Jens Larsen: First, thank you very much for the opportunity to appear here. Another thing I appreciate is the opportunity to glance at the output gap from the OBR’s publications. I think that the fact that they published one at the weekend, to look at carefully and assess this, is a very important element that other forecasters don’t provide.

I think the OBR’s assessment of the output gap is reasonable. I thought the change they made in November, when they reduced the level of potential output-the rate at which the economy can grow substantially in the near term-was the right judgment. I am a little bit more sceptical than them about the return to a normal growth rate, but that is small beer in comparison with the main assessment. So I think it is a sensible call; but the important thing is, of course, how that maps into decisions: how that maps into the assessment of the structural deficit, and how that maps into the monetary policy side-to monetary policy actions.

Can monetary policy close the output gap? Well, actually, if you look at the OBR’s forecast, it takes the full horizon to close the output gap; that would mean expansionary monetary policy for a very sustained period of time. So I think the notion that expansionary policy, monetary policy alone, can do this, is probably flawed.

Q113 Chair: What should the Government be doing, then?

Jens Larsen: I think the strategy that is in place-the fiscal strategy, but also the monetary complement-overall makes a lot of sense, and it’s certainly a strategy that has been understood in the market. So the strength of fiscal consolidation, the commitment to that, combined with the fact that the Monetary Policy Committee can respond to a slowing economy by expanding monetary policy, is very well understood in the gilt market, and very widely appreciated among the people I meet in the international investor community. So I think that’s absolutely essential. There is a very real question of whether you could have chosen a different path, where you had perhaps a little bit less fiscal tightening and perhaps a little bit less expansion of monetary policy. In my mind, that discussion was very relevant a year or two ago when that strategy was set out. I think at this point you wouldn’t want to deviate from the current strategy.

Q114 Chair: You would not want to deviate?

Jens Larsen: I would not want to.

Q115 Chair: Okay; so the Government’s got a problem with its current strategy, but it shouldn’t deviate.

Jens Larsen: Absolutely. I think it is clearly very important, both for the Chancellor and for the Governor of the Bank of England, that there is a perception that there is a commitment to achieving fiscal sustainability and a rebalancing of the economy. Is that rebalancing going as well as we thought, or as the Government thought it would, a year ago? I don’t think it is; but it is very difficult to adjust the strategy when the perception out there is that this is a strategy that’s working. You’ve got to take that into account in an environment where the European strategy for managing similar or in some cases much bigger imbalances is under question.

Q116 Chair: Mr Hilliard, as the other newcomer, have you got anything you particularly want to add? I know that the other two will get their views in whether I ask them or not.

Brian Hilliard: Yes; I think, really, the lines between monetary and fiscal policy in this kind of world are very blurred, and in fact the credibility of fiscal policy is actually delivering a monetary policy impact. As Jens mentioned, we are getting very low gilt yields, which I think are a direct result not only of QE but also of the fiscal credibility, so that is giving us a low yield curve. That is lowering financing costs for all entities in the UK, so to that extent I think the two are a marriage; and I don’t think any fine tuning of fiscal policy would make a great deal of difference. I think actually we have to become reconciled to a fairly slow growth path. The kind of financial shock we have experienced, that has generated this great recession and then a modest recovery, suggests that we are going to see low growth for some years.

Q117 Chair: I think I know what you are going to say, Mr Portes, but by all means: you have published in this area.

Jonathan Portes: I will try to be brief. On the output gap, I disagree with Jens and with the OBR. I think the OBR is being too pessimistic. It is relying too much on survey-based indicators of capacity utilisation. I do not think it is credible to say that firms have only less than half a per cent. of spare capacity-within firms, I mean, given the current levels of employment, which is what the OBR’s estimates are. It is essentially saying that firms, given their current levels of employment, are running pretty much at full capacity, and I find that quite difficult to believe, and I think the evidence that, for example, Bill Martin at Cambridge and so on have put forward shows that the OBR is being rather too pessimistic.

That is the first point. The second point, on gilt yields: I think Brian is just wrong in suggesting that the extremely low level of gilt yields is the result of fiscal credibility. We have fiscal credibility. We have always had fiscal credibility in the sense that nobody thinks that the UK is not going to pay its debts over the medium to long term. Our analysis, which is pretty simple and which can be easily replicated by the Treasury or by Mr Hilliard, shows that the fall in gilt yields is primarily driven by economic weakness. It has tracked what has happened in the US. It mirrors movements in equity markets and the pound. The analytical evidence is pretty strong.

Finally, I take Jens’s point that once you have chosen a wrong strategy, you need to stick with it. I call that the Macbeth argument for carrying on. You know the quote from Macbeth: we are so steeped in blood, we must carry on to reach the other side. My view is that you do not enhance credibility by sticking with a strategy that does not appear to be working. I will leave it at that.

Chair: I think I was right; we could guess those views.

Roger Bootle: I am not sure you could guess mine. First, on the output gap, I want to emphasise how much this is an art rather than a science. Of all the numbers that are printed on this, it comes down to a matter of judgment. Although the words "output gap" are a fairly recent phenomenon, the concept or the surrounding concepts are not; they go back a very long way. What we are talking about is the margin of spare capacity in the economy and that is closely related to the concept of the natural rate of unemployment. It is not the same, but it is closely related. I well remember in the 1980s how the concept of the natural rate of unemployment in the United States was revised down massively in response to growth of the economy. The phenomenon of rapid growth had to persuade academics that their idea of where the growth limits were was completely wrong. It would not surprise me at all if the same thing happened here. My sympathies are very much with what Jonathan said. I suspect that the OBR is seriously underestimating the size of the output gap.

However, given that this is very uncertain, we need to ask ourselves what attitude should we take to uncertainty; where should we allow the margin of error to lie? That is to say, is there a sense in being too optimistic about the output gap? From the point of view of fiscal conservatism, it is probably the right thing to do-to run with an estimate of the output gap which is on the low side. I suspect that it is on the low side. If it is, the result will be that we will find that the economy can grow much further, must faster and the fiscal position will come better earlier and more than we actually expected.

On policy-this is a completely different issue-I incline much more towards what Brian Hilliard was saying. I think that again, this is another area of economics where there is not a great deal of science. Essentially, you are dealing with the psychology of the markets. It might well be that a £20 billion stimulus could be swallowed by the market without its turning a hair, whereas the £2 billion stimulus might cause a panic. It depends why, what the circumstances are, whether the story is convincing, whether it seems that this is the beginning of a flood or whether it is a one-off adjustment. I have written, right from the beginning of this Government, that I thought that their plans were fiscally too tight. However, the idea that having set those plans out, you can now announce some massive splurge in public spending or tax reductions that would not have consequences in the market, I find really rather bizarre. I think that the markets would probably react to that fairly adversely. Is there scope to do something? I think that there is. The Government should aim to boost private sector investment spending. They have made some attempts in that direction, but they could do more. If those attempts required a bit more public spending and a bit more public investment to prime the pump of private sector investment spending, I for one would support that, and I suspect that the markets would be reasonably sympathetic to such a move.

Q118 John Thurso: First, may I ask the panel this? The OBR says that the eurozone is a major risk to the forecast. Can I assume that nobody disagrees with that?

All witnesses: Yes.

Q119 John Thurso: With that in mind, do you see the risk as being mainly through the financial sector, the banking crisis and the euro crisis, or through the export sector? Which is the greater risk?

Brian Hilliard: I think that the banking sector is the greater risk. What I would also add though is that I think that the risks are diminishing. I am not saying that in any way we are out of the crisis, but the stabilisation measures taken by the ECB in particular are going a long way to reassure people. The way that the UK economy is going to react to it is by becoming battle hardened more than anything. They know that this crisis is going to grind on. We have many summits supposedly giving us the solution to all the problems. We find there are incremental improvements that allow the eurozone in total to manage the problem. If that sort of stability continues, that will help the UK. The direct answer to your question is that the banking system’s interconnectedness is the main point.

Q120 John Thurso: As that fades-kicking the can down the road and hoping for the best-does that lead on to the fact that they are our largest export partners, and their not doing so well is overtaking it as a risk?

Brian Hilliard: Eventually, yes. I have to say that one of the hopes rather than forecasts in a lot of these OBR forecasts and others, is the increasing contribution of net exports over the medium term. I hope that is right, but we are continually disappointed.

Q121 John Thurso: Any dissenters from that view?

Jonathan Portes: No.

Jens Larsen: No.

Roger Bootle: No.

Q122 John Thurso: Okay. May I turn to the other big risk that the OBR identified: commodity prices, particularly the oil price? How vulnerable is the UK economy to a bigger than expected increase in oil price?

Jens Larsen: I don’t think from the demand side that the UK economy is directly that vulnerable to an oil price increase. However, it could obviously be very important for the global economic outlook, therefore eventually for our export markets, and certainly for market sentiment. In that sense, it is a very important issue in terms of the global outlook.

The direct issue for the UK might well be pressure on inflation; that we end up with higher inflation and further erosion of real income and a further difficulty for the Bank of England-for the Monetary Policy Committee-in supporting the view that inflation is going to come down quickly. I have certainly shifted up my inflation forecast significantly on the back of the news we have seen about oil prices and commodity prices more generally. That would be a worry for monetary credibility, but it would also be a worry for the outlook for the consumer. High inflation, as you know, has been one of the key factors in reducing disposable income.

Q123 Mr McFadden: May I ask you about bank lending? We have talked about this a lot in Committee recently with various people. To what extent is a continued lack of bank lending still a constraint on the growth forecast? I may as well start with our newcomers: Mr Hilliard.

Brian Hilliard: In the aggregate, not a great deal. The point I would stress is that the corporate sector is flush with money. I know the OBR had a look at this in the previous autumn statement report. Basically, the corporate sector, excluding banks, has been repaying small amounts of funds to the banking sector over the past two years. Lending is obviously important for SMEs-vital in the medium term-but in terms of the dynamic of a recovery, the larger companies are well able to power the recovery if they want to.

I think the issue is much more one of confidence-trying to dispel uncertainty-in two ways. One is the uncertainty of demand, which is pervasive and may be reduced if the eurozone crisis continues to stabilise. The other is the uncertainty of funding. It is puzzling that we have such a large cash pile. It is not just a UK phenomenon; it is in all the major western economies. During the deepest part of the recession, companies felt they had to go to the bond markets to get funds, because banks were at their most cautious at that point. Even though banks subsequently reopened their lending to large companies, I think large companies learned that lesson, and continue to do so. So, there is uncertainty both on the liquidity side of funding and on the demand side.

Q124 Mr McFadden: To paraphrase your point, there is not a lack of supply of lending; there is a lack of demand for lending that relates to a confidence issue about investment decisions. Do the rest of the panel agree with that view?

Roger Bootle: No. This part doesn’t, anyway. I agreed with much of what Brian said, but I did not much agree, dare I say it, with your summary. It seems to me that Brian is right to suggest that large corporates have got substantial cash piles and are not heavily dependent on the banks, and they could step up investment even if there were not any renewed willingness of banks to lend. As far as the SMEs are concerned, it is a question of both demand and supply, and it is very difficult to disentangle them. There is considerable survey evidence to the effect that the terms facing small companies that wish to borrow from banks are substantially worse-tighter-than they were some years ago.

Q125 Mr McFadden: That is what they tell us constituency MPs.

Roger Bootle: They tell everybody. I sat on the Which? banking commission a couple of years ago, and we investigated this. There was a substantial amount of replies along those lines. Although it is often difficult to disentangle demand and supply, the key indicator is what is happening to margins. If you think the problem is lack of demand, you should find banking margins under downward pressure. You do not see that, actually. You see banking margins under upward pressure. I think that is an indication that the banks feel that lending to SMEs is a pretty risky business, and they are not as keen on it as they might be.

Jens Larsen: The only thing I would add to that, following on from Roger’s comment, is that banks are seeing lending to small and medium-sized enterprises as a risky business. That is why they are holding back. The national loan guarantee scheme works by providing funding to the banks, but does not reallocate any of the risk. That is one of the reasons why, in terms of actually encouraging further flow of credit to the most exposed of the SMEs, it is not going to be all that important. There will be an important cash flow effect. Those that can get credit might get it a bit cheaper, but the small and medium-sized enterprises that are looking for credit-that are currently experiencing not just tight credit conditions, but actually not getting any credit at all-are unlikely to be helped much by that initiative.

Q126 Mr McFadden: On the question of bank lending, Jonathan, do you agree?

Jonathan Portes: I agree with what all the panellists have said. Roger is right that there is a problem with SMEs, but I agree with Brian that in some sense this is about the medium term and allowing SMEs to make investments for the medium and the short term. The main constraint on growth is probably coming from the lack of demand for investment, but I agree with what Roger said about the structural problems in the SME market at the moment, and I agree with Jens on the likely effectiveness of the NLGS. It is not a bad idea, but in itself it is not going to solve the problem.

Q127 Mr McFadden: I’m coming on to the NLGS. I want to try to paraphrase more accurately this time if I can. So, large corporates are sitting on cash piles. There is a problem with the price of credit for SMEs, which is reflected in the surveys and what they tell us, so in a sense we have a bit of both demand and supply in the answer.

Let’s come on to the national loan guarantee scheme and get a view on this. The OBR has stated that the initial tranche of this scheme is not large enough to change its aggregate business investment forecast. Jonathan, do you think this scheme is likely to have a significant economic impact? If not, is it a question of the design or the size of the scheme? In other words, if the Government went at this in a bigger way, might that have a bigger effect?

Jonathan Portes: I tend to agree with Jens that it is in a sense about the design. It is not clear to me how this structure will allow credit to go to businesses that would not otherwise have been able to get credit. It may reduce the price of credit somewhat. It may make the banks’ funding position somewhat easier for this sort of lending, but it does not seem likely to have much of an impact in getting money to the businesses that are currently in need of it. To me, it seems more a design issue than a quantity issue. I would not say that they should have done 40 rather than 20 and that that would have had a wonderful effect. I do not think that that is particularly plausible.

Q128 Mr McFadden: And that is because the scheme is about reducing the price of credit a little rather than changing the judgment on who gets it?

Jens Larsen: I agree with that summary. That is exactly the problem-no one wants to assume the credit risk. The banks are not keen to do it. The Treasury is obviously not keen, either. As you have explored on many occasions, the Bank of England does not think it belongs there. So it is very difficult to find someone who will do it. There is not a market that allows those cash-flush corporates to let their funding flow directly to those small and medium-sized enterprises. There are useful initiatives in the Budget and in the pipeline on this front, but that is very much a longer-term effort.

Q129 Mr McFadden: Mr Bootle, what is your view of this?

Chair: Briefly, please.

Roger Bootle: I have nothing to add, frankly. I agree with the others.

Q130 Mark Garnier: Mr Bootle, carrying on from your comments about lending to SMEs, do you think it is fair to say that SMEs have slightly over-optimistic expectations of what banks can offer them? Are they still stuck in a 2006, 2007 type of mentality and not yet adjusted to the new paradigm?

Roger Bootle: There is something in that. It is certainly not the case that all SMEs that want access to bank credit should be granted it. Sometimes you listen to groups lobbying on behalf of SMEs and you get the impression that the banks must be completely off their heads-that there is not really a risk. Of course, we all know from the evidence that lending to SMEs is extremely risky, but equally, that does not mean that the banks have not overreacted, too. That is to say, in being overly generous with credit overall in the run-up to the crisis, the banks have now been under-generous with particular sorts of credit as a direct reaction to the earlier behaviour.

Q131 Mark Garnier: Sure. Given all that, which I entirely agree with, do you think that things like the Business Finance Partnership initiative, which is trying to find a way of getting money-not through the banking system-is a better way of answering that? Jens Larsen, you are nodding.

Jens Larsen: That is a worthwhile initiative. It is difficult to get scale in that, but enabling a system of financing that does not rely entirely on the banking system seems a very good idea. It will eventually enable a broader set of investors, including pension funds and insurance companies, to invest not just in SMEs, but in a broader range of assets on the infrastructure side rather than in Government bonds.

Q132 Mark Garnier: Two questions on that point: first, one thing that banks do have is an outstandingly good distribution network, which some of these other people do not have. Secondly, do you think that £1.2 billion is not quite enough to find an alternative way of financing SMEs?

Jens Larsen: The point is that the market does not exist. I think you could achieve scale eventually, but you have to have a group of investors that wants that kind of product and a group of corporates that is willing to go through the discipline that comes with the process. There is no doubt that market finance for businesses will be more expensive than bank finance was before the crisis. There is a chicken and egg problem: you need to establish a market-establish both demand and supply-and that is not easily done, certainly not in the current environment.

Q133 Mark Garnier: Should we be doing more to source equity funding for businesses as opposed to this obsession with debt funding?

Jens Larsen: As a general proposition, I would agree with that, but the big question is, how do you design a mechanism to get it done?

Q134 Mark Garnier: Jonathan Portes, let me bring you in here. I want to be absolutely clear that I heard you right when you were talking about gilt yields. Did you link low gilt yields with poor economic performance?

Jonathan Portes: Yes.

Q135 Mark Garnier: First, can you expand on that? Secondly, does everyone agree?

Jonathan Portes: This is the simple expectations theory of interest rates. Long-term interest rates reflect the market expectation of the future path of short-term interest rates. That path, assuming that the Bank of England is roughly credible in achieving its inflation target, is determined by expected inflation and expected economic growth. Suppose that we were expecting that the UK would return to relatively healthy economic growth over the next five or 10 years. In that case, we would be expecting 2% to 2.5% growth, 2% inflation, and the Bank would be meeting its target. Therefore equilibrium and short-term interest rates would be at a "normal" level-4%, 4.5%, maybe 5%.

Clearly, 10-year gilt yields are not consistent with that-they just aren’t. Either you believe that we are going to return to normal economic growth reasonably soon or you believe that gilt yields should be very low, but you cannot believe both. If you believe that economic prospects are reasonably good, the current level of gilt yields just does not add up.

Q136 Mark Garnier: But you are talking about the tail wagging the dog. Surely, with quantitative easing and monetary policy from the MPC, the Bank of England is determining interest rates depending on the economic outlook, rather than the economic outlook depending on the interest rates.

Jonathan Portes: The Bank of England determines short-term interest rates; it does not determine long-term interest rates.

Q137 Mark Garnier: It does long-term interest rates through quantitative easing interventions.

Jonathan Portes: Well, quantitative easing is having some depressive effect, but ultimately, if you believe that markets are rational, it is simply inconsistent to suggest that current level gilt yields are consistent with healthy economic growth over the medium term. Equally, the analysis backs it up. If you look at the correlation in movements of equity prices and gilt yields on, say, a weekly or daily basis-how the markets actually work-you see a strong correlation. When equity prices go up, gilt yields go down and vice versa. What does that tell you? People do not buy British equities because they think that the economy is weak, but they buy British equities at the same time as gilt yields go up. We see a positive correlation between equity prices and gilt yields. What does that tell you? Strong economy means higher equity prices. It also means stronger gilt yields,

Indeed, in the past few months we have seen gilt yields finally beginning to rise by 20, 30 basic points. That is a good thing. It means that we are slightly more confident that the bottom will not fall out of the economy and that we will see a recovery some time relatively soon.

Q138 Mark Garnier: I have two questions: first, do you agree with that? Secondly, on the wider subject of quantitative easing, when you look back at the beginning of quantitative easing, the narrative at the time was very much about pumping £75 billion/£150 billion into the economy to provide liquidity, which was sorely needed because of the problems we have. Now, with the Governor of the Bank of England and the economists, the narrative is not about providing liquidity, but about controlling interest rates on the bond market in terms of the longer-term interest rate. You can intervene all the way along the yield curve now, including 100 years on. Do you agree with any of what Jonathan Portes is saying?

Chair: Just try the first question.

Brian Hilliard: What I distinguish between QE1 and QE2 is that, when QE1 was launched, the world was a very, very dangerous and frightening place. The Bank of England embarked on QE not knowing what its impact would be, but having run out of conventional policy tools. What is a little troubling now is that we are seeing the Bank of England describe its continuing use of QE as a conventional tool, and that makes it rather too relaxed in using it. I do not think that the impact of QE2 will be as powerful as QE1. I know that that is not what the Bank of England believes. I do not see immediate inflation risks or anything like that, but there are distortions in the gilt market from doing what should not be ignored.

On Jonathan’s point, I agree in the general sense that expectation theories of the yield curve do drive it. If we saw high yields come through because of a general improvement in the economic background, the Bank of England would not react to that. It would applaud it, because it would tell us that the sort of environment is here.

Q139 Mark Garnier: The tertiary effect of QE was mentioned on the radio this morning. I think that it was HSBC. It was about the effect on the currency. The tertiary effect is that, by in theory putting more money into the system, you are dividing your currency and therefore you can boost your exports. Do you agree with that analysis?

Brian Hilliard: I think the impact on the currency has been overstated. The movement of the trade-weighted index of the pound over the past year or two has been minimal. It has been trading sideways. The big, once-in-a-generation adjustment to the trade-weighted index has already occurred. I do not think that the Bank of England MPC has uppermost in its mind seeing a sterling reaction when it does a QE.

Q140 Michael Fallon: In terms of business investment and the OBR’s new assessment that firms’ cash balances may not be able to support as much investment as previously thought, did you pick that up?

Brian Hilliard: I am surprised it says that. I am shocked by how weak its forecast is for this year. It could possibly be a little bit higher. Then, when we move to the medium term, it is relying on business investment to drive growth. Maybe I am just a good old English pragmatist. I think it will be somewhere between the two. My worry in the medium term about the growth outlook is that we will be disappointed in several demand components and that the investment one looks too weak at the moment, and a little bit too strong in the medium term.

Q141 Michael Fallon: Is anybody else pessimistic as to the extent that cash surpluses will translate into support for investment?

Jens Larsen: I agree with the OBR’s negative assessment of the net amount for investment, but that is on the basis of the reading of the indicators. I do not think that there is much of a cash constraint on investment at that level. That is not the main explanatory factor. I share Brian’s view that, looking further out, the whole forecast is one about this beautiful rebalancing with much stronger business investment and much stronger net exports. One can get a little worried that that will actually happen.

The OBR has moved in the right direction on that. The reliance on this business investment recovery is less than it was in November, and November was less than it was before, so the forecast makes more sense to me. However, I do not think that cash is the key constraint on corporates; the key constraint on investment now is the demand outlook.

Q142 Michael Fallon: Mr Bootle, do you think changes to the forecasts for business investment suggest that rebalancing will be harder than we originally expected?

Roger Bootle: Yes. I was just looking at the history of the OBR’s forecast revisions, and I share Jens’s view that the OBR has been too optimistic about business investment, but I doubt very much whether cash will be the constraint. After all, if we are talking about large companies that find they do not have enough retained earnings and that they have got access to bond markets or equity markets-indeed, better access to the banks than SMEs have-I would be surprised whether that is really a substantive issue. When you look at their cash balances, they are very high by historical standards. The question simply is: do they want to invest? That is primarily about the overall environment of aggregate demand and the confidence that they have in the future.

Q143 Mr Love: May I return to the questions from the beginning about the output gap? I want to start where you left off, in relation to whether we can do anything within the context of not challenging the credibility of the fiscal consolidation to try and boost growth. I wonder if our two new economists-who I think are probably the most conservative, with a small "c", in relation to fiscal credibility-think there are any measures that we might take in the short term to try and boost growth.

Jens Larsen: There was a crucial addition at the end of your statement, which was "the short term". When you are looking at closing an output gap over three to five years, you would talk about structural reforms. There is a lot of talk about structural reforms in the Budget, and in Government policy currently, but what I would be looking for here-if you wanted to boost growth substantially-is to have stronger growth in the labour force and stronger participation by the current labour force, or even inward flows of workers. From an economist’s point of view, a strong labour supply response is what you would be looking for if you wanted stronger potential growth on the horizon for two to five years.

So that would be my answer, but it does not address the short term. In the short term, I do not think there is much you can do to close the output gap at a quicker pace. The OBR’s assessment is really one about where the output gap is, more than how quickly we can close it. My worry is that the constraints are actually going to be coming from the reallocation of resources, the lack of investment in small and new firms, and the lack of job creation there that will hold back potential growth. Anything you can do to improve that reallocation is a good thing.

Q144 Mr Love: You mentioned earlier that we are not actually going to close the output gap, according to the OBR, in the forecast period, and that monetary policy will not do it.

Jens Larsen: It wouldn’t do it by itself.

Q145 Mr Love: Mr Hilliard, you mentioned earlier that we have to be reconciled to a slow-growth path. Is there anything we can do, practically speaking, in the short term?

Brian Hilliard: A little more infrastructure investment would be useful. I think perhaps we have become a little too hung up on the precision of fiscal neutrality. When the Chancellor presents his Budget, does he have to balance it to the nearest £100 million to say that he has spent some money and he is going to pay for it with other things? The markets would be forgiving of £2 billion or £3 billion here or there-without being flippant-if it were seen to be driving the medium-term sustainability of the economy. So, a little more boldness on infrastructure is what I would identify.

Q146 Mr Love: Mr Bootle, you mentioned a scheme earlier on, and I wanted to pick up what Brian Hilliard said about there being a very slight boost to the economy, under £2 billion in this first year. Could we improve that with the prospect of taking it back towards the end of the forecast period? Do you think that might help, because the real pain that the economy will suffer will be during this year and at the start of next year?

Roger Bootle: I think it is possible that something could be done along those lines, but let’s just remind ourselves how tiny these sums are. They might not do much damage but that is because they won’t do much good either. These are ridiculously small sums of money. There is a genuine debate to be had about whether there is scope for a significant fiscal expansion. I think Jonathan will argue that there is, and he would be talking about numbers much bigger than £2 billion or £3 billion. I think 1% of GDP is £15 billion, and 1% is not an enormous number in terms of fiscal contractions or stimulus programmes. These are the sorts of figures you have to be thinking about if you are going to make a big difference: £15 billion, £20 billion or, dare I say it, £30 billion. Would that have an impact? I think it would have an impact, but it might have an impact on the financial markets as well as on the economy.

Where I think the Government should concentrate on-they have done this to some extent-is thinking about measures that make a serious difference without costing very much. That may seem like a free lunch, and in some ways it is. I was struck by the effort that the Government rather belatedly put into developing a plan for growth, which seems to have died a bit of a death. My own experience in talking to officials in both BIS and the Treasury is I don’t think they are seriously interested in it; they haven’t been all along. They thought that the objective is to give George Osborne something to put into a document or a speech, rather than genuinely believing that there are things that can be done.

Let us take something dear to the Government’s heart-or the Conservative part of the Government’s heart-namely, reform of labour laws. I happen to think that that is extremely important. If you are looking at the SME sector-we talk about finance-what is it that gets animal spirits going? What is going to give them the confidence to invest? I think a profound change in the labour laws would have a big impact.

I know that there is room for disagreement on this across the political spectrum, but my point is, that would not cost any money, and the Government have not done anything, or done next to nothing. It is in that sort of area that I think there is significant room for advance.

Q147 Mr Love: Let me ask Mr Portes. I know that you would like to have a significantly greater boost. I am struck that none of you has suggested that the national loan guarantee scheme should be redesigned or significantly boosted. The evidence we heard from the OBR was that £5 billion would make no difference whatsoever, but £20 billion and even greater sums might. I am rather surprised. Regarding infrastructure, as Mr Hilliard mentioned, many think that we could do a great deal more with relatively small amounts of money to trigger infrastructure expenditure, even in the short term. What is your view of what flexibility we have?

Jonathan Portes: First, as Roger said, I think Roger and I agree on 90% or 95% of this stuff on the macro and fiscal outlook. It really is a question of the balance of risk. Where we disagree is that Roger attaches somewhat more weight to the financial market risk.

This, in my view, is the case for action now. It is not because we get an extra 0.5 % growth next year; that really is second order. It is the long-term social and economic damage that we have by allowing the output gap, as Roger and Jens have said, not to be closed towards the end of the forecast period. What does that mean in real terms? When we talk about the output gap here, the OBR is basically talking about unemployment. So what we are saying is that we are allowing unemployment to remain much higher than the NAIRU and structural level for a very long period. We know that that does long-term social and economic damage and damages potential growth and output going forward. That is the case for doing something. It is not in order to get a short-term hit to growth, but to do something about that. That is the overarching point that is important to make.

What could be done? Within the fiscal rules, actually an awful lot could be done. You could do everything that I have suggested within the fiscal rules. For example, on infrastructure spending, public sector net investment has fallen, according to the ONS figures that came out on Budget day, from about £47 billion to somewhere in the low 30s-by more than a third in a couple of years. We are cutting public sector net investment very substantially at a time when we can borrow at the cheapest rates in generations, when there is lots of spare labour capacity and when we are in a very slow recovery. That cannot possibly make economic sense.

Regarding the sort of measures that I have been talking about on the demand side, a temporary, explicitly time-limited cut in national insurance makes absolutely no difference to the fiscal mandate. So there is plenty of flexibility to do that.

Finally, on what the Government could do without spending any money, I would point out that it could stop doing things that go in the wrong direction. I will return-Andrew will like this-once again to immigration. The Government allows the Immigration Minister, Mr Green, to go on television repeatedly claiming it as a success that the number of students coming to this country has fallen significantly as a result of the changes that the Government has made to student visa regulations. In other words, Government Ministers are saying that a reduction in UK exports is a success. If the Government meant what it said when the Prime Minister and Chancellor say that growth is the overriding priority, it would not be allowing Ministers to do that. End of story.

Q148 Chair: Mr Bootle, can I just take you back to where you said that the Government had no strategy for growth? Then you appeared to say that the Chancellor is being thwarted by a bunch of officials who think all he wants is a set of lollipops. Have I summarised it correctly?

Roger Bootle: I am not sure that they are not responding to what they perceive to be the degree of conviction on the part of the Government. All I am saying is that in my own experience of talking to officials I don’t think they are very advanced in thinking about a number of these plans, which is why the documents-

Q149 Chair: No. I am asking about the political will behind it.

Roger Bootle: I don’t know. I thought you would be more familiar with the degree of political will than I would be. I don’t know how much political will there is behind it.

Q150 Chair: You seem to be quite well informed about what is going on in Whitehall.

Roger Bootle: It does not take too much imagination to look back at the history of this. The Government was prodded by Conservative Back Benchers and business to do more for growth and out came a thing called "The Plan for Growth", rather belatedly, and I think it was a rather weak document as well. So there is a suggestion that there is not a degree of political will behind it.

Q151 Mr Ruffley: Roger, from your earlier comments, you think that the negative output gap is slightly bigger than the OBR do?

Roger Bootle: Yes.

Q152 Mr Ruffley: It follows from that, doesn’t it, that the structural deficit is probably lower?

Roger Bootle: Yes.

Q153 Mr Ruffley: Are you aware of any figures which suggest when the structural deficit might be eliminated if the output gap is significantly bigger than the OBR say?

Roger Bootle: I have not got any precise figures to offer you on that. As I was saying earlier, it is a judgment call and it is as long as a piece of string. To the extent that the output gap is genuinely bigger then, as you rightly say, the structural deficit is smaller and could be eliminated more quickly.

Q154 Mr Ruffley: You said something very striking: to have a fiscal stimulus of £15 billion would only be about 1% of GDP. Do you think this Budget taken in the round will make any difference to economic growth?

Roger Bootle: No. I do not think it makes a blind bit of difference. There were some quite favourable measures in it for the medium-term growth outlook. I for one, and I don’t think I’m alone in this, thought that the corporation tax changes were pretty favourable because not only did they immediately produce the tax impact on business, but they were a signal to business of what the Government’s intentions were. So that is something that might well help to boost the animal spirits of business and therefore get investment going. I have said on many occasions in the past that I think we need something similar with regard to personal tax. There are a few straws in the wind and obviously there were some tax changes this time round. But I would like to see a forward commitment so that people could see what the structure of tax was going to be. There are major political obstacles to that, I realise.

Q155 Mr Ruffley: You said this time last year and you have repeated today that a fiscal stimulus would not necessarily spook the markets if it were for the right reason.

Roger Bootle: Yes.

Q156 Mr Ruffley: But you went on to say that it is very difficult to judge what might be acceptable to the markets given that there is a very clear plan. Were there not such a clear plan it would be perhaps easier to explain to the markets why you might want and I might want a £15 billion stimulus rather than a revenue-neutral Budget. Could you give some indication as to what you think the Government could do by way of tax cuts which would not spook the markets? You have lots of clients who are market players. If tax cuts-significant ones of £10 billion or £15 billion-were to be introduced and those were matched by commensurate further public expenditure reductions, what sort of things are we talking about? Are we talking about cuts in employers’ national insurance? Are we talking about further cuts in corporation tax?

Roger Bootle: The last idea that you have introduced is an altogether different one, which is to say, without altering the overall balance between spending and tax and without altering the forecast deficit levels, cutting both tax and spending. I do not think that the markets will be spooked by that at all. Why should they be? They are concerned about borrowing levels and the path of public sector debt. If the Government were to take that sort of measure, there would be no direct implications at all. If you could persuade yourself that this would stimulate aggregate demand-some people think it would, and there is an argument that it would and one that it would not-the markets might actually take to it favourably. They might think that the structural changes that are brought about were actually going to be beneficial from a market point of view. However, that is an altogether different thing from the idea of cutting taxes without a corresponding cut in Government spending. It is completely different.

Q157 Mr Ruffley: Why is that argument not made more often?

Roger Bootle: It is not made more often because the Government have found it pretty difficult to come up with cuts in expenditure of the size that they have. They have run into enormous political difficulty. It is therefore judged that deeper cuts would get them into very deep water, but it seems to me that it is actually a serious runner to advocate further cuts in current Government spending, offset by reductions in tax.

Q158 Mr Ruffley: I think the IFS has calculated that, over the five years of this Parliament, it is about a 3.4% real-terms cut in total managed expenditure from 2010 to 2015, and that does not seem to many of us a particularly vicious axe attack on public expenditure: 3.4% in real terms over five years is not huge. Why, again, do you think that there are not more voices in the City saying that this is not really very serious?

Roger Bootle: There are some. In fact, there are more people saying that it is not serious in the world of broadcasting and journalism, but it is a very difficult question to get the balance right on, because when you look at the overall numbers the cuts do not seem to be that big. If you look at particular Departments, however, they are pretty big, and because you have the ring-fencing of, in particular, the NHS, the cuts in some Departments are going to be really very big indeed and bigger than we have been used to at any point in the post-war period, if not earlier. There is a serious debate to be had about this. If you look at the Irish experience, which I was looking at recently, there is a country that really has embraced public spending cuts in a seriously big way with, of course, big cuts in public sector pay.

Mr Ruffley: Can I just ask Jonathan Portes one question very quickly?

Chair: Yes, with a quick reply.

Q159 Mr Ruffley: On the issue of closing the output gap, what do you think are the three things that the Government should be emphasising in this Budget or implementing that will get rapid progress on closing the output gap?

Jonathan Portes: Infrastructure spending, cutting national insurance contributions for the low-paid, and house building.

Chair: That was an excellent short reply. Thank you very much. I am sure that, as a consequence of the fact that we have these exchanges, you may have further thoughts. If you do, please feed them in as soon as possible, but it would have to be pretty much by the close of play today or tomorrow if we are going to be able to incorporate them into our work. Thank you very much for coming. I am sorry that it has been somewhat curtailed, but we are on a very tight schedule.

Examination of Witnesses

Witnesses: Paul Johnson, Director, Institute for Fiscal Studies, and Carl Emmerson, Deputy Director, Institute for Fiscal Studies, gave evidence.

Q160 Chair: Mr Johnson, may I begin with you and ask whether you think that the Government have a tax policy or what you described as a "hotch-potch" of reforms?

Paul Johnson: They have a bit of both. As the previous panel said, the changes on corporate tax, for example, have been laid out fairly well. It is pretty clear what direction the Government want to go on corporation tax and the same is true on the personal allowance, but in the Budget we saw a range of other things, which appeared to be somewhat unpremeditated-for example, what happened to the allowance for pensioners, which may not be a bad move over the medium run, but shows every sign of being rather rushed. The changes to stamp duty were certainly not what one would think of as part of a long-term tax strategy, because they make further reforms to stamp duty in an efficient direction more difficult to achieve.

The way that child benefit is now going to be taxed back, although probably less damaging than what was originally proposed, creates quite a lot of complexity in the system and, as an interesting aside, adds one more bit of the tax system that is not indexed. The point at which child benefit is to be withdrawn is not indexed, the point at which the personal allowance is withdrawn is not indexed and the point at which the top rate of tax starts to be paid is not indexed. There is a whole range of different bits and pieces in there, therefore, that look like less of a strategy than the two big things-the corporate tax and the personal allowance changes.

Q161 Chair: There is always a shade of grey. Which side of the line are you? Is it black or white?

Paul Johnson: I think that I would be on the negative side of the grey here. We knew where they were on personal allowances and corporate taxes, but there was nothing new, as it were, in the sense of moving towards a strategy.

Q162 Chair: So "hotch-potch" is better than "strategy"?

Paul Johnson: I think I stand by hotch-potch.

Q163 Mr Ruffley: Two-thirds of the tax consolidation for this Parliament has been done, but about 30% of public spending consolidation. Could you indicate, wearing your public-spending-expert hat, whether you think that the spending totals that are being published will be hit?

Paul Johnson: They are going to be extremely tough to hit and it will take a significant amount of political capital to hit them. What was interesting about what we saw this year is that there have been some underspends in departmental budgets, despite the scale of the cuts intended through this year. In one sense, that is perhaps not that surprising given the political capital that would be lost if there were overspends. It is clear where the balance of risk lies.

In some sense, we have seen the slightly easier wins happening, but I certainly do not think that the public have got their head round the fact that the large majority of the cuts are still to come. The numbers that you quote-the 30% already done-are off a baseline of assuming that real freezes is a reasonable baseline. It will feel tighter than that, because the normal baseline is to move up in line with the economy.

Q164 Mr Ruffley: Where is the extra £10 billion that the Chancellor referred to in his Budget speech? Could you tell us something about that? What do you think it means and where will it fall?

Paul Johnson: Sorry, the extra £10 billion? Oh, in the future, after the next election. My understanding of what that was saying was that if you are going to have total public spending falling on departmental budgets in the same way that it has over this spending review, then there is another £10 billion that you will have to find from, for example, welfare cuts. You could do it through tax increases. If you think of a budget constraint, you have departmental spending on one side and tax increases or welfare cuts on the other. One place you could end up on that budget constraint is to have a similar level of annual falls in departmental spending as we have had before. If you do that, then you have to find £10 billion through welfare cuts and tax increases. Clearly, you could do it all on one end, or all on the other. He is telling us one point on that budget constraint.

Carl Emmerson: To give some figures on that, the £10 billion is in 2016-17 prices, so in today’s terms, it will feel more like £8 billion. If you do not want to cut departmental spending or central Government spending on public services in the next Parliament, it is not £8 billion that you need; you would need £20 billion from welfare. If you do not want to cut welfare, then instead of cutting departmental spending at 2.3% a year-the current rate of cut after economy-wide inflation-you would have to cut it by 3.8% a year on average. To keep to Mr Osborne’s total spending limits, those are the kind of constraints that we will be operating with in the first two years of the next Parliament.

Q165 Mr Ruffley: He needs that magnitude of fiscal consolidation to meet his 2016-17 target, which it now is, for eliminating the structural deficit. Is that right?

Carl Emmerson: It is to meet his target for getting spending down and for borrowing, taking into account the fact that social security spending and debt interest spending are continuing to rise. For example, the number of pensioners is growing, so there are some underlying positive pressures on the spending side, so it is to offset that and to meet the spending cuts that he needs to bring the deficit down in line with his plans.

Q166 Mr Ruffley: Is it the case that this is the tightest fiscal consolidation since the second world war?

Carl Emmerson: It is the longest sustained cuts to public service spending since the second world war-if they are delivered. That is certainly the case. It is almost twice as big as the seven-year period of cuts delivered between 1975 and 1982 after economy-wide inflation. That is on public service cuts.

Q167 Mr Love: May I turn to the distributional impact? In your charts, you have excluded tax and benefit changes affecting mainly the rich. Can you tell us why you did that and which benefits and taxes you are talking about? Can you also tell us what the differences are between what your distributional chart shows and what the Government show in the Red Book?

Paul Johnson: Essentially, we have not put in there the impact of increasing stamp duty or of reducing the top rate of tax from 50p to 45p. The reason for not including the stamp duty change is that the numbers of people who are affected are tiny and who it will be is very hard to determine. The reason for not including the 50p change is that if you believe the Government analysis that the cost is only £100 million then the impact on people’s incomes on average will again be extremely small. We probably want to come to the discussion of the 50p rate in a minute. So, if you take account of what looks like a very big behavioural change, then the impact on the distributional charts will be very small. At that end of the distribution, we have done very much what the Treasury has done in the Red Book.

The places where we have done different things are very much the same as the places where we have done different things in the past. For example, we have included allowance for changes to employment and support allowance, for council tax benefit changes and for some other changes to local housing allowances which, while you cannot identify the specific individuals in the data who will be affected, you can know that a proportion of a particular type of individual will be affected. We have modelled those, and the Treasury has not. That is why we see larger falls in incomes at the bottom of the distribution than it does in its charts.

Q168 Mr Love: One of your charts includes universal credits. How have you modelled that? What is the implication?

Paul Johnson: When we take account of universal credit, we have looked at a hypothetical world in which universal credit is fully in place by 2014. It will only just be beginning to be in place by then, but it is very difficult to model a transition system. What that shows is that universal credit does increase the amount of money going to particular family types towards the bottom of the income distribution, especially to couples with children. That makes the overall picture look more favourable to very low-income couples with children. One thing that I think has changed since previous charts we put out is that we know a bit more about the child care element of that, which again appears to favour those out of work with young children. The overall impact that we show is quite a significant change relative to a world in which you do not take account of universal credit. I should stress that that is a hypothetical world in which we assume the whole of universal credit is in place by 2014, which of course it won’t be.

Q169 Mr Love: You are also assuming that the scheme as outlined will be delivered and that there might not be any reductions in the universality, if I can put it that way.

Paul Johnson: Indeed.

Q170 Mr Love: Okay. May I move on to the 45p tax rate? I am interested that HMRC turned to some work that the IFS had done through the Mirrlees review, particularly in relation to taxable income elasticity. I am surprised to discover that Arthur Laffer has made a comeback in the HMRC report. I am curious to know to what extent you can influence taxable income elasticity by changing the tax reliefs and the loopholes, if I can put it that way. Would an alternative choice for the Chancellor have been to accept the report but make changes that would have limited the elasticity, with regard to the report that you did for Mirrlees?

Paul Johnson: That is clearly one of the choices that you have. Taxable income elasticity is not necessarily a fixed given in all places and at all times. As the number of allowances changes, the taxable income elasticity will change. It is likely that the taxable income elasticity in the US is a bit higher than here. There is some evidence that in Denmark, for example, it is rather lower than it is here. That has to do with the structure of the tax system. It is absolutely right that this is not a number fixed in stone by some divine command. It is something that can be influenced, in principle at least, by changing the way in which reliefs and allowances work.

Q171 Mr Love: What is your overall assessment of the HMRC report and the Chancellor’s response to it? There is the suggestion that 48p is the optimal level and that the reduction to 45p will therefore cost a very limited amount. You mentioned a figure of £100 million had been suggested. Does that all seem credible in the context of current circumstances?

Paul Johnson: A number of things are striking about the HMRC report, the most striking of which is the scale of change in incomes of the people on over £150,000. It is extraordinary that we see a fall in their recorded income of 25% in the years just before and after the introduction of it. The problem the HMRC had was that a lot of that was forestalling: how do you think about the counter-factual? What it has done, broadly speaking, as much as it could given the information, is try to compare what happened to the incomes of people between £115,00 and £150,000, with what happened to the incomes of those earning over £150,000.

We haven’t seen the data and we haven’t got to the bottom of all of it. We might have one or two quibbles with what it has done there, in the sense that the incomes of people just under £150,000 may have been influenced by the higher rate, in that some people might have brought their incomes down a bit. There is maybe a little problem there.

The real issue is: does it look from what it has done that its central estimate is broadly sensible? Probably, yes, but as you can back out from what it has said, it is incredibly uncertain, to the extent that we think that its estimate suggests there is only a two-thirds probability that a revenue-maximising rate lies between 30% and 75%. Those numbers are absurd in some sense, but that gives you a sense of the level of numbers of assumption and uncertainty that underlie what it has done.

If that were the only thing we knew, we would be pretty sceptical that its results bore a lot and sceptical about how much weight you put on the results. The thing that makes us think that you may want to put more weight on them is that they are actually pretty much in line with what previous studies here and elsewhere have got.

Q172 Mr Love: Is it your intention-just a very brief answer-to get the data and do more work in this area? I think shining a light of evidence, because of the very uncertainties you have talked about, would be welcome at this point in time.

Paul Johnson: The brief answer to that is yes, subject to us being able to get the data.

Q173 Mark Garnier: Continuing from that one, HMRC expects that the cost to the Exchequer in 2012-13 of taxpayers deferring income until 2014, for the 45p cut, is going to be about £2.4 billion. Do you agree with that?

Paul Johnson: Again, there are two things there. If people forestall in the other direction, in the same way as they did this time round, then that seems like a reasonable estimate. I suppose in our mind it does beg the question as to what the advantages were of delaying the change, because the estimates here are that there will be a substantial cost in the way that it impacts on people’s behaviour, in terms of doing that kind of forestalling. So given that we have found out that the level of forestalling is so large, and we have had an estimate of what that will look like next year when it is put in place, I guess a question for the Government is do they think the benefit of delaying it for a year is large enough to offset the additional amount of tax planning that will result because it is being delayed for a year.

Q174 Mark Garnier: The other question of course is, if you were to leave it in any longer, do you think it would form any sort of structural damage to people’s approach to the tax regime? If you left it for three, four or five more years, do you think tax avoidance systems would become so embedded-I don’t necessarily want to suggest that everybody is rushing around avoiding tax, but do you think people would become much more thoughtful about tax, to the point where it would become structurally damaging to the economy at that high level?

Paul Johnson: As the HMRC document says, one of the uncertainties around our estimates of how much it will cost to reduce the top tax rate is that there may be some significant asymmetry, in the sense that if you have, because of the 50p tax rate, invested in avoidance schemes, it is not clear you will just unwind them as soon as it goes. They acknowledge that as a risk to their estimates. Presumably the longer that you keep the higher rate in place the more significant that risk might be. HMRC seem to think that it’s a significant risk already.

Q175 Mark Garnier: Professor Laffer drew his famous curve on the napkin in the ’70s, when we had a very different world, and exchange controls were still around to a certain extent. Do you think now that we have a very much more international sort of financial community, that actually the Laffer curve has so many different variables coming in on it, just simply looking at a low tax rate in absolute terms is now completely irrelevant, and we need to look at them on an international comparison as well as local rates?

Paul Johnson: Well, from the point of view of the UK economy, the way the Laffer curve works, and the way the analysis is done, as it were, implicitly takes account of everything that is going on elsewhere, because part of what you see in terms of behaviour changes-people moving income somewhere else, or moving themselves somewhere else-is of course determined by what is happening in other countries, so from the point of view of an individual country, I don’t think the purpose or structure of the Laffer curve changes.

I think you are right in the sense that one of the things that will determine where the revenue-maximising point comes does depend very substantially on what’s happening in a whole series of other countries, which is related to the previous question of the taxable income elasticity; the Laffer point will change over time according to what’s happening to tax allowances, according to what’s happening to tax rates in other countries and a whole series of other variables.

Q176 Mark Garnier: Turning to the child benefit cliff edge, do you think the Government’s come any way close to addressing the cliff edge problem with those solutions?

Carl Emmerson: In terms of how individuals lose their child benefit as their incomes rise there is now no cliff edge. It is not the case that people will find themselves worse off after getting a pay rise, which would have been true for some individuals under the original system. It is now the case, as long as you have fewer than eight children, that you will not face an effective withdrawal rate of over 100%. So they have dealt with that problem. The other problem that people identified with the initial proposal was that one-earner households could be punished relative to two-earner households. You might not think that that is fair. Clearly there is still an issue, and people who were concerned about that before may well still be concerned about it.

Q177Mark Garnier: Do you not agree that this highlights a greater problem with the tax system itself? The number was picked because it happened to be the number at which you moved from the lower rate to the 40p tax rate. Of these two hypothetical households next door to each other, the couple with the single earner on £84,000 or £85,000 a year will still pay £4,000 a year more in tax than the couple earning £42,500 a year. That in itself is also unjust. This merely confirms that it is a problem in the whole tax system in general.

Carl Emmerson: I guess what you are pointing out there is the difference between the income tax system, which is based on individual income, and the benefit system, the tax credit system, which is generally based on joint incomes. So, for example, if you want a benefit targeted at lower income households, which is defined on the income of the total number of individuals in the household, you would want to use the tax credit system rather than the income tax system, which is not very well designed for that because it is based only on individual income and does not take into account the resources in the household as a whole.

Q178Mark Garnier: Do you think the method they are using of taxing the household in order to recover the child benefit is the best way of doing this or do you think there are simpler ways of addressing this?

Carl Emmerson: There is clearly an argument that can be made for just keeping child benefit universal. There is also an argument that can be made for saying, "No, we want to target lower income households" and perhaps using the tax credit system. It is harder to defend the kind of withdrawal that the Government have gone for.

Q179 Mark Garnier: So you think this is not a very good way of doing it?

Carl Emmerson: It is better than their initial proposals but it still could be improved further.

Q180 Michael Fallon: Mr Johnson, the change to the age-related allowance was described by Dr Altmann of Saga as an "outrageous assault on decent middle-class pensioners", but your comments seemed a bit more relaxed about it.

Paul Johnson: I think there are problems in the way that this was announced, particularly coming in so quickly without giving people much of a chance to plan. To get a sense of the scale here, the group most affected will be those who are retiring next year because they will not gain the expected benefit of it immediately. We think the maximum loss, which is quite significant for that group, might be up to £300 a year. If you are on a relatively modest income, that is quite significant. For all the other groups the loss is only the loss relative to what would have been indexation and the losses there are much smaller.

The loss over time also depends on what you think the counter-factual would have been. The Government policy is that the personal allowance will rise to £10,000 over the next couple of years and therefore some of that £300 loss will be offset by increases in the allowances over the next couple of years. That is one of the reasons why to have announced, for example, that this policy would happen at the point at which the main personal allowance hit £10,000 would have both given it the sense of a more strategic change and given people a bit more time to plan and have a less one-year effect. But for pensioners as a whole, the effect is relatively modest and it remains the case that if you take all of the tax and benefit changes that have been implemented by this Government, pensioners will have been less affected than other groups.

Q181 Michael Fallon: The tweaking that you are suggesting is only really a difference of a year then is it?

Paul Johnson: It is a difference in year-

Q182 Michael Fallon: One year, is it?

Paul Johnson: The £300 that I mentioned is only a one-year effect if you assume that that allowance will rise faster than inflation the following year. You can get a big number like £300 and you can get a much smaller number for the large majority of pensioners who are only affected by the lack of indexation. Even for that group affected by £300, they will be affected by less in the following year.

Q183 Michael Fallon: When you say that it is perhaps surprising that this is the first tax change specifically targeted on pensioners, what do you mean by that? What is the surprise?

Paul Johnson: I suppose that the surprise is that the scale of the fiscal consolidation is such and the scale of the cuts in benefits and increases in tax for other parts of the population are such that to have effectively not got any money from a substantial group of the population and, indeed, a group who again, on average, have seen their incomes rising significantly more quickly than the other groups, is clearly quite surprising. That is, I suppose, not surprising politically, but from the point of view of how you are going to share out the pain, it is quite striking up until now that this group has been fairly much protected.

Q184 Michael Fallon: To share the pain-just to be clear-you would have expected the Government to have taxed pensioners earlier and harder.

Paul Johnson: I am not saying that I would have expected them to, but were the Government to be saying, "We are going to share the pain equally across the population," then they would have done more that would have affected pensioners than in fact they have.

Q185 Chair: In drawing that conclusion, are you going back two years or to the start of the crisis?

Paul Johnson: What I am doing is going back two years, but I think the same would be true if we went back to the start of the crisis.

Q186 Chair: Would you be capable of showing us that analysis? Is that something that you would be able readily to put together?

Paul Johnson: Yes.

Q187 Chair: I think the Committee may want to see that if that could be done at speed. That is an interesting piece of work.

Just to be clear on your answers to Mr Fallon, are you saying that if there had been a one-year transition to the £10k allowance, there would probably have been virtually no losers and there would have been time to plan?

Paul Johnson: No, I certainly would not say that. There would have been losers in expectations. It is important to be clear that the group who are losing most here are those who are transitioning to state pension age, so it is not that they are losing one year on another; they are losing relative to expectation. Now, the amount that they would have lost relative to expectation would have been less if it had been delayed a year or two and if the personal allowance for everyone had gone up over that period, because the gap between the two would have been less.

Q188 Chair: But on reasonable expectations, what you have just said would imply that that loss would be very small. Is that correct?

Paul Johnson: I do not have the number in my head. It would go down from £300 to a number that was still reasonably significant. It certainly would not be going down from £300 to £100.

Q189 Chair: Why don’t you give us a couple of reasonable assumptions and give us that figure as well to see what we are talking about?

Paul Johnson: Yes.

Q190 John Thurso: I want to ask you about stamp duty land tax, but before I do that, Paul, may I ask you a question? You gave a series of presentations in the week running up to the Budget, which were very good. What surprised you? What was your biggest surprise?

Paul Johnson: The pensioner tax allowance was the only significant tax policy that was not reasonably well trailed, and we, like everybody else, were fairly surprised by it. I have by now lost sense of what surprised me. Were we surprised by anything else?

Carl Emmerson: I thought the most significant number in the Budget was the £10 billion welfare cut. It is not a new policy, but it is the Chancellor now starting to point out the trade-offs between public service spending and welfare spending in the next Parliament if he is to get his public spending plans kept to. I thought that that was the most significant number, because it was drawing attention to something and it is a very big number, whereas most of the numbers in the Budget were actually relatively small.

Q191 John Thurso: You said earlier that SDLT is not part of a long-term strategy. Do you think it will have any effect on the property market generally?

Paul Johnson: It will certainly have some effect. One presumes that it will proportionately reduce the prices or values of properties that are above the £2 million level, and it will presumably increase the incentives to keep the price just below £2 million, just as each part of the slab of the stamp duty system has that effect. That is relatively small, and I think the Treasury numbers suggest about 3,000 transactions a year, which is a pretty small part of the property market. However, I guess that the longer-term concern is that if you are continuing to move in this direction at that end, unwinding some of these less desirable effects more generally through changing stamp duty looks less likely than it did three weeks ago.

Q192 John Thurso: This was brought in basically as a way of taking money from richer people. Will it achieve that objective? Will it bring the taxes in?

Paul Johnson: I think the Treasury is expecting £200 million or £300 million from this, and within that it has made some allowance for reduced numbers of transactions and it has also made some allowance-it does not tell us how-for avoidance of that, including keeping things below the £2 million level. We have no basis for thinking that its £200 million to £300 million is wrong, but even within those numbers, it is expecting a reduced number of transactions.

Carl Emmerson: It is worth noting that the OBR identifies five or six policies in the Budget in which it thinks that the costing is particularly uncertain. The changes to stamp duty is one that it flags up as falling into that camp.

Q193 John Thurso: Ultimately, this is not a particularly sensible or simple way of taxing. Is this not making the case for a better way to tax property, as in land value tax?

Paul Johnson: As we have said, there is a strong case for reviewing property taxation more generally, and thinking about the structure of council tax, whether we will continue to charge it on relative values as they were in 1991, whether we continue to charge it in a way that rises much less than proportionately to the value of the property and whether we want to continue with a transaction tax that has an impact on how the market works. Yes, it increases even further the need for a more substantial review and strategy on housing tax.

Q194 Chair: Have you anything that you have been unable to put into the public domain- either in written form, prior to this meeting, or orally-that you would like to add to the evidence?

Carl Emmerson: A very small comment on the child benefit withdrawal-you lose 1% of your child benefit for every £100 of additional income. That means that the withdrawal rate that you face will grow as child benefit grows in cash terms, because 1% will be a bigger number, which seems a rather interesting way of withdrawing a benefit in the benefit system. As Paul said, the £50,000 point at which you start to lose child benefit is fixed in nominal terms, whereas previously it was to be linked to the higher-rate threshold, which typically grows in line with inflation.

Paul Johnson: Another thing that the Committee might want to think about, which relates directly to that point about indexation, is that we now have a hotch-potch of different ways of indexing bits of the tax system. The allowances and so on are, by default, increased in line with prices, but the £150,000 number is not increased at all. Within the NI system, we even have this odd situation in which employer NI thresholds are increased by the RPI, but employee ones by the CPI. The combination of different ways of indexing is becoming less rather than more sensible.

Chair: The overall complexity is increasing rather than decreasing-that seems to be your verdict. Pat McFadden wants to add a quick rejoinder, but we will finish on time.

Q195 Mr McFadden: Following from John Thurso’s question, we know fairly clearly the cost of some of the measures announced in the Budget-for example, increasing the personal allowance to £9,200 has a clear cost attached. We are less certain about the revenue-raising parts of the Budget, such as stamp duty, cuts in reliefs for high earners and so on. The Chancellor was careful to present the Budget as being a neutral overall package. Is there a danger that the costs are certain, but the revenue-raising parts are less so, and that this might end up being something of a tax giveaway Budget rather than a revenue-neutral one?

Paul Johnson: There is some truth in that. It is not only that the revenues are uncertain; the 50p to 45p is uncertain. The uncertainty might not be symmetric in the sense that, as I said, if people are getting used to using avoidance schemes, they might carry on using them.

Some of what we have said on this has been slightly over-interpreted in the press. If it does result in a fiscal loosening, it will be of a trivial amount. As the previous panel described, the Chancellor should not think that a £500 million loosening will spook the markets-I am not saying that because I think it is a £500 million. Equally, if it results in a loosening of a few hundred million pounds relative to what was intended, I don’t think that will do any damage to anything.

Chair: Thank you very much indeed for coming. I am grateful to you for agreeing to supply those further couple of points on one of the most controversial issues. We will take a break and resume at 11.30 sharp.

Examination of Witnesses

Witnesses: Gillian Guy, Chief Executive, Citizens Advice, Professor Dieter Helm, University of Oxford, Steve Hughes, Economic Adviser, British Chambers of Commerce, and John Whiting, Tax Policy Director, Chartered Institute of Taxation, gave evidence.

Q196 Chair: Thank you for coming to our third session this morning. I will begin with a question to John Whiting. Is the tax system now simpler than it was two years ago?

John Whiting: That is a good question to start with, Chairman. I heard the previous panel talk about a hotch-potch.

Q197 Chair: You are the key figure in the Office of Tax Simplification. I was hoping you would be able to give me a yes or no answer.

John Whiting: It is a bit of a curate’s egg-the proverbial curate’s egg: it is good in parts. It has got simpler where there has been good consultation and things have evolved carefully. Even if we end up with extensive legislation, it has been knocked into shape and well thought through both in terms of policy and the exact wording. It is less good where consultation is not followed. Child benefit, which you have just been talking about, is a good example. I think the Office of Tax Simplification is making a difference.

Q198 Chair: I was not asking that. I was asking whether the Chancellor has delivered net.

John Whiting: Yes, but we are making a difference. It is getting a little simpler. To use another phrase, there are some green shoots of simplification around, but they need nurturing. Is it simpler overall? I can only quote a figure that I suspect I quoted to you last year, which was 100 versus 382, which is 100 pages of legislation chopped out by the OTS last year and 382 pages of new legislation brought in, so we are probably losing, but not by so much.

Q199 Chair: The Chancellor has given a pretty strong nod in the direction of retrospection. What effects will that have if it is embedded into the tax system?

John Whiting: I do worry about retrospection. It has great potential to do damage to the image and reputation of the UK’s tax system. It damages it because it takes away some of the reputation for stability, certainty and fairness, which in many ways are the cornerstones of our system. Businesses in particular can look at our system and say that they know where they are. They know that if they settle something, it is settled. They know the operation of law is what it is today; it is not going to be changed retrospectively.

All of that said, I accept that you can never rule out retrospection completely, but it really is not something that you want to waive regularly. We at the Chartered Institute of Taxation put up a paper about 18 months ago as part of the tax policy-making discussion, suggesting it was time to really tackle this issue of retrospection and when, if at all, it would be used. It would be good to take that forward and bottom out why it is thought to be necessary, and when, because it really ought to be in a very tightly controlled box to avoid scaring things.

Q200 Chair: Is this one of those measures where, once politicians have an appetite for it, their interest in it may grow and grow?

John Whiting: I think that is a genuine risk. It is possibly a solution for some lazy drafting of legislation, because you could in extremis get to the stage of, "Well, it doesn’t really matter what the legislation is, because we can always correct it later, and correct it retrospectively." That is certainly not what we should do. We need a certain system that people can rely on at the time. Members may be aware that India has just threatened a whole package of retrospective measures in its budget. I have already seen a lot of industry saying that that tends to suggest they should not go and invest in India, and they are considering making representations to the Indian Government. I am not saying we are going that far, but the risk is there that it damages the image for stability of the system.

Q201Chair: And it damages the stability from the perspective of inward investment into the UK.

John Whiting: Yes.

Q202 Mr McFadden: I want to ask Steve a couple of questions about bank lending. Is it your view that the current level of bank lending is a restraint on economic growth?

Steve Hughes: To a certain extent, yes. We now have evidence through something called the SME Finance Monitor, which was the first independent, big survey of bank lending conditions conducted post-financial crisis. It shows quite clearly that younger, high-growth, smaller businesses find it much more difficult to access finance. If those businesses are having difficulty accessing finance for their growth ambitions, that is certainly a constraint on economic growth.

More broadly, we do not know whether that is more of a structural problem or a precise problem created by the financial crisis. There has always been a problem-or market failure, as some call it-in the provision of finance to those businesses, but how much more acute it is following the recession is something that we do not know. In terms of the things that can help, or public policy that can be provided to aid those businesses in that situation, it is also very difficult to assess where help can come from. As for the schemes, interventions and initiatives that are already out there, there is the national loan guarantee scheme, the enterprise finance guarantee and so on; they are a bit of a mishmash of interventions that help some, but are ultimately not known widely and used by the business community.

Q203 Mr McFadden: I attended a very interesting talk by your new director general at the Banks’s stadium in Walsall on Friday, at which he emphasised the need for economic growth as well as deficit reduction. Do you think that the current problems with bank lending are more about supply-the banks have been unwilling to supply credit to businesses at a reasonable price-or more about demand and confidence in the country’s economic future, and a reticence on the part of businesses to invest and do the borrowing necessary?

Steve Hughes: To sit on the fence, it is a bit of both. On the supply side of the equation, the problem is that there has been a huge breakdown of trust between lender and lendee. Frankly, some businesses do not want to approach their bank even though they want finance, because they just assume that they are not lending. Again, the statistics to show that come from the SME Finance Monitor.

Equally, when you have schemes coming through the banks, or a system whereby-I have spoken to bank relationship managers who say that for 10 years prior to the financial crisis they were simply order takers, lending to those who walked in through the door. Now they have to be more proactive in how they engage with businesses, which gets back to the old argument about relationship management and understanding the business.

Obviously, there seems to be a bit of a skills deficiency on the front line of the banking system. When you try to communicate products such as the enterprise finance guarantee down through bank hierarchies, it is very difficult to explain how a business can walk into its branch and find out, when they ask about the EFG or the credit easing scheme, that nobody knows about it. A perfect example would be that state aid sign-off for the national loan guarantee scheme occurred on the Thursday; the banks signed up over the weekend and it was launched on the Tuesday. Somehow, all the bank relationship managers are meant to know and understand a scheme, so that when a business walks in after seeing it on the TV, they are able to explain to them.

On the demand side-the second part of your question-you have to look at the wider problems of the economy to understand why demand is muted. It is muted for several reasons, not least external problems, such as the eurozone crisis. In particular, chambers of commerce have reported numerous people asking, "What happens if there is a disorderly exit from the eurozone, and what happens to my contracts in that situation?"-so, contingency planning, fear of the unknown, and the risk associated with any kind of investment. The returns on that investment are simply unknown, and therefore, they do not want to borrow.

Q204 Mr McFadden: My final question to you is about the national loan guarantee scheme. We asked previous witnesses this morning whether it was likely to have much impact and their answer was no. What is your view?

Steve Hughes: My answer would be some, but little impact, not of material benefit. Ultimately, it addresses one aspect of the lending problem, which is the pricing of loans. It will make loans cheaper for some businesses, but those businesses are more than likely to be the businesses that would have been viable or deemed viable by credit scoring systems and allowed to have finance anyway. Ultimately, it is just giving them a bit of a bonus on the pricing of their loan. There are wider problems with the system that need to be addressed.

Q205 Mr Love: May I follow up that question by asking you this? The Government admitted, when they launched the scheme, that it was likely that there will be no new net lending as a result. Do you agree?

Steve Hughes: Sorry-no new net lending?

Mr Love: Yes.

Steve Hughes: One of the things about these schemes-and Project Merlin, going back to all the initiatives and setting them in the context of the Government providing initiatives in relation to bank lending-comes back to the trust issue. If there is a situation or a scheme that encourages SMEs to re-engage with their bank, or shop around and test the competitive nature of the banking system, that is a good thing. How much that will happen through these schemes is an entirely different question. We know that some banks are trying their hardest to encourage or generate market share within the business lending market, but we do not know why the others may not be engaging in that. In terms of new net lending, which was the original question, again-possibly not the previous answer I gave about lending just going to businesses that would have already applied for finance but under this scheme would just get it cheaper-that is the danger.

Q206 Mr Love: Would it have helped-a yes or no answer to this, because we have to move on-if the scheme had been larger, for example if instead of £5 billion, it had £20 billion or £25 billion initially?

Steve Hughes: Not necessarily. The scheme is coming in tranches anyway. It is coming in £5 billion tranches. There is another danger associated with this, which is that if one tranche runs out, you may have a gap before the next tranche comes in, which is a bit of a problem in terms of perception and attitudes towards the scheme. But if it is running out of money, it can be monitored.

Q207 Mr Love: The OBR is suggesting that the difficulties in the finance markets may well have worked their way through, and so the benefit of the scheme may well not be as great as it is currently, when markets are not functioning effectively at all. But anyway, I shall not continue on that.

Can I turn to Dr Helm? The Government have announced a number of specific measures to improve infrastructure. How important are these measures? Do you think they have gone far enough?

Professor Helm: On the one hand, it is extremely welcome that infrastructure has become part of a Budget, and significant enough for the Prime Minister to make a speech about it. But the scale of the shortfall on infrastructure investment against the policy still leaves a pretty big gap. I estimated back in 2010 that if you added up the previous Government’s commitments in transport, energy, water and communications and took pretty conservative assumptions, some £500 billion of capital investment was on Government ambitions required over this decade. That is £50 billion a year, and my guess is that we spend about £10 billion or £20 billion. So the gap between what needs to be done and what is being done remains very large. It is a good news story that it is finally being taken seriously, but we are not anywhere near closing up those gaps.

Q208 Mr Love: We talked in earlier sessions this morning about fiscal credibility and how that limits the amount of infrastructure investment that can take place. Are there any other new mechanisms we could use that would directly impact on the way the markets perceive infrastructure being invested in?

Professor Helm: It is a fundamental question. My guess is that tinkering at the margin will not make much difference. The fundamental problem is this. If you ask what the deficit is, you can get an answer in cash terms, but you have no idea what has been done to the assets. So you can run down the assets and the deficit will not look so large, or you can build up assets and it could look huge. Any sensible way of taking accounting forward says that you should look at the Government’s balance sheet. You should look at the assets that we are leaving for the next generation, and you should look at the liabilities that we are giving the next generation. When it comes to the infrastructure assets, there should be a capital maintenance charge against the revenue account. Net of that, we can work out what our deficit should look like.

Carrying that logic through, if you think that we have a lot of catch-up investment to do to make good our infrastructure, the capital maintenance charge should be pretty large. In that case, this generation’s charge for the next generation has not been met. Until you have a balance sheet on which, if you borrow money for an asset, you have an asset and a liability, you cannot have a sensible discussion about what public investment in infrastructure ought to be. Whole-of-Government accounts are a first step on that road, but we are a long way from seriously distinguishing between investment and consumption. This is about investment, and it is about sustainable investment for the next generation.

Mr Love: I know the Chairman will not want me to go any further down that road.

Chair: Not because it is not interesting, but because it is not the focus of this particular inquiry.

Q209 Mr Love: But I take your point about all-of-Government accounts. It has taken us a long time to get that far, so maybe over a period of time we will move further.

Let me just ask you one final question. The Chancellor and the Prime Minister have been on record recently talking about aviation strategy. What should we be looking for in a new aviation strategy?

Professor Helm: I don’t think anybody thinks that where we have got to at the moment is a very satisfactory position to have arrived at. Clearly, there is demand for more aviation, and clearly there is a constraint on infrastructure. Therefore, some decisions will have to be made about whether to meet that demand at all and whether the UK wants to be a hub airport as well as providing its own internal services. If the UK is to do that, there needs to be a proper environmental assessment of the options, as well as the other components of the assessment of the options. Everybody knows what those options are, but everybody seems to be unable to face up to doing that analysis in a clear and open way. Hopefully, that process will finally get under way.

Q210 Mr Love: Are we in a crisis? Some people are presenting it as a decision that we need to make because we are losing out to international competition. Do we have time to take this decision? Is it something that we need to think about very clearly over the next few years?

Professor Helm: There is a prior question: do you want to be an international hub airport? Many countries get by without being international hub airports. The interchanges take place through Heathrow and not through other airports that they could have gone through. There is a major decision to be made on whether we really want that. There are arguments on both sides of that equation. If you say that you do want to do it, certain things follow-"What is necessary to do to achieve that outcome?" Clearly, what is happening at the moment would not achieve that outcome, but the prior question is out there. Do you really want to do that?

Q211 Chair: Do you think we should have a major hub?

Professor Helm: My honest answer is that I am not sure, because I have not seen an analysis that convinces me either way.

Q212 Chair: If you did think we needed a hub, what would you do?

Professor Helm: If we needed a hub and that decision had been made, we would look at the options in front of us.

Q213 Chair: I am asking you to make an assessment of them.

Professor Helm: Well, I cannot do an assessment off the top of my head because I have not done the analysis. That is not a fair question.

Q214 Chair: You have said, "I do not know" to both of the questions that have been posed to the Government.

Professor Helm: Yes. If you are doing public policy on infrastructure, there ought to be an appropriate process that confronts the question head on, does the analysis to support it and then thinks through the policy consequences. For people to say off the cuff, "I’d do this," or, "I’d do that," is exactly how we shouldn’t go about the process. I say that with due respect.

Chair: I think you have made your point about the broader perspective of these decisions very forcefully.

Q215 Mark Garnier: John Whiting, may I turn to the 45p/50p tax rate question? Looking at the international community, both in terms of people who live in London or the UK who come from overseas and people living overseas who might want to come to London or the UK, do you think that that cut in the top rate of tax is likely to change people’s behaviour and make the UK more attractive to them either to stay or relocate here?

John Whiting: Undoubtedly, it is going to make the UK appear more attractive because it is a signal. It is part of the UK’s shop window for individuals and entrepreneurs, just as the corporation tax rate is part of the shop-window advert for businesses. Of course, the two come together, so cutting it is bound to make the UK look that bit more attractive.

Q216 Mark Garnier: Do you think it is an effective addition to the shop window?

John Whiting: I think it is a useful addition to the shop window. As you alluded to, Mr Garnier, if you tabulate the rates, at the moment the UK’s rate is at the top. Most sensible investors will, of course, look underneath the shop window rate at everything else, including the infrastructure that Professor Helm was talking about, but it is an important signal. It probably comes back to something I have said very often, which is that my feeling is that the 45p rate or the 50p rate is almost more symbolic than a matter of how much it actually raises, as you heard in the previous session. It is a bit like the points on infrastructure. What is it you are trying to achieve? In many ways, tax needs as much of a strategy as infrastructure. Where are we going with this? What are we trying to achieve?

Q217 Mark Garnier: That is a very interesting point. On that basis, do you think there is an argument for reducing it back to 40p, where it was before?

John Whiting: There is an argument, no doubt.

Q218 Mark Garnier: Sorry; do you think there is a convincing argument for reducing it? Of course there is a general argument.

John Whiting: I am going to sound like Professor Helm, my friend to my right. There are arguments on both sides. I go back to the point that there is a bit of symbol here.

Q219 Mark Garnier: But with your huge experience as a tax consultant-you have more experience, perhaps, than anybody else in this country in terms of what behavioural effects taxation has-do you think, if you were Chancellor of the Exchequer, that it would send a much better and much clearer message to the international community if we were to reduce the tax rate to 40p?

John Whiting: It would send a clearer message to the international community. You have to balance that with the message that it sends domestically. You cannot just look internationally. Clearly, with this there is an element of the rich sharing the pain of everybody. As with so much of tax, it is a balancing act. It is for the Chancellor to take that decision and balance the various factors.

Q220 Mark Garnier: Can I ask a specific question about other countries? A company in my constituency that manufactures carpets with a manufacturing operation in Portugal has been offered an amount of money to relocate its carpet manufacturing facilities from Kidderminster to Portugal, with a cash incentive to pay the costs. Yet, of course, the top rate of corporation tax in Portugal is 29%, compared with the 22% that it will be here. Do you think that the fact that the Portuguese Government are prepared to offer a cash incentive demonstrates that we as a country are becoming increasingly competitive by reducing our corporation tax, and that-it may not be enough to effect the move-it reinforces the argument that we are now coming back to a leading position on the global stage in terms of assistance to manufacturing through the tax system?

John Whiting: Yes, I think it shows that the tax system is getting broader and better, in that sense. There are an awful lot of nuances in this. It is interesting that you used the example of carpet manufacturing. They might want to invest a lot in equipment. They might therefore look to capital allowances. The capital allowance rate has been coming down at the same time as the headline corporation tax rate. I presume you are talking about a large business that might actually benefit from the headline rate cut. Let us not forget that the vast majority of businesses gain no benefit from the headline corporation tax rate cut, because they are paying at the small profits rate or, of course, are unincorporated and are losing on capital allowances and gaining no benefit on rate cuts.

I think the answer, as with so much, is that it depends, but I come back to the fact that it is a signal. It is interesting that the Portuguese are trying to pick winners. Obviously they think it is a good business to try to pick. I am not sure that is really the sort of business we as a country should be in.

Q221 Mark Garnier: Gillian Guy, can I bring you in on child benefit? What is your view of the child benefit changes for higher earners?

Gillian Guy: We welcome the changes introduced in the Budget, because they will take less from people than previously proposed. It is also helpful to have a tapering of that effect for the margin between £50,000 and £60,000. The issue still remains, however, that there is an anomaly between single-income families and couples. It is possible for a couple to earn almost as much as the limit and not lose their child benefit, whereas a single person very quickly goes over the threshold and loses it. There is an anomaly that has been carried through from the original proposal to the Budget.

Q222 Mark Garnier: It is marginally reduced. But do you not agree that that anomaly is carried through to the tax system generally? You have two hypothetical families, one with a single earner on £84,000 a year who is paying £4,000 a year more than the household next door where there are two earners on £42,500, so the anomaly carries through anyway, doesn’t it?

Gillian Guy: I think that it does, but if we have an opportunity not to reinforce it by propositions that come forward, that would be a good thing to do, and it has been missed as an opportunity here.

Q223 Mark Garnier: As an overall point, given the people who have been asked to lose this benefit, do you agree that it is not an unreasonable proposition that those people who are on higher earnings are in a better position to contribute to the sorting out of the financial problems?

Gillian Guy: I think that it is commensurate with the argument that there ought to be an even spreading of pain. Those who are more capable of dealing with that ought to be the ones who take the brunt of it. This is a small piece, though, of that argument. When we look at things such as the personal tax allowance and the impact that it is said to have, the impact that it actually has on real people is that the headline-it is a bit like corporation tax-applies to only a certain number of people and not to those who are in greatest need. So, it feels as if child benefit is just a very small part of that. It is welcomed by us, and it is welcomed as a new proposal subject to that anomaly, but it does not deal with the pillar of the Budget, which is supposed to be fairness, or with the impact, on lower-income families particularly, of the personal tax allowance.

Q224 Mark Garnier: This is my last question. Child Poverty Action Group and Mumsnet argue that it is absolutely right that people with broader shoulders should bear the greater burden, but that it is wrong that this should be levied on families with children and that it should be done as general taxation. Do you think that that argument holds any water?

Gillian Guy: If the argument holds water it is not one that we-

Q225 Mark Garnier: I am sorry, but do you agree with it?

Gillian Guy: It holds water but it is not one that we are promoting because we think that there are other arguments that need to be promoted more strongly. For example, if there is not a disregard in terms of benefits and universal credit for the addition in personal tax allowance for low-income families, that benefit is going to get eroded completely, and it is those things that we want to draw attention to more than the other point that you raised.

John Whiting: May I add a quick point on child benefit? I am sure that you will not miss it, Mr Garnier, but the sheer amount of extra administration and checking that the process will bring in must not be underestimated. There is a great deal more work to be done for the Revenue and for a cadre of people in pursuing them.

Q226 Mark Garnier: That is a very good point. Richard Murphy mentioned this the other day, in terms of tax forms, with having to work out what is going on and the extra cost that there will be. Do you think that the Government have it completely wrong with the way in which they are raising the money? Do you think that there is a far better way of doing it?

John Whiting: You could say that there would be an easier way of doing it, which would be to scrap child benefit and just compress it and fold it into tax credits, but that has a major impact and huge distributional shifts. Almost as soon as you say that you want to withdraw child benefit from a sector of those who would collect it, you are imposing an administrative burden, with all the connotations of people mixing it up, having to repay, misclaims, and all the rest of it that we saw so much of with tax credits. We start from a very simple all-but-universally-taken-up relief and are putting an administrative burden on it.

I totally agree with the points that Gillian made about it being better than it was, but I am simply saying that the administrative load must not be underestimated. There is a big need for proper and careful communication, and for making sure that people do not get the wrong message about things such as having to give it up, or not staying on the register in case they lose their job. It is all an extra problem.

Q227 Chair: Mr Whiting, since you said that it must not be underestimated, perhaps you could give us an estimate? Would you be prepared to have a go at that?

John Whiting: I can give you an estimate.

Chair: Thank you very much.

Teresa Pearce: John, the HMRC report says that 500,000 more people will have to do self-assessment forms because of the child benefit changes, and that it will cost £100 million in staff over five years and £8 million in IT. That is quite a large amount. I want to ask about child benefit-not about how we tax but about the principle. We remember when women were not taxpayers and we had wives’ income allowance and, under Margaret Thatcher, independent taxation came in. At the time it was said that she ran the country but could not sign her own tax return. It was ridiculous and changed to independent taxation. What concerns me about this, although it is better than what was suggested before with child allowance, is that it is a step back to family taxing. You will have a situation in which one person’s income, be it benefit, will have to be declared on another person’s tax return. Do you think that that is a step backwards for women’s financial emancipation?

John Whiting: I think that it is. The point is very well made: we have a very uneasy meeting of benefit, which tends to be on a family unit because tax credits are like that, with a tax system that is independent taxation. I do not think that that division has ever really been tackled since tax credits were in force. The moves on child benefit erode that independent taxation even more. You are going to end up with the need for HM Revenue and Customs to use some of those extra resources that you pointed at, to police family units and to monitor relationships that come together and that break up. That has an implication for one of the halves’ tax bills. It all seems as you suggest, a bit of a backward step on independent taxation.

Q228 Teresa Pearce: Do you think that there would need to be a change to the independent taxation regulations to police this?

John Whiting: It almost comes back to the previous point. What is the strategy? As Mr Garnier was driving at and, as Gillian Guy said, one argument is that we should, for example, compensate the family unit by transferrable personal allowances. If one half does not use it, it should be transferred. It would be a bit like the wife’s relief that there used to be in the system that you and I perhaps remember. It needs looking at and, fundamentally, I wonder if, 20 or so years on into independent taxation, it will not be time to have another look and decide strategically where we are going with this. Are we really going down the independent taxation route or are we perhaps looking at family units? It is more than tax. It is, of course, tax and benefits.

Q229 Teresa Pearce: I want to ask you a few questions, Gillian, about the age-related allowances. When he announced it, the Chancellor said, "over time we will simplify the tax system for pensioners" by doing away with the complexity. He then announced that the changes would not be made over time, but now and in 12 months’ time. It was quite sudden. Do you support the changes? If you do not, would you have supported them, had they had been more phased-in?

Gillian Guy: There is a degree of phasing, which I suppose is what allows the Chancellor to say that it is not a significant immediate impact. A large number of people coming up to pensionable age will be impacted straight away, of course. In the current circumstances, the costs of living, as we all experience, are rising as are debt levels . People come to us with 7 million issues a year, and debt and benefits are the number two issue, so we don’t want to see particularly vulnerable groups-I put pensioners in that category-actually suffering a loss, but obviously, large numbers will do so.

As we catch up with the rest of those pensioners, they will also lose out, something to the tune of £83 a year. That may not be a huge amount, but it has to be considered in terms of the cumulative impact. Fuel prices continue to rise, and that is a key worry; 43% of the people who come to us are worried that they will not be able to meet their fuel bills. We have examples of people coming into our bureaux who do not heat their homes because they are worried about not being able to afford it. Again, it is another impact on those people. This group of people very often have to rely on their savings in order to live in their retirement, and they are getting very low interest on them. They cannot bank on them in the future in the same way as they used to.

It is the cumulative impact, as always, of such measures that needs to be taken into account. I have been in this Committee before talking about that. I also think that there is a slight perverse incentive in terms of what is tantamount to higher taxation. We are asking the younger generations to save for retirement, but then to say "Actually, you’ll be worse off in the end" does not offer them much of an incentive to do so.

Q230 Teresa Pearce: Do you think any behavioural changes will be brought in by this change? Do you think people may decide not to continue to work after a certain age or to do part-time work? Given that their tax allowance has gone, will there be any changes in the way in which people approaching retirement plan?

Gillian Guy: There may well be changes in that because they will have to make a different allowance for what they can expect to come to them in the future, and also, how much will be taken away out of the income that they manage to derive. There are far bigger things causing choices at the moment. As I have said, it is that cumulative picture that is important to take into account. This is a group of people that ought to be protected and we tend to forget them and concentrate on other generations.

Q231 Teresa Pearce: Given that the whole issue of pensions and retirement is being debated at the moment, with extensions to the age at which people retire and the auto-enrolment into pensions, do you think that there should have been more of a joined-up thinking piece on retirement and ageing rather than just a one-off?

Gillian Guy: I think that from Citizens Advice point of view, we would say that all of it should involve more joined-up thinking. When we look at things such as another large chunk-say £10 million by 2016-coming out of welfare reform, for example, in the midst of all of these other measures coming forward, we urge Government to think about joined-up thinking across the piece, and pensioners are not an exception to that.

Q232 Teresa Pearce: Mr Whiting, you are the tax director of the Office of Tax Simplification. In your report, looking at the simplification of taxation for pensioners, you said that none of your findings had been formulated into final recommendations. Were you surprised by this announcement?

John Whiting: I was surprised that it was taken forward so quickly, yes. The context is that we undertook to do a two-stage review of pensioner taxation. The first would document the problems and codify all the problems. Hardly surprisingly, the complexities around age allowances was raised by some in virtually every group that we talked to the length and breadth of the land-difficulties in making sure that the right amounts were given, coding problems and all those sorts of issues. Hardly surprisingly, it comes through as a source of complexity. Having logged it, we listed a number of ways in which it might be worth considering how you might tackle the complexity. Unsurprisingly, getting rid of age allowances is in the list. Stage two was to go ahead and look at them and try to work out what might be the best way forward. We would have to do that within our remit of being broadly revenue-neutral. So, we would be looking at a balance.

Q233 Teresa Pearce: So what would have been top of your simplification list?

John Whiting: You cannot get away from the fact that if there is a measure that adds to complexity, the easiest way of solving that complexity is to get rid of it. In pure simplification terms, clearly abolishing age allowances would be a contribution to simplification. Then again, one could look a little larger and say abolishing income tax would be a great contribution.

Teresa Pearce: It would be very popular as well.

John Whiting: It might be more popular than some. Obviously, these things have to be put in to a certain context. I am not going to deny that abolishing age allowances had to be on the list. My personal view, rather than that of the report, is that this is an issue that has been on the cards for the last two years with the intention to move to a £10,000 personal allowance. It is something that virtually everybody in receipt of age allowances wants to know about. I am sure that Citizens Advice and the low-income tax reform group have consistently asked what is happening to the age allowances. Had it been known and planned, people could have adjusted for this and come to expect it a little sooner. It may be precipitate now, but, arguably, it is almost two years after the point when it might have been tackled.

Q234 Teresa Pearce: Tax is complicated, and people do not understand it. People often do not try to understand it because they think it is complicated. One of the suggestions that has been made is that people should get an annual statement about how their tax is spent. From what I have seen, the annual statement is going to look like a council tax bill, with a pie chart. Welfare will be one chunk, and that will include pensions. Do you think that that will simplify the matter or will it confuse people that it is all out-of-work benefits?

John Whiting: I wholly support the concept of the tax transparency statement and something that will encourage people to engage more in the tax system. I think that it is an admirable idea and an admirable aim, because you are right-people do not engage enough with the tax system. They are just automatically put off. If a brown envelope arrives, the tendency is to put it behind the clock or whatever, or just bin it and hope it goes away. So I think that the concept of a transparency statement is admirable; I very much support it. Regarding the detail of what exactly it shows and how, we are back to the need to communicate and to communicate clearly, so that when your constituents get all these statements, they don’t form a queue outside your surgery, asking you to interpret them, because there is clearly that risk. We do not want to end up with HMRC’s phone lines being in meltdown, with people asking what the statements mean. There is a lot of design work to be done on these statements, but I think that the objective is to be wholly supported.

Chair: We don’t want our phone lines in meltdown either.

Q235 John Thurso: Professor Helm, may I come to you? I want to talk about the measures designed to promote investment in energy. The usual hierarchy for decision making in energy supply is security first, affordability second and emissions third. We seem to have been doing that slightly the other way round, with emissions first, affordability second and security seeming to come third. Is the UK continuing to underestimate the importance of energy security over the next five to 10 years?

Professor Helm: Let me take it in two very quick bits. The first bit is that you are right; everyone seems to agree that there are three objectives of competitiveness in some sense, security and emissions. And security is within that frame. If you look where we are, on emissions, globally nothing has been done to do anything about climate change. Coal-burn goes up, the rate of increase of emissions goes up and in 25 years nothing whatsoever has been achieved in addressing those questions, and I mean that seriously. In the UK, carbon consumption is going up. It is just because we measure carbon production that it looks like we are doing well-we are not. So, if you ask, "Is this a policy framework to address climate change?", the answer is, "No."

If we look at security-the question you asked-in 1990 our system was roughly 80% coal and 20% nuclear. Nearly all of that capacity will be closed by 2023, bar one nuclear power station. So there is an enormous wall of existing capacity from the’70s that is coming off the system.

Are we addressing the provision of an investment framework to ensure that we have security of supply? By that, I do not just mean the lights going out, but sufficient security so that we do not see price spikes all over the place to achieve that security. Not yet-it’s a mess. We have been reviewing energy policy for years. There have been 12 years of reviews of energy policy after each election, and White Papers, etc. Do I have any confidence that we have a framework yet that will provide sufficient incentives to build the power stations, to provide one of the basics of an economic system going forward? No.

Q236 John Thurso: I saw some research-I think that it was produced by Nomura-that indicated that capacity and demand would be pretty close to being equal at about 60 GW in 2016, 2017, 2018 and 2019. Do you concur with those figures?

Professor Helm: I think that trying to estimate precisely how the balance will be in five years’ time is not how we should think about energy policy. Remember that if you go back really recently in investment cycles-back to 2005-you would expect GDP to be about 18% higher today than it actually is. That is why we do not have an energy crisis. Compared with the 3% growth rate, if you work out what has happened since 2005 there is a lot less demand on the system than we previously had. The question that one really wants to address is, "How do you provide a proper, long-term capacity contracting market in which you can ensure you have sufficient investment in that system by having contracting to have that system there?" That is what we do not have.

I used to think that we would have a problem in 2011. We would have had a problem in 2011 had that economic downturn not taken place. If economic growth is 3% to 4% per annum from now onwards to the end of this decade, we will have a serious problem. If it’s nought, we probably won’t.

Q237 John Thurso: So, in the likelihood that there will be growth, and that the rate of growth will grow, that problem you have identified comes forward. The Chancellor, therefore, is absolutely right to do a dash for gas, is he not?

Professor Helm: I read very carefully what the Chancellor said, and I think what he said was that the Government were going to look at the investment incentives in respect of gas. There is a really important problem here, in Germany and in a number of other countries: if you bring more intermittent power on to the system, such as wind, which has a zero marginal cost, when you invest in a gas station or any other base load station going forward, you can no longer rely on that station running at base load for some time to recover your costs.

Therefore, in Germany, here and elsewhere, anyone now wanting to build those kinds of stations needs some kind of contract to do it. That is the right question to ask. Whether there should be a dash for gas-meaning lots and lots of gas-is a completely separate question. The problem we have at the moment is that there is not any incentive to build any of it. Clearly you are going to need some of that to get through that period, regardless of what your energy policy framework looks like.

Q238 John Thurso: The point, presumably, being that you have to have base load. Therefore, we will have to build twice the capacity, because for every capacity of intermittent renewable, you would need an equal gigawatt of base load for the three or four days a year when the wind does not blow.

Professor Helm: With due respect, that is slightly confused. We need back-up capacity, so that when intermittent generation isn’t available you have other capacity. That means flexible capacity. However, you also need base load to take up some of this load from the coal stations going off the system and from the nuclear stations going off the system. Remember, we are closing most of our nuclear industry. Even if we build a few more, we are actually reducing the share of nuclear in the frame.

You need both of those things. What are the incentives to invest in this world we have created? Secondly, within that framework, we now no longer have the luxury of this massive surplus of supply that came from the 1970s, because we de-industrialised and we didn’t need it so much. Now we don’t have that, do you have a policy framework that ensures that sufficient capacity is effectively built, because you have to have that for the system benefit? My answer to that question is, not yet.

I think the energy market reforms, although they ask some of the right questions, have created an immensely complicated system. I am sympathetic to the comments made about simplicity of the tax system. It is very complicated. You have individual contracts for feed-in tariffs, for different kinds of technologies, plant by plant negotiations, separate capacity market, and separate energy market. That is a recipe for confusion and expense and I think it is going to be costly on the cost of capital for investment.

Q239 John Thurso: There appears to be relatively widespread agreement from industry, green organisations and lots of others, that the carbon reduction commitment scheme is simply too complex and burdensome, and therefore it is not achieving the goals for anybody. What would be a sensible alternative?

Professor Helm: Most economists would immediately answer the question by saying, "What you want to have is a price of carbon, have a carbon tax, get it done, fix it, make sure that you set it low originally but have a rising trend, and people know in the long term what is there." Instead, what we have is the European Union Emissions Trading System, which is short term, volatile and very low. We now put a carbon floor price in because the EU ETS cannot deliver the price we want. Then we extend these commitments on a company by company, case by case basis. Again, what you create is, by definition, an enormous bureaucracy and lots and lots of costs, but what for? What you really want to do is not say you know exactly what firms and individuals should do, but set a price and let the market sort it out. We will eventually get there.

The trouble with lots of different ways of getting at the same problem is that you create a whole industry of people involved in it, but you have to look at the bigger picture. Are you actually achieving the objective you set yourself, which is to reduce the emissions at the least cost, given that anything you do to reduce those emissions will have cost effects? As we know, we have lots of people in fuel poverty and lots of people facing these constraints.

I welcome the step that has been made, but I would have it as a more radical discussion about what we are really trying to do here and how that fits with our security and competitiveness, as well as our commitment to addressing global climate change, and therefore our carbon consumption, not our carbon production. Between 1990 and 2005, carbon production in this country under Kyoto fell 15.4%. If you add back the imports and the carbon we actually consume, which is our genuine carbon footprint, our emissions went up 19%. That is why at the global level, emissions keep going up, the coal burn keeps going up in the developing countries and we are destined for beyond 2° already in the frame we have constructed. That is why I say nothing has been achieved in this way. We ought to clarify what we are trying to do and address what is a really urgent global environmental problem as best we can, without incurring costs without benefits.

Q240 John Thurso: Okay, thank you very much. Can I just quickly ask Steve Hughes for the business take. What is the view of the Chambers of Commerce on what was done for the carbon tax floor price?

Steve Hughes: I don’t know what work we did on that piece of policy, but I can submit it to the Committee afterwards.

Chair: Well, thank you very much for coming. I am sorry that it has been somewhat concertinaed, but that is the way of things with the parliamentary schedule we have been faced with. Thank you very much. You have given extremely interesting evidence on all fronts.

Prepared 29th March 2012