Oral evidence: Autumn Statement, HC 870Tuesday 9 December 2014
Oral evidence, 9 December 2014.
Witnesses
Paul Johnson, Director, Institute for Fiscal Studies, and Carl Emmerson, Deputy Director, Institute for Fiscal Studies, gave evidence.
Chair
Welcome again. You are very familiar with our cross-examination of these issues. Could I begin by asking you, Mr Johnson, how important you think marginal rates are to incentives and therefore presumably productivity? We have just been discussing that. Then give us a brief rundown on the shape of marginal rates in the personal tax system at the moment.
Paul Johnson
Marginal rates are clearly pretty important in people’s behaviour and work incentives, both at the bottom end of the scale where marginal rates are highest because of the withdrawal of tax credits and housing benefit particularly, and at the top end of the scale where people can be very responsive in terms of not so much probably how much they work but how they declare their income or where they work. It is important not just to focus on marginal rates though because at the bottom end of the scale the average rate, the effective tax rate that determines how much you get in work relative to out of work, is probably even more important. So if you don’t get much more or less in work than you get out of work that is potentially going to have a big impact on your behaviour.
Chair
That is a rather special kind of marginal rate.
Paul Johnson
Indeed. It is an important one and for a lot of people it may be more important than the marginal rate that impacts what happens if you work an extra hour. So I think there is quite a lot of evidence that both these things matter. They matter differently for different people actually. For people over the age of 60, say, these things matter a lot because they have potentially more choice about how they behave. For example, for married women with children or lone parents with children, these things tend to matter more than they do for your average 40 year-old man who will tend to work pretty much whatever you do to him. It does matter who these things apply to. In terms of the structure of the marginal rates, if you just look at the income tax and national insurance system, you have something that looks complicated enough. You move from 12% to 32% to 42% to 62% to 42% to 47%. I may have missed one there. If you include the tax credits and housing benefit, you obviously have marginal rates in the 90% and 70% before you just get back into the income tax rate, and then between £50,000 and £60,000, as child benefit gets withdrawn, you have very high tax rates for those groups. It is worth saying there is one other thing that was introduced in the autumn statement, which is the postgraduate loans. Postgraduates repaying both a postgraduate loan and an undergraduate loan, even if they are just a basic rate taxpayer, will face marginal rates of 50% relative to the standard 32%. There is a whole series of different things in here. For some people these marginal rates are really quite high.
Chair
Has the IFS done any studies of the extent to which people are sufficiently aware of the huge steps or cliffs they encounter in marginal rates and therefore the extent to which it is changing behaviour, or are you aware of research of that type?
Paul Johnson
We don’t have work looking specifically at people’s awareness but we do have work looking at ex-post the extent to which people respond to these things. You can see responses for some of those groups that I described, for people between 55 and 65, for mothers with children and so on.
Chair
They are evident ex-post for previous introductions.
Paul Johnson
They are evident, yes.
Chair
How do you mark out of 10 the Government’s performance on dealing with some of the complexity in the tax system that is evident with these?
Paul Johnson
In the individual bits of the tax and national insurance system, this Government has not made any desperately big changes. You have moved a lot of people out of income tax through increasing the personal allowance but you have not moved anyone out, any earners of direct tax.
Chair
So any mark you give is really a mark on the previous Government. That is what you are saying, isn’t it? So mark the previous Government and then tell us about how the current one is doing.
Paul Johnson
The previous Government introduced the 62% rate on over £100,000 and then a higher rate over £150,000. The current Government has taken national insurance and income tax away from each other and has introduced this new band on people with child benefit in there between £50,000 and £60,000. Once universal credit comes in, if it does finally come in, that will simplify and reduce some of the rates for other groups. I would not give either terribly high marks.
Chair
Out of 10?
Paul Johnson
I don’t know—six.
Chair
Do you have anything you want to add, Mr Emmerson?
Carl Emmerson
In terms of how has this Government done, I would say there are some reforms that have improved how the tax system works but actually perhaps it was just a missed opportunity.
Chair
We are looking here at the personal tax system for the time being.
Carl Emmerson
Indeed. So there has been a huge deficit. There are things you could have done that would have raised money that would have tidied things up, so in that sense a missed opportunity. The child benefit withdrawal is implementing something that has a marginal rate that depends on the number of children you have. From next April, some married couples will also get a transferrable allowance, but if you move from having £1 of income below the threshold to £1 above you lose all of that. That is perhaps not such a huge deal in the short run but if a future Chancellor wants to make that thing more generous and decides to go further and reward marriage using that instrument, then it will become worse and worse, this great big cliff edge where it says, “Ask your employer for a pay cut and you will be better off”, which is not a good feature of a tax system.
Chair
Do both of you agree with the Mirrlees Review conclusions, which are that the withdrawal of the personal allowance above £100,000 is patently absurd?
Paul Johnson
Yes. It just introduces an additional tax rate of 62%, so the tax rate goes 42%, 62%, 42%. That does not look like a terribly sensible system.
Chair
Here is an area that is right for reform in the next Parliament—
Paul Johnson
You would think so. It is also worth say that because—
Chair
—when whichever Government is in power has a bit of money to lubricate the system. As Mr Emmerson has just said, some of this has been caused by the deep financial stringency that has been required after the crash.
Paul Johnson
You are also affecting more and more people with this because the point at it comes in has not been indexed even with inflation for five years now, so the real impact of it is growing all the time. I think this is an additional issue with the tax system. We have a series of bits of the tax system that are just not growing with inflation, the £100,000 mark, the £150,000 mark, and inconsistencies about others, and indeed a lot of the things in the pension tax system.
Chair
You seem to making the case for another Rooker-Wise-Lawson amendment.
Paul Johnson
We do seem to have lost that in many of the new elements of the tax system and that is quite dangerous in terms of moving the tax system unintentionally or at least non-transparently towards a new place. The annual limits have come down for the way in which we tax pension contributions. There is no sign that they are ever going to be raised in line with inflation. The point at which child benefits is withdrawn, the point at which the 62% rate comes in and so on, all of these seem to be fixed in nominal terms and that will, over time, transform the way the tax system works and not in a positive way.
Steve Baker
Can we turn to ring-fencing? When this Committee reported on the 2014 Budget we said, “Ring-fencing distorts spending decisions. It also weakens rigorous scrutiny of spending in ring-fenced departments”. Does the IFS agree?
Paul Johnson
Ring-fencing is clearly just a political decision about where you want to concentrate your resources. The impact of ring-fencing going forward, particularly if the NHS, schools and ODA continue to be ring-fenced, does make a very big impact on the cuts that will be required on the OBR figures in the non-ring-fenced departments. That is just an arithmetic outcome of the fact that a very large chunk of public spending is being ring-fenced.
Steve Baker
If I put that in very plain language, ring-fencing some departments amplifies the effect on other departments?
Paul Johnson
Yes.
Steve Baker
Thank you. The IFS has noted that, according to Government policy, total departmental spending would need to fall by a further 14% of GDP over the next Parliament. You also noted that that implied unprotected departmental spending would need to fall by 26%. Would removing the protection of ring-fenced budgets lead to more efficient cuts in expenditure?
Paul Johnson
Let us be clear, that is not percentage of GDP. That is just the percent in real terms that it would need to fall.
Steve Baker
Okay, but it is the same question. Would removing the ring-fencing lead to more efficient spending decisions?
Paul Johnson
Let us put the pensions to one side, because that is not a formal ring-fence within the DEL. There are two big ring-fences there. One is health and one is schools. My sense is that even if one were not to formally ring-fence the NHS, there is not a lot of appetite to cut it, and indeed we are seeing an increase in spending on the NHS next year. There is strong lobbying from NHS England and others to increase going forward. Whether the formal ring-fence is making a difference to those decisions I do not know. The schools ring-fence, interestingly, which is not quite as big as the NHS ring-fence but it is still very big, appears to have come under considerably less scrutiny and there may be scope for scrutinising both those things.
Steve Baker
Does the IFS form a view on departments’ ability to cope with particular cuts or reduced rates of increase?
Paul Johnson
We do not have a particular view of what would happen if the schools budget or the transport budget was increased or reduced by 5%. We do know, for example, that within the transport system there are very high value projects that are not happening because spending is not happening. We have a view about public sector pay, which is a particularly important part of this whole story. One of the reasons that public sector spending has been able to be kept under control over the last five years is that it has been possible to keep public sector pay down, because it is only just about now catching up with the very sharp cuts in private sector pay. That has been more possible over this five years than perhaps it will be over the next five years.
Steve Baker
But you would not form a view, for example, on whether the NHS could cope if the ring-fence was removed and spending was cut or an extra £2 billion or £2.5 billion or whatever this Government promises? You would not form a view on the consequences of those kinds of political pressures?
Paul Johnson
We do not have a model of the whole NHS in order to say that the effect would be this or that. We can look over long periods and see what has happened over long periods.
Carl Emmerson
We tend to say, “What has happened to the NHS budget? How does it compare historically? How does it compare internationally? How does it compare to the ageing pressures you have?” For example, if one were to freeze the NHS budget from 2010 through to 2018, you then see what is happening to that budget per head and per age-adjusted head, given that the older population is growing much faster. We would point out that that is a 9% drop. It does not mean it cannot be done, but it shows that perhaps a freeze would be quite a challenge for the NHS.
Steve Baker
Yes. You might be able to say that 9% drop would imply such and such for productivity but, of course, you would not try to explain how that productivity would be realised.
Carl Emmerson
No. We would also say that we have not had a period where the NHS budget has not risen.
Steve Baker
Just finally from me, do you think that the proposed cuts are possible without a reimagining of the state?
Paul Johnson
They are possible, but I think that will require significant change in the way things are delivered. If you look at the non-ring-fenced DEL budgets from 2010 to 2020, you are looking at average cuts of something like 40% on the OBR numbers. It is not to say that is impossible, but that will require a change in view about how they are delivered and what it is that is being delivered.
Steve Baker
You are not challenging the underlying assumptions about, for example, whether the NHS is free at the point of use, I do not think. You are talking about how they are delivered. Is that right?
Paul Johnson
Clearly that is an option that is open. We have a health service that is freer at the point of use than most health services internationally. Something that is a little bit different would not be impossible from an economic point of view, although it would obviously be challenging from a political point of view.
Jesse Norman
Just picking up that point, Mr Johnson, you seem to be in a position of saying that the squeeze on the public finances is going to be caused in part by the ring-fencing of the NHS budget but, at the same time, saying the NHS budget is under enormous pressure because of international comparisons and ageing population and the rest of it. Am I right about that?
Paul Johnson
I think both those things are right. For a set amount of spending, clearly if you are going to protect big chunks of it like the NHS you need bigger cuts elsewhere.
Jesse Norman
The reason you are protecting it is because you have these escalating pressures on the NHS. That is the reason it is being protected.
Paul Johnson
Absolutely, of course.
Jesse Norman
I want to turn to the question of tax revenues, which are absolutely the foundation, it seems to me, of economic forecast. Do you think the OBR is too pessimistic about tax revenues? That was the view that was expressed in the previous session.
Paul Johnson
That largely depends on forecasts, as Kevin Daly was saying, about earnings, where he is more optimistic than the OBR. We do not make our own forecasts about earnings. I think, given their forecast of economic growth and earnings and the composition of growth, their forecasts for tax revenues look reasonable. Clearly, if things turn out better than they are suggesting—and, as your previous witnesses suggested, the Bank of England and a number of other commentators think they will turn out better—then there is happily some risk on the upside here.
Jesse Norman
Potentially quite a geared return. If earnings start to move that could have quite a significant effect on tax revenues, could it not?
Carl Emmerson
Potentially we have seen the same in reverse since the Budget. One of the big things in the OBR’s numbers is that in three years’ time they are expecting to get about £20 billion less from income tax and national insurance contributions, partly because earnings growth is now expected to be weaker but partly because they now think you get less tax per pound of earnings in the UK economy. Clearly there is a risk on one side that recent trends could continue and the OBR may be proved to be too optimistic again, but these things could unwind and one lesson learned is that it is very difficult to do these forecasts. These numbers can move in a very large amount.
Jesse Norman
Right but for the avoidance of doubt, you do not have any private views as to whether or not you think the OBR is too pessimistic?
Paul Johnson
No.
Carl Emmerson
No.
Jesse Norman
Can you talk a bit about the composition of tax revenues and shortfall? We know one of the reasons is a lower effective tax rate. There were various one-offs in the way in which tax revenues have been below. To what extent do you think is this a structural problem, a permanent reduction or a long-term reduction in the tax revenue-generating base, and to what extent is it not structural but a function of a particular set of economic circumstances?
Paul Johnson
It is difficult to know what is a set of circumstances that will continue or not. If it remains the case that a larger proportion of the working population is self-employed, that will result in less tax revenue than the similar world in which those people were in employment, partly perhaps because they are declaring less income but particularly because the tax system structurally takes less tax from people who are self-employed because they pay very different amounts in the way of national insurance contributions, for example. If that economic change is structural then the tax change will be structural. When it comes to many of the other elements that is to do with what is happening to earnings growth. If we are in a structural world of very low earnings growth, then we are in a structural world of very low tax revenue, but if we are not then the tax revenues ought to take off again.
Carl Emmerson
We are saying there are some other risks too. We are taking a large amount of tax revenue from a relatively small number of people. That makes it harder to forecast as well. The rich are paying a relatively large share of revenue. The OBR is forecasting very strong growth in stamp duty revenue. That may materialise, but again it is harder to forecast how many housing transactions there are going to be in five years’ time compared to today. It is very difficult thing and it is not just about earnings growth in the economy.
Jesse Norman
That is interesting, but the point you seem to making is that there is no evidence, as matters presently stand, that we are looking at, necessarily, a long-term reduction in the capacity of a Government to raise tax revenues.
Paul Johnson
If we get back to productivity growth and earnings growth then clearly we will get back to some degree of tax revenue growth. If we continue what we have over this period, which is employment growth with very little in the way of earnings growth, then that is going to create problems for Chancellors in the future.
Jesse Norman
The multi-billion pound question is the one that was raised earlier, which is the question as to whether or not the current situation we are in is a function of labour market conditions or whether there is a permanent reduction or long-term reduction in productivity growth. Do you have a view on that? The average worker generally seems to be better educated now and more productively using equipment than in the past. The idea that that person has somehow permanently become less productive is a bit of a hard stretch, is it not? Where do you come out on that argument?
Paul Johnson
You are right. The average level of education is still rising quite fast and so the productivity puzzle is an even bigger puzzle than it looks, because you would have expected things to have—
Jesse Norman
It points towards the labour market argument rather than a productivity argument.
Paul Johnson
Yes, exactly. You would have expected things to have got better. That said, we have been drawing new groups into the labour market. For example, if people in their 60s are happy to work 10 to 20 hours a week in relatively low-productivity jobs, it may be that there is some sort of structural shift in which there is an additional group who are willing to work those less productive jobs and that may have a statistical effect in the long run. This is not on the basis of much evidence, unless we believe the world has changed fundamentally into the future. My guess is that we will get back to something that looks more like it was pre-recession, but when that will happen is anybody’s guess.
Jesse Norman
But the effect could be quite powerful economically because, as you say, we have these self-employed people. You have more people in the workforce than before, broadly speaking. If productivity starts to reassert itself then the actual amount of money in the economy doing productive, generative work could be quite significant. Just to pick up on the point about self-employment, that is not necessarily a bad thing from an economic standpoint, is it? These people may be contributing less in tax, but the actual amount of economic activity may well be high and productive, benefiting the economy generally.
Paul Johnson
Particularly if the alternative was they would not be in work at all.
Chair
Just to clarify the answer you gave to the key question, which is whether these falls in tax revenues are structural or not, what I think you said was if incomes go up then we will find that tax revenues are more buoyant. What we need to know is, for any given unit of income, whether the permanent yield in income tax is going to be lower than we used to think. That is what structural means. Is this structural or not? The OBR seem to be saying it is. What does the IFS say?
Carl Emmerson
There is a fantastic chart in the fiscal evaluation report the OBR produces where they are saying, “In the current year, what is the average tax rate on coming from income tax and NICs?” It is much lower than what they thought back in June 2010 and only a small amount of that change is explained, they think, by policy changes such as the increase in the personal allowance. A lot of it looks like other changes that are going on in the economy. That does not mean it is going to keep falling going forward. Clearly there is a risk it does, but there is also a risk that it bounces back up to what we were expecting back in June 2010.
Chair
I am asking the same question, which I think is the key question that Jesse asked. I am asking it again and I am still looking for the IFS answer. Do you or do you not agree with the OBR? The OBR have made a big call here and what I am asking the IFS is: do you agree?
Paul Johnson
The OBR is making a call much more on its view about the structure of the economy than it is about the interaction between the tax system and the economy. We agree with its view about the interaction of the tax system and the economy. We do not have a view about the structure of the economy.
Chair
Well, we will take a look at that in the transcript but I cannot help feeling that that was a—
Mark Garnier
A thin gruel.
Chair
Yes, whether that was soup or water it is difficult to tell, but do you want to have a go, Mr Emmerson? “No thank you”, he says. We have great witnesses here, Mark. Have a go yourself; see how far you get.
Mark Garnier
Can I turn back again specifically to the shape of Government and what we are trying to get out of it? The OBR says, “Between 2009-10 and 2019-20, spending on public services, administration and grants by central government is projected to fall from 21.2 per cent to 12.6 per cent of GDP”. The idea is that 40% of these cuts are going to be delivered during this Parliament with 60% more still to come, as you know. Genuinely, how realistic is it that public services are going to be maintained to any kind of familiar standards while trying to deliver such significant cuts in future expenditure?
Paul Johnson
If you are cutting spending on something by 40%, it would be pretty impressive performance if it was continuing to perform at the same level that it was before you imposed 40% of cuts.
Mark Garnier
You expect it to be unrealistic to be able to cut this without an effect on services?
Paul Johnson
Without an effect on services would be pretty difficult, yes.
Mark Garnier
Just out of interest, if you go back to the mid-1990s as a long-term period, what was the Government spending as a percentage of GDP? Do you know those numbers off the top of your head on this specific point, on these services, administration and grants?
Paul Johnson
It was certainly high. Our calculation is that, if you look at DEL spending excluding the NHS, it was about the same in real pounds terms in 1997 as it will be in 2020 on these forecasts. That is over 20 years of economic growth with the same real pounds spending on non-NHS DEL spending. That suggests a much lower proportion of GDP in 2020 than in 1997.
Mark Garnier
What about going back further than that? This comes to the fundamental question of: what do you expect out of Government? What I am trying to get to is: is this a recent phenomenon, where we have seen quite a high percentage of GDP being spent on Government, or is this something that is going back 100 years, where we are now seeing a fundamental change?
Carl Emmerson
The OBR’s figures show that Government spending on public services in 2020 would be at its lowest level since 1938 and we know the NHS is much bigger than what it was in 1938, so clearly the spend on other—
Paul Johnson
It did not exist in 1938.
Carl Emmerson
Exactly. The spend on the rest is squeezed quite significantly as a share of GDP. As Paul just said, in real terms you are talking about departmental spending outside the NHS back in real terms to what it was in about 1997 or 1998.
Mark Garnier
Nonetheless, it still comes to this great quandary that if you look back to 1930 you see, in the very broadest sense, tax receipts between 30% and 40% of GDP and the cost to the state between 40% and mid-50% of GDP. At what point does this ever work, Paul Johnson?
Paul Johnson
I am not sure I follow the question.
Mark Garnier
If you just go back over this long-term period, without being able to pay back debt without selling national assets, given what we know about tax receipts in terms of percentage of GDP over a long period, is it ever possible for a Government of this size to be able to pay sustainably into the future?
Paul Johnson
Other countries clearly have tax as a proportion of GDP at higher levels than those that we have at the moment and some countries have them lower. If you look at the US and Australia and a lot of non-European OECD countries, they have smaller levels of taxation. A lot of European Union countries would have higher levels of taxation.
Mark Garnier
But they are quite different economies. They are much smaller economies, are they not?
Paul Johnson
Well, Germany and France are not. I do not think it is economically implausible to suggest that you could have 1% or 2% or even 3% of GDP more in tax than we have at the moment, but that could be a big choice.
Mark Garnier
That can come from sorting out the productivity puzzle, getting higher wages up and that kind of stuff.
Paul Johnson
If the economy starts growing then fiscal drag is always the easiest way of increasing the tax to GDP ratio. I think your point is an important one because what we are not looking forward to in these figures is tax as a proportion of national income any lower than it has been for 30 years. Indeed, I think it still hits something close to its 30-year peak. We are not looking at tax as a proportion of national income at a particularly low level going forward. Therefore, to be looking at spending significantly higher than in these numbers you would need to have a state and a tax take that is a bit bigger than we have seen in the past. I think there lies the dilemma because we are going to have a world in the next 10, 20 or 30 years in which the demands on the state are going to be bigger. We have a bigger, older population and the demands on pensions and health and so on are going to be greater. One way of dealing with that is to squeeze everything else to ensure that we keep spending on pensions and the NHS and the squeeze on that, as we have discussed, is quite substantial. Another way of dealing with it is to say, “Well, the demands on the state on the bigger. We just will have a bigger state”. That is a big political and economic choice.
Mark Garnier
If you cannot finance it—
Paul Johnson
Well, the question is: can you finance it? Could you get an extra percentage point or two or three from taxation? It is not economically impossible. It is politically very difficult, clearly.
Mr Love
The Chancellor has claimed so far that he has been able to “control public spending, improve public services, reduce the deficit and still cut income taxes”, all at the same time. Would you agree with this assessment?
Paul Johnson
The deficit is smaller. Public spending, at least on public services, has gone down although it has not gone down very much at all overall because of pressures on things like pensions. I cannot remember what the numbers are, but the overall level of TME has come down very little over the last five years. Income taxes have come down a bit, but other taxes clearly have gone up. Taxes in toto have gone up over this period, not least because of the very big increase in VAT at the beginning of the Parliament.
Mr Love
Would you like to add to that, Mr Emmerson?
Carl Emmerson
No, I think he is right. The Chancellor has delivered the spending cuts on public services that he intended at the start of the Parliament. He has delivered a net increase in taxes from things that he has chosen to implement. However, despite being a Chancellor who has put taxes up, on average he has been able to find money for some big giveaways on the tax side. You have seen some big tax cuts and some big tax takeaways. Overall it is a takeaway. He has clearly cut the deficit but he has not cut it as much as he hoped.
Mr Love
Let me look at some of these issues in greater detail. The Chancellor said in January that to reduce the deficit without even faster cuts to government departments will require £12 billion of further welfare savings. Is that still the case?
Paul Johnson
We think that if you are to look over the whole period of the forecast horizon, now out to 2019-20, to keep the rate of cuts for departments at the same level as they were over this Parliament you would need rather more than £12 billion of welfare cuts or tax increases.
Mr Love
What sort of figure are we talking about?
Paul Johnson
We reckon something more like £20 billion or £21 billion.
Carl Emmerson
One of the reasons for the difference is the Chancellor is referring to a £12 billion welfare cut to keep the pace of cuts up to 2017-18 and, of course, the forecast horizon now goes to 2019-20. We are including all four of those years, so it is not a surprise that we get a number that is roughly twice as big. It is not quite twice as big but it is that kind of ballpark.
Mr Love
So the Chancellor needs to update his figures from £12 billion to £21 billion?
Carl Emmerson
If he wants—
Mr Love
How successful has he been at restraining welfare expenditure? There have been a number of changes, particularly in housing benefit. Has that meant that expenditure has been constrained or is welfare expenditure continuing to rise?
Carl Emmerson
The measures he announced at the start of the Parliament to cut the welfare budget have delivered cuts, but they have not been as big as what was expected at the time. The biggest change is a move from RPI indexation for most benefits to CPI indexation and a move to 1% in many benefits. Those changes did not deliver the savings he hoped because the gap between RPI and CPI and the level of inflation has turned out to be lower more recently, so that did not achieve as much of a saving as hoped. The other changes such as the shift from incapacity benefit to employment support allowance, which the last Government had started, and the shift from disability living allowance to PIP, both look like they are going to save less than what was hoped for because of operational reasons. As you start to do these reassessments of health, you find savings but not as big as was hoped for. The welfare cuts have delivered cuts but not as big as what were intended at the start of the Parliament.
Mr Love
Your analysis suggests that by 2019-20 88% of deficit reduction will come from spending cuts while only 12% from tax increases. Is that sensible?
Paul Johnson
There is a choice here and, referring to the conversation we were just having, what that choice implies is no increase in the long run or at least the medium run share of tax revenues and, therefore, in the long run of the state in the economy. If you were to say, “What would be a good explanation for that choice?” it would be to say, “Well, we do not want to take the recession and use that as a reason for ratcheting up the size of the state”. That would be the defence you would make of that. I think the argument against it would be that this is what we were discussing earlier also, which is the scale of the cuts that it implies and the fact that potentially an economy is capable of coping with a slightly higher take from Government. That is exactly the balance you need to weigh there, again in the context of a world in which the demands on the state probably are growing because of demographic change.
Mr Love
Originally the Government’s intention was that it should be an 80:20 split. You have suggested it is 88:12. Are we moving in the wrong direction? Should there be more consideration given to tax increases?
Carl Emmerson
The reason the ratio is changing is because originally the plan was for 80:20 but since then the deficit has proved more stubborn. More action is needed to get it down and what the Chancellor has done is, instead of responding by saying, “Hey, I am going to do some more tax rises”, he has said, “Hey, what I am going to do is do some more squeeze on spending in the next Parliament”. At the margin, all of the additional action he is doing to get the deficit down is coming on the spending side. That brings that ratio up from what was 80:20 to something like 88:12 and, as Paul just said, that is a choice that we have as a country. It is not right or wrong.
Mr Love
It is a choice, but you have used some flowery language describing the impact on other government departments than those that are ring-fenced as being colossal cuts. You are indicating now, in terms of welfare expenditure, the structural changes they have made to try to budget have been disappointing. Does that not mean that, realistically, going forward any Government will need to look to tax increases to make up the difference and keep the deficit reducing?
Paul Johnson
I suspect that will be easier and that is why, if you look at the tax increases over the period of the consolidation, most of them happen straight away and the spending cuts have been over a much longer period. It is not going to be impossible to make those cuts, if that is what the Government wants to do. It just needs to be clear what the impact of those would be.
Mr Love
Let me ask you one final question. The Government is saying that in the future they will look to tax reductions; £7.2 billion is the IFS estimate. In the context of deficit reduction, is that sensible?
Paul Johnson
It makes everything else much more difficult. It has been very striking over this Parliament how £12 billion or so is being spent on increasing the personal allowance and something like £7 billion or £8 billion on reducing corporate tax. Those are remarkable choices in the context of the deficit reduction you have and, therefore, the spending cuts you have. Clearly, cutting taxes makes the arithmetic elsewhere more difficult.
John Mann
Mr Johnson, if you were an employer who would you choose to employ, a 40 year-old with virtually no work history and severe mental health problems, who is perhaps an alcoholic, or a young graduate from the European Union?
Paul Johnson
If I was looking for a graduate-level job, I would employ a graduate. At the IFS we are always looking for graduate-level jobs.
John Mann
One of the problems in shrinking the welfare budget is, of course, that some people are not attractive to employers and those people remain in society and do not hold down jobs. There is a lot of evidence in relation to that. For example those with drug and alcohol problems may be forced to take a job by the state but they often get out of that job very quickly, not least because—they may or may not want to—the employer is not very keen to keep them on. There is an ongoing problem with today’s policies in shrinking the welfare budget. You have identified that it would be a big political shift to start cutting pensions in real terms and you have identified other ring-fenced departments. There is a set of current policy fixtures that could change, but you are doing your assumptions, as I understand it, presumed on them not changing.
Paul Johnson
We have illustrated the impact of essentially the whole series of options that you would have. You could do what the numbers in the Green Book suggest, which is make all the cuts through DELs going forward and you could do anything all the way up to a world in which it is all done through increasing taxes and reducing welfare. If I recall, that requires something like £45 billion of tax increases or welfare cuts to keep DEL cuts to zero over that period. What we try to do is illustrate the whole series of trade-offs that are available.
John Mann
With current policy projections you are suggesting cuts in some government departments. Let us take Defence as an example. How much are you predicting, with current policy decisions, the Defence budget will need to be cut by 2020?
Paul Johnson
The average cuts for non-protected departments over that period, given the policy assumptions you are describing from 2015 that protections continue, would be 14%. If Defence gets it share of that then it is 14% but, of course, you could decide to cut Defence more and other things less or Defence less and other things more.
John Mann
That is predicated on no change in the current status within the European Union and migration.
Paul Johnson
Yes. I do not think the OBR’s numbers or any of the numbers we have put together are based on us being outside the EU.
John Mann
Has anything significant changed in the economic methodologies that you have used over the last five years?
Paul Johnson
To be honest, what we are discussing here is very straightforward. It is a straightforward spreadsheet looking at the trade-offs, given a certain amount of money, in terms of where that money goes. If you have an assumption about what total spending is and you know the size of the population and pension spending and so on and the total amount that is going to go on protected departments and the number of protected departments, there is not much methodology to change.
John Mann
Why then did you fail to identify five years and four ago in your projections, including when you came to this Committee, about the Chancellor missing so significantly his promises on deficit reduction and on the huge increase in national debt? You missed that five years ago. You did not project that what the Chancellor was saying in his first Budget was going to be so out. What I am interested in is why.
Paul Johnson
The reason he was out is that the economy in the first half of this Parliament performed much less well than he and the OBR projected and, as we have described on a number of occasions, we do not make our own projects of what is going to happen to the economy. We take economic projections and apply fiscal models to them. Given what has happened to the economy, the deficit has not come down. It has not been very much to do with changing fiscal projections, given economic projections.
Carl Emmerson
If you look at the history of official forecasts in the UK for the deficit, looking four years out, average error of projected borrowing, it is about 4% of GDP. So that is getting on for £80 billion. That is the average error. Clearly, whoever sits here and tells you the deficit in four years’ time is going to be X could well be out by a magnitude of £80 billion up or down and still be making an average type mistake. You could get bigger errors and you would expect bigger errors in times when the world is much more uncertain. You have plan not only on the basis of the central forecast, your best guess of how the world might evolve, but you also have to think a lot about the uncertainty around it and what you would do if things turn out to be a lot better than you expect and what you would do if things turn out to be a lot worse than you expect. One thing you can be pretty sure of is that it will not turn out exactly how you do expect.
John Mann
I want to ask you about the OBR’s projections on the so-called Google tax. Do you think it is realistic to bring in the amounts of money that have been specified, particularly in the ensuing years after next year? Do you think that is an underestimate or an overestimate?
Paul Johnson
First, the numbers are not terribly big. From recollection, they are a small number of hundreds of millions. Secondly, given that we have no details whatever of what this tax is going to look like, I do not know.
Alok Sharma
Just picking on the diverted profits tax, this is a unilateral measure and clearly the Chancellor and the Government have been leading the OECD on these issues relating to tax avoidance. How effective do you think this is going to be as a measure in raising taxes?
Paul Johnson
We are expecting the details of this tax hopefully this week. We have almost no details of it, so it is very hard to know. My understanding of it is that it will be looking to identify those bits of profit that are in some sense undertaxed because of fairly aggressive avoidance behaviour. I think one should think of it more as an anti-avoidance measure than anything else. My understanding again is that the revenue projections are based on HMRC’s bottom-up estimates of where they think those aggressive measures are happening and where they think they can get it from. To be honest, we are not in possession of any of that data or analysis to be able to make an independent assessment.
Alok Sharma
You are absolutely right. We need to see the full details of this, but do you think this will set a precedent for other jurisdictions to follow as well, given that it is predicated on the fact that if you have economic substance in a particular jurisdiction that is where you ought to be paying your taxes rather than diverting them to somewhere where you can get a more effective tax arrangement, shall we say?
Paul Johnson
That is an interesting question. In one sense, my understanding of where the BEPS process is heading is it does want to get to a world in which there is more relationship between economic substance and where the tax happens. One of the issues about the BEPS process is that there may be a zero sum game here and this may result in a different set of arguments internationally about where this revenue can be raised. Exactly how it was going to fit into that I do not know, but I would not be surprised to see other countries trying to do very much the same kind of thing.
Alok Sharma
I appreciate that you want to see the full details of this, but how compatible do you think such a tax would be with the double tax treaties that the UK has with other jurisdictions?
Chair
That is a tough question.
Paul Johnson
I think you may need to ask a lawyer about that, if I am honest. I do not know.
Alok Sharma
Could I just ask one more question very briefly, which is to do with the taxing of banks and offsetting prior losses only at 50%: how optimistic are you that this is going to raise £3.5 billion over the next five years?
Paul Johnson
The first thing to say is, whether it raises £3.5 billion in the next five years or not, that is not, on the basis of the way the legislation is currently drafted, going to be £3.5 billion in total additional. That is just money brought forward because of the way the tax is designed. Whether it would lead to additional efforts by those banks to avoid that tax or find other ways of not paying it, I do not know. It looks a bit like a windfall tax on a particularly greedy bank.
Alok Sharma
Do you consider this a retrospective tax?
Paul Johnson
Is it a retrospective tax? It is effectively retrospectively changing the rules around the treatment of losses.
Mike Kane
My question is around the air passenger duty and the changes that were made. They are abolishing it for under-12s in May and under-16s in May 2016. Any quick views on what you think of that?
Paul Johnson
I do not think it is going to have a big economic effect. My youngest children are turning 12 next week, unfortunately.
Mike Kane
Paul and Carl, you are very well-educated men, University College London and Birkbeck College London. It does not have a big economic effect. I want you to now project yourselves so that you are northern regional economists and you are looking out for the interests of regional airports outside the south-east of England. Let me ask you the question: do you think it will have any effect?
Chair
I do not think they have thought about that one.
Paul Johnson
I do not think either of us are experts on air passenger duty and the impact of how children are treated in that. In terms of if this is devolved to Scotland and they charge a different amount to airports in England then clearly tax competition issues will come into play.
Mike Kane
That is well read, because my next question was the Smith commission will give this as a devolved power. Therefore, the SNP are already saying they will scrap air passenger duty north of the border. At £194 per flight over 6,000 miles, how do you think that will impact in terms of Scottish airports and, say, Durham Tees, Newcastle, Manchester, Leeds, Bradford, Liverpool?
Paul Johnson
That will clearly provide a competitive advantage to flights going out of Scottish airports and will distort choices about where those things happen.
Mike Kane
Should we have differential airport passenger duty in the UK? This is still a blanket policy. It is a classic capital-centric to get tax from Heathrow while bashing regional economies and drivers of growth in the regional airports elsewhere in the country.
Carl Emmerson
To turn the question around, if we are going to devolve taxes within the UK we should think carefully about devolving those that are particularly easy to measure where they are and will not distort location decisions. Property taxes are a good tax to devolve. That is why we have council tax devolved. Things like air passenger duty are going to be more problematic. It does not mean it is impossible and it does not mean you should not do it, but it is not going to be as good as property taxes and things that are less mobile. You asked whether we should have it uniform. If I was going to have an APD I would have it uniform on all people, not just those aged over 12 or 16.
Mike Kane
Yesterday I was with the chief executive of Cathay Pacific, the chief executive of Manchester Airport Group and the Chinese Consul General. They have had to fight for years to get to point-to-point, the first flight to China from a regional airport in the UK and they say it is down to APD. If we had differential APD, APD holidays or no APD at all we would reboot our northern and regional hubs with point-to-point to growing economies. Any thoughts?
Paul Johnson
I am afraid I have no idea about the responsiveness of where flights go from according to the tax rate.
Chair
It is always good to find out what the IFS do know and what they do not know. We have found a couple of little corners they do not know this morning.
John Thurso
I predict Wick International will be booming within a decade. Moving rapidly on—
Chair
It is just down the road from your constituency, is it not?
John Thurso
It is in my constituency, as you should remember having driven through it.
Chair
Of course, once you get north of Inverness—
John Thurso
Can we come back to the OBR’s new welfare trends report and ask if you find that useful and if there are any changes you would like to see in it?
Carl Emmerson
I think it is a very useful report. When you think about what the welfare cap has done, maybe the annual welfare trends report is the bit you can definitely say is an improvement and perhaps it is a surprise we did not have this before. In terms of what could be done better, for a first year I can see why they have tried to do the whole of the welfare system in one report but I think, going forward, it would be quite good if you had a particular focus on particular parts of the benefit system. Maybe the OBR should think about support for housing costs in one year’s report and look carefully at the drivers of that and maybe in the next year’s report look at the drivers of disability benefits and the health of the population, rather than try to do every single part of the welfare system in 150 pages.
John Thurso
That is a very interesting observation and begs the question: which one would you like to see them do first?
Carl Emmerson
I mentioned those two because they would be high on my list.
John Thurso
If it was your choice, which would you—
Carl Emmerson
Which would I do next? I think I would probably go for the disability because that is where a lot of the Government’s reforms are. On housing benefit, because we have now CPI indexed the maximum amount you can get, the public finances are a bit less sensitive to what happens to private rents. Probably the health of the population, the level of disabilities and how that is feeding into disability benefit spending, would be pretty high on my list.
John Thurso
Paul, can I come to you? You had an article in The Times recently that caught my eye, which I cut out and kept. It has a statement in it that you wrote, which I suspect was deliberately meant to be provocative but it says, “Pensioners as a group have stopped being poor”. Is it your thought that the state needs to start rethinking where pensions sit in the welfare system or how they sit in the amount spent?
Paul Johnson
What that statement was supposed to say was that 30 years ago pensioners were much more likely to be poor than people of working age and there has been a fantastic change over that 30 years that now pensioners are less likely to be poor than people of working age and, indeed, for the first time about three years ago, on an after-housing-cost basis, average pensioner incomes are higher than non-pensioner incomes. The world has changed is what that was trying to say and it has changed dramatically. That is not to say there are not poor pensioners. It is just that it is no longer the case that a very large proportion or a much higher proportion of pensioners are poor. My sense is that the policy thinking has not necessarily caught up with that new reality and, therefore, you might want to think about whether we are taxing pensioners appropriately, whether we are taxing pensions appropriately and whether we are thinking about the universal benefits that are available appropriately, with one note of caution that the generation of pensioners 20 or 30 years hence may look very different from this generation. We have seen a big change in 30 years. We may see another big change over the next 30 years, so we do need to be aware of that change.
John Thurso
There are two elements in looking at pensioners and pensioner poverty or affluence. One is, of course, what any given set of pensioners have managed to save for themselves or contributed to arrive at having a pension, and you draw attention obviously to all the public sector pensions. The other, and I think the one that most of us are perhaps more concerned about, are the pensioners who are pretty much completely or very largely reliant on the state pension. The triple lock was designed specifically to ratchet that up, whatever the circumstances, in that whichever one of the various measures happens to be doing best they will get the best measure. Since over time each measure will have moments of being best, the net effect is always an above-average increase. That then begs the question: at what point do you say, “Right, we have achieved the rebalancing. Now is the time to change that”? That was the bit you did not get into in your article. What are your thoughts in that direction?
Paul Johnson
My thoughts are very much consonant with what you said. If it goes on forever then the pension does not become infinite but it just grows forever. You do need to take a view about at what point you revert to either price or earnings indexation rather than the better of both. The judgment on that will depend on a range of things. To the extent that you have a very unequal distribution of income among pensioners with a large number on relatively high incomes, paying increasingly large amounts to them becomes a less effective use of money. To the extent that we move to a world in which more pensioners have less income then spending more money is a better use of money. You have to contextualise it in terms of the distribution of incomes that you have among pensioners. There is no right answer to how big this number should be. It would be good to know what Government and Opposition think that number should be because at the moment we do not know. What we sense is it is just continuing until that point at which someone decides to stop, but it would be quite nice to know what that point would be.
John Thurso
Do you suspect that the decision point is beyond the time horizon of the current forecast and, therefore, Governments and Oppositions will worry about it when they get there?
Paul Johnson
Most likely.
Carl Emmerson
I think Governments also need to be aware, when they are making other changes to the tax system, how it affects pensioners differentially. Over this Parliament we have increased the personal allowance a lot. That has not benefited pensioners. If we continue to increase the personal allowance, however, as we will do next April, it will benefit pensioners. If we continue to run policy as we have done over the last 30 years or so where we tend to cut income tax rates and put up national insurance rates that will reward pensioners relative to the working age population, because pensioners do not pay national insurance whereas the working age population do. That may be intended, and it is fine if it intended, but if it was not intended then perhaps we should be a bit more aware about what we are doing and what redistribution is going on.
John Thurso
The state pension was supposed to be contributory. Do you regard it as contributory?
Paul Johnson
Not in any serious sense, no.
John Thurso
No. Is that something we should be looking at again? In a way, if you say, “Right, here is a pension; you have paid tax but there is absolutely no relationship between it”, you are inevitably into having more requirement from taxation to pay that. To what extent would a return to a contributory basis help in that or would it be irrelevant?
Paul Johnson
My view is that the move to the single-tier pension is the logical conclusion of what is now 36 years of trying to move away—SERPS was introduced in 1978. I think the history of pensions since 1978 has been moving away from SERPS. The single-tier pension takes us to the logical conclusion of that, plus a series of other changes that have weakened the contributory contributions necessary to get a full basic state pension, such that the very large majority of people were in any case building up rights to the full basic pension. With the single-tier pension we will have something that is close to a citizen’s pension or one that is universal, essentially based on a history of having lived in the UK for the past 30 or 40 years. That feels to me like a relatively straightforward, rational state to be in. There is a different rational state to be in, which is a fully contributory system, but it seems to me that would have involved 30 years of moving in one direction and then start moving in the other direction. It may be that we should just stick with the place that we are then comfortable.
John Thurso
We have chosen and probably should not change the concept of universality in relation to the state pensions.
Paul Johnson
My sense is that the changes we are seeing towards that single-tier, pretty much universal state pension has moved us into a pretty sensible position in terms of the structure.
Chair
Thank you very much for coming to give evidence. We have run on just a little. We have Treasury questions that a number of colleagues will want to attend and so we have to bring the session to an end. Thank you very much indeed. Oral evidence: Autumn Statement, HC 870 3