Oral evidence: Summer Budget 2015, HC 315Wednesday 15 July 2015

Oral evidence, 15 July 2015.

Witnesses

Professor Phillip Booth, Editorial & Programme Director, Institute of Economic Affairs, Jonathan Portes, Director, National Institute of Economic and Social Research, and Michael Saunders, Chief UK Economist, Citi, gave evidence.

Chair

Welcome and thank you very much for coming to give evidence to us this afternoon. As you probably have seen from the agenda this afternoon, we are pretty pressed for time and you might feel short-changed in the exchanges, or even cut off, in which case please write down further thoughts that you may have so that we can use them in evidence if you would like them to be in the public domain. I would like to begin with a question to Michael Saunders about the symmetry of monetary policy and whether you think we are indifferent to deflation of 1% or inflation of 5%. We are after all at zero, 2 away. It is a question I asked the Bank yesterday and frankly they did not answer it very directly. I wonder whether you could do a better job.

Michael Saunders

No, I don’t think they should be indifferent. I think they should fear deflation much more than an overshoot in inflation. I think that is because the tools for getting out of deflation are probably less effective. If inflation is too high, we know how to deal with it. We have done it plenty of times in the past. If you whack up interest rates far enough and long enough, inflation will come down. On the other side, what you are seeing around the world, a number of countries with lowflation or deflation hitting the zero band on policy rates and finding it hard to go much further, using QE, and the effectiveness of these tools to break out of lowflation so far has been much weaker. So to me that is an argument for policy to be asymmetric or for inflation targets to be a little bit higher.

Chair

Very interesting comments. I am not going to explore them further because we are pressed for time.

Steve Baker

The MPC’s Martin Weale said that the risk of holding rates low for a long time is minimal but that of raising them soon is large. Professor Booth, what is your view?

Professor Booth

I don’t agree with that. If he is talking about the current time, I think the risk of continuing to hold rates down is to give the impression that rates will remain low, basically whatever; that will lead businesses and households, I think, to increase their borrowing on the expectation that that will continue to happen, and borrow to finance projects, purchases and so on, which are not necessarily sustainable should rates then adjust. I think the risk of raising rates at the current time, given the likely trajectory of inflation, is quite minimal. Surely seven years after the crash the economy has begun to normalise. Insofar as we have a problem at all it would appear to be productivity problem and not an aggregate demand problem, as it might be termed. Also to some extent commercial interest rates have become rather decoupled from central-bank interest rates so the risk of the central bank sending a signal currently by beginning to raise rates is, I think, insignificant.

Steve Baker

To save time, I will just say this. You and I both know that I belong to the school of thought that thinks that holding rates low for a long time also risks capital misallocations. Do you think that is something that the Bank of England should spend more time thinking about?

Professor Booth

I do. The BIS have thought about these issues and that is what I was implying, that if you hold rates too low for too long, and also signal the expectation that they will be held low for a long period of time, then that will lead businesses to borrow to finance projects that in the long-term are unsustainable. Yes.

Steve Baker

Leading to a worse problem later?

Professor Booth

Yes.

Steve Baker

Does anybody else wish to add to that particular perspective? Is the risk of holding—

Michael Saunders

I take the opposite view right now. I think that right now there is no great rush to raise rates. Sure, rates will probably rise over the next year or two but right now inflation is zero; wage growth is picking up but is not dangerously high. So I do not see an urgent problem to be dealt with. The risk of raising rates early is that sterling might rise very sharply and that would hit our export sector and import disinflationary pressures. After all, the target is 2% inflation and in that sense an early rate hike might well make it higher.

Steve Baker

But you do not worry about mispriced credit leading businesses into making bad decisions?

Michael Saunders

Right now, no. I think the economy is growing very nicely; business investment is quite strong. I do not see great evidence, apart from some bubbling areas of the housing market, that the economy is over-investing in a way that you should worry about.

Steve Baker

We are short of time so I will move quickly. The IEA has published at least one book that described the idea of the euro as a pan-European currency as utopian and bound to fail. I have in mind Hayek’s Denationalization of Money. Do you think was a reasonable summary, looking back with the benefit of hindsight?

Professor Booth

Not entirely. I am rather more pro-euro probably than many members of this Committee as a matter of principle. The idea of decoupling currencies from nation states is something I find quite attractive and you may do as well. However, it was structurally flawed. I think some of these structural flaws were predictable in advance but I don’t think anybody predicted quite how serious they were. The biggest structural flaw is the fact that the ECB essentially takes on credit risk of all member countries no matter how credit-worthy they are through its monetary policy operations and however strict the no bail-out clauses are, which I think are very important for a pan-national currency, they are not operational in practice because of the way monetary policy operations are followed. That is the problem that needs to be resolved should there be reform of the euro.

Steve Baker

Jonathan Portes, I think you have supported the euro in the past. How do you reflect on the euro now?

Jonathan Portes

Just for the record—I am not sure what you mean by that—I was a civil servant up until January of 2011 so obviously I made no public statements up to that point except insofar as I was doing so as a civil servant. I broadly agree with what Philip said. The way that the euro has been implemented and the way in particular that eurozone policymakers have taken decisions over the past five years have been deeply damaging in some respects to some European economies clearly. Is the idea that it makes sense for more than one country to share a currency always wrong? No. We could spend all day discussing the structural flaws in the euro—

Chair

Well, we are not going to.

Jonathan Portes

—and we won’t. I will merely say that I do not agree with everything Philip said but broadly the point is that it was not in principle a completely mad idea but there were a number of serious structural flaws and the way that policymakers have responded has made those apparent and possibly made them worse.

Chair

I want to tell colleagues there is a chance of a vote on the ten-minute rule Bill. If I can find three colleagues to assist me to carry on, I am intending not to vote on it so that we can keep the session going. How many colleagues are not intending to vote? One, two, three. All right. I’m fine. We can carry on. That is good news.

Wes Streeting

I want to ask you about the issues of the path for wages and also unemployment and where you see the trends going. The Bank’s “Inflation Report” said that the uncertainty around the path of wages is considerable. I am interested in your view about how you see wages panning out in the foreseeable future. Secondly, the overall headline figures on unemployment are up today. I am interested in what you think the trend is likely to be.

Jonathan Portes

I’ll take that first. Obviously one should not take too much from one month’s figures but I think there are some indications that we may have reached the limit of significant further reductions in unemployment and significant further increases in the employment rate. So that has two sides to it. In some ways it is bad news. The good performance of the UK economy in creating jobs has been the single most important success story over the last few years so the fact that is coming to an end is bad in itself and also of course bad for growth going forward. The upside one might hope would be that it would lead to the wage growth coming back to something much more like what we would describe as normality, which is significant real wage growth, year on year. Again there is some sign of that in the figures but the Bank is right; that is both what the Bank assumes, the ODR assumes and what we assume will happen but there is considerable uncertainty about it. We will have to see what happens.

Chair

Any other questions, Wes? Wes Streeting No, unless there are differing views, in which case I am going to have to read the transcript and go and vote. So if you do have conflicting views, I will be interested to read them.

Mark Garnier

A number of factors in this budget affect the housing market. We have the 1% reduction in social rent, the £1 million inheritance on main homes, the buy-to-let interest rates, allowances have gone down to the basic rate, the mortgage market review and the influence of pension assets coming out. Have you had a chance to work out what all this stuff is going to do to the housing market?

Professor Booth

Well, we are not forecasters; we leave witchcraft to the national institutes but conceptually this is a pretty important question and it goes to the heart of this budget. This budget was not an economist’s budget, I can tell you. All the examples you have chosen might have gone down very well politically but they make no sense as far as the economics are concerned. Increasing the inheritance tax threshold but only for housing assets does not make sense. On restricting the extent to which you can offset financing costs against profits from buy-to-let, financing costs are a business cost and they should be offsetable against profit from buy-to-let. Restricting rents on social housing so they will fall further below market rents also does not make sense and may well lead to a reduction in social house building as well, which is not desirable. There has been a movement towards subject subsidies, which I think is by and large right. If you want to fix the housing market you do not do it simply—well, you do not do it at all—by pumping more demand into a market with fixed supply; you liberalise supply.

Mark Garnier

On that business-cost thing, you have private individuals paying potentially 45p in the pound tax whereas businesses are now going to be paying 18p in the pound tax. So it does create quite a big differential.

Professor Booth

You have to borrow to finance, like you do with any other business, and then whoever is providing the funding pays tax at whatever their rate happens to be.

Mark Garnier

Yes, but a business borrowing would be getting the credit, if you like, at 18% whereas a private individual is potentially at 45%. That creates an anomaly between private individuals acting as a business and a business acting as a business.

Professor Booth

It depends who owns the instruments that are funding the lending. If those instruments are held by households they will be taxed on the returns—

Mark Garnier

Oh, I see.

Professor Booth

—the interest that is being paid, at their tax rate. So we have symmetry in the system at the moment. We tax debt in one way and we tax profits in a different way. There are some rather uncomfortable interactions of that system and I think it should be radically reformed but just to choose one aspect of the system, limiting the tax relief to some extent on one particular type of business, does not make any sense at all to me.

Mark Garnier

No, fair enough. Jonathan Portes, you are in witchcraft: what do you think it is going to do to the housing market?

Jonathan Portes

I agree almost entirely with Philip; you do not solve the serious structural problem of the lack of supply in the UK housing market by messing around with demand mostly in ways that will tend to increase demand. Taking it all together, I doubt this will make our problems significantly worse, although I could be wrong—I think they will probably make them marginally worse and they will not do anything to make them better. The real test is whether the other things that the Chancellor has announced on planning and supply have a meaningful positive impact. We live in perpetual hope on this, of course. The previous Government tried to do things on planning and supply that did not work. The Coalition Government in 2010 said it was going to do lots of things on planning and supply, which equally failed to deliver. Will it work this time round? Again, we live in hope. I should mention this. The social rented sector measure: I have rarely seen the OBR be quite as rude about a policy measure as they were about this one where they said not only would it reduce the number of houses built but that if, as you probably should, you counted housing associations as part of the wider public sector, it would increase public borrowing at the same time.

Professor Booth

Slightly worse than that, they suggested that because of these measures and solely because of these measures and the requirements on housing associations to sell off part of their stock, the ONS might require them to put housing associations in the public sector.

Mark Garnier

That is quite an interesting point. Both of you have mentioned that this is dealing with the wrong end of the equation, dealing with the demand rather than supply. On the basis that supply is not forthcoming at the moment to the extent that it should be, is property fairly priced? The reason I ask that is because if you look back over these long trends historically it is still about 35% overvalued on an average-price to average-earnings basis. Having said that, the low interest rates change that. But a lot of dynamics have happened over a number of years, including a huge inventory in the buy-to-let taken out of the owner occupier market, and a number of other things. Having said that though, even at this higher level, house builders are not building houses. So what is going on in the housing market? Why does there seem to be a limited amount of supply, given the fact that in the most basic economic terms it has to be worth building at the moment, doesn’t it? Jonathan Portes. Then we might get Michael Saunders off the bench on that one.

Jonathan Portes

When it comes to predicting house prices or saying what is fair I tend to share Philip’s view that it is slightly akin to witchcraft. As you said, we have limited understanding—given that we are now in this very low interest rate environment—of the extent to which these historical relationships hold good. Why are house builders not building? It does appear to be a combination. There are some perverse incentives that seem to arise from the structure of the housebuilding market for land banking, sitting on land with planning permission. It is not, frankly, my subject area so I am not sure I could say much more on that but I think there probably is something happening there.

Mark Garnier

Michael Saunders; do you just want to finish off on that and then we will move on?

Michael Saunders

I don’t think the budget measures will do much to boost or slow housing demand either way. At the moment demand for housing looks like it is fairly strong. The home ownership rate is the lowest for decades. Surveys suggest that a very high share of people thinks it is good time to buy a house; mortgage rates are super low. That is one of those conditions, I expect house prices will go on rising and I agree with you, the issue here is the restriction on supply. What I hear from companies is that planning law is a major part of this.

Chair

All right. We are going to move on.

Stephen Hammond

Can we get to some of the heart of the budget measures then, please, and the overall macroeconomic effects? The first thing clearly is that the pace of deficit reduction was pushed back a year effectively; it will be a year longer before we get to surplus. Can I ask you three points on that? First, that pace: does pushing that back surprise you? Do you think that the balance between reduction in spending and tax increases is the right balance and if it is, what do you expect that to do for growth? Also, given that the first year of surplus has been pushed back a year, are you changing any of your growth forecasts as a result of that? Finally, can I ask you to comment on the concept of an expansionary fiscal contraction?

Chair

Apart from that you have nothing to bite on.

Professor Booth

If I answer those from the bottom up, then Jonathan will certainly find something to disagree with me about on this set of questions. I think there is very little evidence in most times—especially when monetary policy can bite—that reducing a budget deficit will lead to a contraction of the general economy over a period of, say, six to 18 months. It might do over a period of, say, nought to six months. There are several reasons for that. One very important reason for the UK, which does not necessarily apply to the eurozone, is if you are very open to capital movements and you have a floating exchange rate, the budget deficit and the overall net borrowing position of the economy affects the exchange rate and if you raise the budget deficit, as long as you do not raise it so much that it disturbs confidence, then it will tend to raise the real exchange rate and that will have an impact on the private sector of the economy. So Jonathan and I take very different views about that.

Jonathan Portes

I disagree with almost none of that.

Professor Booth

Okay. With regard to the other questions, I think they have now really become an irrelevance. Nothing surprises me in terms of postponing the time at which the budget will be balanced and I don’t think it really matters all that much anymore. Whether the budget deficit is 2% or 1.8% in 2017, 2018, or whatever it might be, is really irrelevant to the big picture of the enormous fiscal headwinds that we are going to face over the next 30 years. So I am relatively relaxed about that. I think it is fairly irrelevant as far as growth is concerned and then as far as the spending tax balance is concerned, my big concern there is the balance between cutting one type of spending and cutting other types of spending. The protection of the biggest proportion of the welfare budget, so these very damaging things have been done to child tax credit systems, which will reduce work incentives, is my biggest concern. This has been a problem since 2010: triple lock put on pensions; pensioner benefits protected; means tested benefits to pensioners protected and people of working age being treated in an entirely different way. That of course also makes the fiscal headwinds over the next generation much worse as well as making it more difficult to deal with the current fiscal situation.

Jonathan Portes

I agree with a very large part of what Philip has just said. Expansionary fiscal contraction: the notion that fiscal contraction would be anything other than sharply contractionary in 2010 was obvious nonsense at the time and so it proved. The notion, however, that—as Philip said—now that we are much nearer normalisation of economic conditions in general and interest rates might be expected to rise over the course of the Parliament and monetary policy to regain traction, the notion then that fiscal policy one way or the other would have a much lower impact on the economy, I think, is as Philip said, absolutely right. So the pushing back of the surplus target, which we regard as sensible from a macroeconomic perspective will lead us, other things being equal, to adjust our growth prospects, or growth forecast, up slightly, but it will not have a huge impact in the way that fiscal policy did several years ago.

Stephen Hammond

The definition of slightly?

Jonathan Portes

We would be assuming, now that we are much closer to normalisation, that the fiscal multiplier will be that much more towards the sort of normal value we would expect in a small open economy for exactly the reason that Philip stated around monetary exchange rate policy of perhaps 0.3 and again that that effect would only last for—again as Philip said—six to 12 months rather than being very prolonged. So the relaxation in fiscal policy represented by this budget will have a positive impact on growth relative to our previous forecast, but it will not be transformative; it will not change the numbers by a huge amount. So that is the first point on growth and expansionary fiscal consolidation. On the surplus target, I think the implication of that is that from a macroeconomic perspective targeting the projected path of fiscal policy over the next Parliament does not look to us to be a significant negative impact on growth. From a macroeconomic perspective it appears to be reasonable. I would make one point, though. In the last Parliament the fiscal framework within which targets were embedded meant that when things went wrong, the Chancellor was able basically to ditch his target, ditch the secondary target, and readjust policy, allow the automatic stabilisers to work and all the rest of that. That is not provided for in this fiscal target. This fiscal target says that unless growth goes below 1% then the target is a surplus by 2019/2020. So let us imagine what would happen if growth were not the 2.5% that we, the Bank, the OBR and everyone else, is forecasting in our central forecast. Suppose growth was about 1.25%. Under that situation the Chancellor in principle would still be fully committed to the surplus target. Now you only have to look at the back of an envelope to realise that that growth shortfall would lead to a £35 billion or so hole in receipts. Right? There would be a cumulative growth shortfall of about 5% so receipts fall by 5%; £35 billion shortfall; £35 billion more in spending cuts. What the Chancellor’s charter of budget responsibility says is that if that is what happens, if growth is 1.25% for the next four years—and that could happen; anything could happen—then we will still hit the surplus and to do that we will make £35 billion-worth of extra spending cuts. That is simply not going to happen. We know it is not. The Government will not do that. We know that by their previous record. It would be economic madness. They will not do it; quite rightly. So in that sense the surplus target is simply not credible. The Government do not intend under those circumstances to hit it. So there is a big question mark it seems to me about what it means. If growth proceeds along the lines set out in the forecast, it is not unreasonable, but the way it is set out in terms of the framework, simply does not make sense. It will not happen and I think that is something you should be pressing the Chancellor on. I could talk about the balance between tax and spending cuts but I think Andrew wants me to shut up now.

Chair

Well, don’t think I want you to shut up but before I bring in Helen Goodman I would like to just go back over some of the territory that we covered in the last Parliament. You argued for a fundamental change in policy in 2011 and in 2012 in pretty lurid tones. You quoted Macbeth. Do you want me to give you the quote? “I am in blood, stepp'd in so far that, should I wade no more, returning were as tedious as go o'er.”

Jonathan Portes

That’s right.

Chair

You came out with something like that and then explained that what you meant was that the Government seems to have decided that since it had gone so deep into the wrong policy it was going to carry on with that wrong policy. Do you think the Government did fundamentally change policy?

Jonathan Portes

There was clearly a very significant change of policy, effectively admitted by the Government quite recently in some of the revelations that came out; the argument between Danny Alexander on the one side and other people within the Government about this. There was clearly a significant change of policy. It was not the fundamental change of policy that I would have wanted but there was a very significant slackening off in fiscal consolidation after about—

Chair

Stabilisers kicked in. What else was there?

Jonathan Portes

The stabiliser kicked in and there was a significant structural shortfall in tax revenues, which the Government under its plans should have been obliged to make up but they chose not to.

Chair

That was the stabilisers.

Jonathan Portes

No, it was not the stabilisers then. There were two things going on. There was a structural shortfall. That is what the OBR said.

Chair

You are calling it a structural shortfall on the basis of OBR reports. Nobody really knows whether it is structural or not.

Jonathan Portes

That is true. But whether you measure fiscal consolidation according to the headline deficit or according to the best estimates of the structural deficit that we have, any way you look at it there was a significant slackening off on fiscal consolidation. Does that represent a significant policy change? It depends on what your counterfactual is and what the baseline is and we could argue about that. In economic terms there was clearly a significant reduction in the pace of this consolidation and in my view that was one of the factors, not the only factor, but one of the factors that contributed to the reversal of economic fortunes.

Chair

Your view is that the Government did surreptitiously change course and it listened to some degree to arguments from people such as you but did not like to admit it and that as a result the pickup that we now have and the relatively strong performance can be attributed to that significant change of course.

Jonathan Portes

Only in part. Others things went on as well. The eurozone was in a dreadful state in 2010, 2012 and then went back into at least stasis from 2012 to 2014. That was a relative improvement for us. Obviously the oil prices helped as well. So I would not attach all the weakness in 2010 to 2012 to mistaken policy; nor was all the bounce-back the result of the change in policy, but it was one of the factors that contributed to what we saw.

Chair

I will leave listeners outside this room to—

Professor Booth

Could I make a very brief point on the fiscal rule issue?

Chair

It had better be very brief because Helen Goodman wants to come in on this point.

Professor Booth

I think in the handbook of possible fiscal rules the Government is choosing a very, very, very bad one. I think it was 78 economists that wrote to The Guardian criticising the Government and I wrote an article criticising them because they used all the wrong arguments. One of them then responded using similar arguments to Jonathan’s and he is absolutely spot-on in his critique of the fiscal rule that has been chosen.

Chair

Helen wants to come in on exactly this point.

Helen Goodman

Thank you. I was a little bit surprised that Mr Portes had such thoroughgoing criticisms of the new fiscal rule but you did not seem to be saying that you thought the long-term impact would be deflationary. Could you just explain that apparent dissonance?

Jonathan Portes

It is for the reason that Philip set out, which is that there is a degree of consensus that has grown up over the past 20 years in advanced developed economies that short-term macroeconomic fluctuations are where possible best dealt with by monetary policy. The big criticism that I and others made—the argument that Philip was just alluding to—was that in the circumstances of 2010 to 2012 where we were in uncharted territory for monetary policy and for a number of other things and monetary policy was clearly ineffective in some respects, fiscal policy was much more important in addressing short-term macroeconomic fluctuations. As we now return to something closer to normality, the reasons to believe that fiscal policy is either the right tool to manage demand or that it has as big an impact given what monetary policy can do, are much weaker. That is not to say that a sharply deflationary fiscal policy will not hit demand—it will—but monetary policy is much better able to respond than it was five years ago and over the next few years in a small open economy like the UK, our model and the general approach of macroeconomists would suggest that you should not worry that much about fiscal policy, from a macro perspective. There are lots of other issues, again which Philip alluded to, although we probably disagree on what the answer is, about the balance between taxes and spending, what you spend the money on and all the rest of it, but those are not about the macroeconomic impacts of fiscal policy.

Helen Goodman

Turning to Professor Booth, if we look back over the last 60 years I think we had surpluses in seven out of those 60 years but we had growth below the Chancellor’s 1% in 11 out of the last 65 years. So what we would have had, had we had this rule over the last 60 to 65 years is an almost exact reversal of the position that he is proposing. Do you think, if we had had this rule, we would have had such high growth since the Second World War?

Professor Booth

Such high economic growth or such high growth in the debt?

Helen Goodman

Such high economic growth.

Professor Booth

I think for the reasons that Jonathan set out, if we had started with this rule in 1945 we would have quickly dispensed with it because it is an unworkable rule. When there are unforecast changes in tax receipts or government spending the suggestion here is even if these changes are not structural that there would have to be cuts in planned spending or increases in taxation, which—

Helen Goodman

It is just too clunky. Is that what you are saying?

Professor Booth

It is too clunky, yes. So to have a structural debt break or something of the type that Switzerland has, I think that would be perfectly sensible. So in Switzerland, I think I am right in saying—

Helen Goodman

They target the debt ratio.

Professor Booth

They target the debt, yes, and if you go over the debt ratio then you have to reverse it the following year unless the cause is random fluctuations as opposed to structural changes. So that has both the rigour of reversing deviations from the rule in future years as well as being a more sensible rule to start with.

Helen Goodman

Okay, I understand. Mr Saunders, are you with the 79 or are you with Mr Portes and Professor Booth?

Michael Saunders

I think the fiscal rule is not very well phrased. I think the cyclical adjustments should be there and done properly and I think that the rule also fails to distinguish between current and capital spending. One of the things I preferred about the previous version of the rule was that the fiscal target was in terms of current balance whereas with this rule any government that is constrained by it, if it takes the rule seriously, would probably be tempted to cut capital spending and I think in the past that has been done and has often been the wrong thing to do.

Chair

To the panel, very quickly, all three of you. Has there ever been a fiscal rule from the government, any government since the war, that, with the advantage of hindsight has filled you with confidence and to which as a result you think we should turn now?

Professor Booth

Not really. Kwasi Kwarteng persuaded me that the Swiss one worked as well as any.

Chair

In the UK; of the UK’s rules

Professor Booth

No. And I should say that with any other rule my great worry is that governments, as this Government has done, massage up current tax receipts at the expense of future tax receipts, reclassify social security liabilities and this type of thing, in order to reduce the explicit debt. This has happened in Hungary for example.

Chair

I would like very much to hear more but I do not have time now. Has this made borrowing any cheaper, Mr Saunders? That would be a good measure.

Michael Saunders

It has not made borrowing cheaper, no. Has there been a fiscal rule that has been successful? No. I would say it has always been a question of under what circumstances do governments either try to manipulate the figures or abandon the rule, so you just have to be ready to do so.

Chair

That is a clear answer. If you can do something even more briefly, Mr Portes, that will help.

Jonathan Portes

There is no perfect rule but on the whole I would give the rule in the last Parliament maybe 2 out of 3, partly because of what we have just discussed. Although it had to ditch the second half of the rule, the first half of the rule worked in its interest. It was able to change policy in a reasonably sensible manner. So combined with the OBR, which is very important—the institutional aspects are very important, to have that independent check—I would give them 2 out of 3 for the last Parliament.

Chair

I am going to bring in Jacob. This is about ring-fencing and hypothecation, very quickly. Then there is time to bring in the colleagues who slipped off to vote.

Jacob Rees-Mogg

You will obviously know about this from the budget, that more public expenditure is ring-fenced; now defence and counter-terrorism is included along with health, schools, overseas aid, pension benefits and child benefits. Is it efficient from an economic perspective for the Government to be tying its hands in this way? I don’t mind who answers first.

Chair

As long as you answer quickly.

Jacob Rees-Mogg

Is there anybody who thinks it is efficient? So you all think it is inefficient to a greater or lesser extent?

Michael Saunders

I do because what tends to happen is things that are just within or just without either get benefited or squeezed in a way that is quite arbitrary.

Jonathan Portes

It is fairly inefficient but I think that sometimes the dangers are overstated. For example, even without the ring-fence, the level of health spending projected for the next Parliament is the bare minimum that any government would have had to do for perfectly good and sensible political reasons anyway, and that is the biggest one. I don’t think it is a brilliant idea but it may make somewhat less difference than some people think it does.

Professor Booth

My problem is that it is really an attempt by governments, or a particular political party, to get what public-choice economists describe as expressive applause from particular interest groups that feel strongly about a particular issue. So that is how the pensioner benefits ended up being ring-fenced. The health service was ring-fenced, although I agree with Jonathan that it probably would not have made any difference, in order to neutralise it as a political issue. The aid budget was ring-fenced in order to completely castrate the development charities in the 2010 general election in terms of their political campaigning. Now I think the defence budget has been ring-fenced for a similar reason. So I think it is almost wholly done for bad reasons.

Jacob Rees-Mogg

Do you think doing it for these bad reasons then, prevents a proper discussion on where public expenditure should go because if you have half the public expenditure ring-fenced, any cuts have to come from the other half and there is no point in even talking about the ring-fenced bit?

Professor Booth

Absolutely. The Government is stuck up a blind alley when it comes to discussion of the welfare budget because a huge proportion of it, even that part of it that goes to relatively well-off people, if those people are older, is ring-fenced and not just ring-fenced but also pledged and planned to increase faster than public spending, the price level and indeed wage growth in general.

Jacob Rees-Mogg

Do you think these problems are fully understood by the public? Or are they seen, still, as good things to do electorally?

Professor Booth

Well they are certainly seen as good things to do electorally otherwise they would not be done because I think they are done for purely political, not economic, reasons.

Jacob Rees-Mogg

Any other views on that? Or shall we move on? The other side of the coin, which is now not only do you have half the public expenditure ring-fenced but you have the taxation to pay for all the public expenditure about to be legislated for to prevent it going up. Do you think this is equally ill-advised?

Jonathan Portes

Yes, I think it is. I see no particular case for legislating—there may be a case for reducing taxes but for legislating to tie your hands to reduce taxes, there are circumstances in which it makes sense for governments to tie their hands—for example in defence of the Bank of England or whatever. The case for legislating to reduce freedom over future tax rates seems to me to be far, far less clear and I think the result is that since the Government did feel it needed to put up taxes, you end up, as under the previous Government, with stealth taxes; taxes that nobody, certainly not me, understands. Philip was trying to explain to me before the meeting how the dividend-tax increase works and I don’t think he entirely succeeded, I am afraid. But that is the sort of illustration of what governments do when they cannot raise the main tax rate.

Jacob Rees-Mogg

So spending ring-fencing is a bad idea; tax ring-fencing is a bad idea. The Treasury for centuries—

Professor Booth

There are exceptions, I think, on tax ring-fencing and that is to prevent tax increases that would not be transparent. Things like the Rooker-Wise amendment to index-linked tax thresholds, that is a good idea.

Jacob Rees-Mogg

Do you agree with that?

Jonathan Portes

Yes, I agree with that.

Professor Booth

The very last thing we need to do is legislate to not increase taxes that are about as transparent as they come, the basic rate of income tax for example.

Jacob Rees-Mogg

All right. So the final bit on all of this is something the Treasury has praised for centuries but has been brought back in the budget and that is hypothecation of taxes. Does any of you think hypothecation is a good idea?

Jonathan Portes

You don’t want to have two thirds or even one third of your budget on either side hypothecated. I think there are cases when from a political economy perspective there is a case for hypothecation. For example, we got ourselves into a terrible mess on national insurance by effectively removing the hypothecation principle.

Chair

We will move on, but I think we have the answer, which is not much and your view is not at all, is it, Mr Saunders?

Michael Saunders

Yes.

Chair

And your view is—

Professor Booth

I agree hypothecation is appropriate in certain circumstances, potentially with road taxes and also national insurance.

Chair

Very limited then?

Professor Booth

Well, for a particular purpose also, where it is possible to have alternative private provision so that hypothecation almost becomes like a price and people can opt out of the Government’s services, as they did with pensions and national insurance rebates, and have their own alternative private provision. Then the whole idea of hypothecation, I think, becomes rather more sensible.

Jacob Rees-Mogg

Do you think that applies to vehicle excise?

Professor Booth

It could well do, depending on what the Government’s plans might be regarding potential privatisation of the road network.

Bill Esterson

Going back to the fiscal rule, what would be the impact on households and on businesses in terms of borrowing and savings?

Jonathan Portes

Obviously from a macroeconomic perspective things have to add up. A fiscal surplus for one side means that everybody else must definitionally be in deficit. Of course, that adjustment could happen through the current account, to the extent that it would be a good thing, or it could happen through households and/or companies borrowing more. To go back to what I said earlier, again one of the reasons why accelerated fiscal consolidation in the 2010 to 2012 period was a mistake, and in my view was a predictable mistake ex ante, was because it was clear that households and companies had no desire to borrow more and, therefore, we were exacerbating things by reducing the amount the Government were borrowing. The Government were doing the sensible thing of picking up the slack by borrowing. The case for Government to be doing that over the next few years, because we are coming back closer to normal times, is much weaker. For example, we see that companies are indeed now investing considerably more. I am considerably less worried about that sort of overall national accounts problem than I would have been four or five years ago.

Bill Esterson

In so-called normal times, not a problem.

Jonathan Portes

Much less of a problem, yes.

Bill Esterson

Much less of a problem, yes. Professor Booth, any different comments?

Professor Booth

Nothing further to add. Perhaps for the record I could register my disagreement with Jonathan about the interpretation of events between 2010 and 2013 but there is no need to rake over that. I don’t disagree with what he has just said.

Bill Esterson

I will move on to young people. What is going to be the longer-term economic effect, quite apart from the effect on young people themselves, of having young people who have not been able to get into the labour market?

Jonathan Portes

We have quite a lot of evidence that early labour market experiences matter quite a lot. In other words, the relatively high level of youth unemployment and low wages of people who did get into employment over the last few years is likely to have a permanent negative impact on quite a large number of people. On the plus side, it will not be as bad as it was in the early 1980s when youth unemployment was far higher than it has been over the past few years.

Bill Esterson

I am also interested in the impact on the economy, the longer-term effect on the economy of having people who have not had that experience early on.

Jonathan Portes

The historical evidence would suggest that there will be a negative impact; these lasting negative impacts on people’s employment probability, wages and so on will go on for some time. But of course the fact that it happened before, that it happened after the early 1980s recession, does not mean it has to happen now. There are policy actions that Government can take in terms of helping people retrain, making sure that people who had a bad time in their early 20s have a much better time in the labour market in their mid-20s. There are plenty of things we can do to avoid those long-term negative impacts.

Michael Saunders

I think this is getting us on to one of the big issues in the Budget, which is the shift between tax credits and pay. The UK, through a series of tax and benefit reforms over the last 15 years, ended up with a system that when the recession hit proved very effective at getting people back into work. We had less of a spike in unemployment and a quicker drop in unemployment than after previous cycles and after other countries. That was mirrored in the big expansion of people employed in relatively low-paid sectors. Some people worry about the side effect of that, which is the productivity puzzle, but I think we should be quite grateful for the fact that we ended up with much less of a hangover of long-term unemployment, and all the hysteresis effects that come from that, than we had in previous cycles, and tax credits was a part of that. I think they have helped to raise workforce participation and also, by topping up the incomes of the low-paid, probably helped to cap pay and thereby encourage labour demand. That has been all part of the story for the growth of people in low-paid sectors. I do worry as to whether the simultaneous withdrawal of tax credits and what is now in effect a much higher minimum wage for the over 25s reduces both the supply of labour and the demand for labour in a way that, if a future downturn hits, the outcome in terms of jobs may not be as good as this last one has been.

George Kerevan

Mr Saunders, the current account deficit is a large number; we seem to be surviving well despite that. Can you think of any plausible circumstances, not theoretical circumstances but plausible, within five years in the UK where the current account deficit might impact negatively on Government policy?

Michael Saunders

At the moment, the reason why the current account deficit is not a big problem is because it is not a classic story of the UK importing lots amidst a debt-fuelled consumer boom, which has been the story many times in the past. It is chiefly because the UK has very large external assets and foreign investors have very large amounts invested in the UK. The yield on our overseas assets is really low, chiefly as a side effect of the super low interest rates and sluggish growth in the euro area. So we are not earning as much on our overseas assets as foreign investors investing in the UK earn. That yield differential also attracts lots of capital into the UK, which more than funds the current account deficit that is caused by that yield differential. That may well continue for a while. Circumstances under which that could cause a problem would be if foreign investors start to worry about the UK’s commitment to economic stability in general, because after all we do have to fund that current account deficit. I would say the question of EU membership is a very important thing. What I find talking to investors around the world is that is probably their number one concern about the UK. But if that happened, if greater risks were to grow, then the adjustment would be that the pound would fall, I suspect. I do not know how directly it would affect Government policy and in a sense the exchange rate would be the shock absorber.

George Kerevan

Do you think that the loss of foreign capital earnings will reverse if interest rates start to rise?

Michael Saunders

If interest rates start to rise in the UK, the mathematical effect of that would probably be to make the current account deficit worse because foreign investors would earn more on their deposits in the UK. The only way the current account deficit within this framework would correct significantly would be euro area growth is strong enough to push up the return on our external assets. That may well be some time away.

John Mann

Mr Saunders, you talked of deflation and your concern in relation to that. Is there any particular country that we should be studying in order to look at this issue and some of the complexities in dealing with any potential deflation, in your view?

Michael Saunders

Switzerland, Sweden and New Zealand are all countries that have faced significant currency appreciation. In the case of Sweden and New Zealand it was after relatively early interest rate hikes, which then squeezed their export sectors and have produced a persistent lowflation or deflation.

John Mann

That is very helpful. Mr Portes, you have blogged about immigration. Is what in essence you are saying that we have the wrong kind of migrants coming here?

Jonathan Portes

No, I was not making a negative point about immigration. I was merely observing, as Michael quite rightly said, that the effect of the changes to the tax credit and the national minimum wage will be to reduce the relative labour supply of people with children, most people already in the UK labour market, and reduce relative labour demand for those people from UK companies. At the same time I noted that this will not affect labour supply for people under 25, particularly those who might be attracted here from eastern Europe, and indeed people over 25 without children, which make up a significant proportion of people who come here from eastern Europe. This may rather paradoxically actually increase the relative attractiveness of migrants for UK employers and the UK labour market to migrants while reducing it for British families currently resident with children. It was merely an observation. I am not saying anything about the wider impacts of migration from the European Union, which on the whole I regard as being broadly positive.

John Mann

Have you not missed this issue of 30 hours free childcare? In fact, isn’t it more likely to be migrants with children, attracted by free childcare if in work, who are more likely to come here than under 25s?

Jonathan Portes

Most migrants who come here don’t have children when they come and all the evidence we have suggests that the primary motivation for migrants from eastern Europe to come here is the headline wage rate; first of all, the fact that our labour market creates a lot of jobs and, secondly, that minimum wages here are pretty high relative to anywhere in eastern Europe, which of course will be even more the case now, and we speak English. There is very little evidence that they really understand things like the tax credit system, let alone the system for the provision of childcare. Of course, once they have been here a year or two then they learn how we work and then they start claiming tax credits and no doubt they will take advantage of the childcare and all the rest of it. So they will end up in the system but that is not the reason they come in the first place.

Professor Booth

Could I strike a dissenting note on deflation, as it has come up a couple of times?

Chair

Very quickly, and then I think we are going to have to close.

Professor Booth

When thinking about deflation, you should distinguish between a temporary fall in prices or temporary very low inflation as a result of a fall in some prices, which is what we are experiencing at the moment in the UK. We are not experiencing deflation as such. Even when you do experience this continuous decline in prices, which some people worry about, you can also distinguish between one that is expected and understood and embedded within people’s expectations and decision-making and sudden shock deflations. I think Japan’s problems are far greater, more structural than simply the problem of deflation it has had over the last few years. I think deflation is something of a red herring in the debate about Japan.

Chair

We have covered a large number of areas there in a short space of time and no doubt only some of them, nothing like as deeply as we would like. So if you have further thoughts you would like to add, please put them on paper and let the Committee see them in due course. Thank you very much for coming to give evidence. It was extremely interesting. We are going to move straight on to the next session. Examination of Witnesses

Witnesses

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

Chair

Thank you very much for coming to give evidence this afternoon. Can I begin with a question to you, Mr Johnson? You have seen the announcement on the proposal to give a statutory base to the Office of Tax Simplification. You work in the field of trying to think through what should be done to the tax system on a daily basis. What do you think the structure of that body needs to look like in order to make it effective, and in particular in order to give it enough independence for its views to carry credibility?

Paul Johnson

The OTS over the last few years, as you know, has been a relatively small organisation that has sat very much within the Treasury, reporting to the Chancellor, working on an often widely defined set of issues but often coming to very narrowly defined sets of recommendations, to which no one has a responsibility to respond explicitly. I think something that involves a clear responsibility on perhaps the Chancellor or the Treasury to respond to recommendations would be helpful. A situation in which the OTS is reporting directly to a committee of Parliament would also be helpful, and a close working relationship and understanding within HMRC of what OTS is doing, the feedback that it is getting from its extensive consultations and the reasons for its conclusions. The more independent that you make an organisation like the OTS, the more difficult it becomes for it to be impacting on the day-to-day policy, both making and administration. I think one of the difficulties that it has faced is that a lot of the complexity in the tax system is deep policy complexity. There is administrative complexity where you can make changes that tidy things up around the edges, but the OTS has inevitably over the last few years strayed into areas that potentially make quite a big difference to the structure of the tax system, whether you are talking about the taxation of employee benefits or whether you are talking about the integration of tax and National Insurance contributions. A lot of the complexity is created by those deep policy decisions and it is inevitably difficult for a small organisation to change those, but I think it would be helpful if it had a platform for explaining why the complexity that people observe is driven by the overall policy and, therefore, allow it to force Government, as it were, to respond to that.

Chair

For that it needs some independence. Its leadership needs some independence.

Paul Johnson

I think that independence and particularly the responsibility on this Committee or another committee and the Chancellor to respond—

Chair

Accountability in some form here is what you are saying?

Paul Johnson

—to those recommendations, yes, indeed.

Chair

Okay, that is very helpful.

Chris Philp

I would like to ask about the achievability of the welfare savings. In the past, the IFS have questioned the Government’s ability to achieve savings in the welfare budget. Would you agree that the £12 billion of welfare savings set out for the coming period are pretty clearly itemised and will, therefore, be achieved following the Budget last week?

Paul Johnson

Clearly, savings are achievable if you cut the generosity of benefits and that is what is being proposed and that is clearly achievable. I think there are two riders to that. One is that benefit spending can rise even when you are making those cuts, and we saw that very clearly over the last Parliament. There were cuts to the generosity of housing benefit but housing benefit spending rose because rents rose and earnings fell. You are always at the mercy of what is happening in the rest of the economy. One other thing I would say is that the £1.4 billion I think it is that is scored as a saving on housing benefit is not a saving on housing benefit. Essentially, it is a cut in the support to housing associations and local government. It is not a cut in the generosity of housing benefit. I think it is rather odd that it was scored in that way.

Chris Philp

Okay. I think the IFS has been recently quoted as saying that 13 million families will be £260 a year worse off due to the effects of benefit changes, so across that 13 million average. Does that analysis account for the effect of the proposed national living wage? Have you done analysis that looks at the combined effect of the reduction in benefits joined together with the very significant effective increases in the minimum wage?

Carl Emmerson

The 13 million families is simply the number of families in the UK receiving working age benefits that the Government has subjected to the four-year freeze. There are 13 million people who will lose from that measure. The Government has scored that as saving about £4 billion, which works out at £260 a year on average. That is how we worked out that number. It is just the losses from one particular measure on the scorecard. If you are talking about how much families will lose from all of the welfare cuts, then clearly the Government has scored that at £12 billion, so it is a much bigger number. If you want to think about the gains from the higher minimum wage, the OBR estimates that £4 billion extra in employment income will be generated from the higher minimum wage, so there will be some compensation for some of those families that lost. It is important to remember that, first, the minimum wage has to be paid for somehow. That is not just free money appearing in the economy. There will be fewer hours worked or there will be higher prices or lower returns for shareholders; somewhere the money has to come for these people. You also have to remember that some people will benefit from a higher minimum wage who will not be losing tax credits. The compensation is not perfectly targeted at the group who are losing from welfare cuts and from the benefit cuts and the tax credit cuts.

Chris Philp

The Treasury has produced figures that suggest that for a typical family with one working full-time person on the minimum wage, when you put all of these changes together for that particular exemplar demographic, so one full-time person on minimum wage, they will be better off by 2020 when you net all these effects together. Is that an analysis that you accept?

Carl Emmerson

There are certainly examples where families are better off as a result of the package set out in the Budget, even if you just look at the benefit cuts and the minimum wage increases. They tend to be families who are working a lot of hours at the minimum wage, so they benefit a lot from the minimum wage increase and they do not qualify for much in tax credits anyway. If you look at other families where the hours are lower and perhaps they are earning more per hour, they will not benefit as much from the minimum wage increase, if at all, yet they can still lose a lot in tax credits.

Chris Philp

That is a very interesting point that you have made there. I think what you are suggesting—and I think this is something I would agree with—is that the combined effect of the tax credit reduction and the increase in minimum wage might actually serve to encourage people to move more towards full-time working as compared to part-time working because there are much stronger incentives now to work full-time rather than part-time and that might well be beneficial for the economy.

Carl Emmerson

For those who are receiving a higher minimum wage they may well want to work more hours per week if those hours are on offer from their employer. I mentioned before that somehow a minimum wage increase has to be paid for. Of course, there are a set of people who are out of work for whom the returns to working now may be lower because they will not be able to get as much in the way of tax credits if they are to work.

Chris Philp

Yes. I think that is an important point, Mr Chairman. I think that the net effect of all of this may well be to push people more towards full-time work than part-time work and that is worth bearing carefully in mind. In terms of the perceived fairness of the changes, which some people have commented on, the distributional analysis produced by the Treasury is quite instructive and it compares the proportion of spending received by the various quintiles in 2017-2018 as compared to 2010-2011. What is very interesting is that even after all of these changes we have heard about, the bottom two quintiles essentially receive the same proportion of spending, 24% and 26% respectively, and pay pretty much the same share of tax, 6% and 8% respectively, as they did five years ago, which would suggest to me that these changes do not have a redistributive effect and do not penalise people on low incomes. The distribution of both spending and taxation is essentially unchanged over that 2010 to 2018 period. Do you accept those Treasury figures that the distributions, both for spending and tax, have not changed and there is not, therefore, any unfair penalisation of people on low incomes?

Carl Emmerson

In terms of the distribution of spending, I think what it is showing is that the Government has been cutting, say, benefits targeted towards the middle of the income distribution harder than it has been cutting benefits that are targeted towards the bottom. Therefore, the share going to the bottom has not declined as a result of that. If you look at all of the tax and benefit changes that have been implemented since January 2010, which is roughly when we started the fiscal consolidation and dealing with the deficit, and you look at the loss from tax rises and benefit cuts by decile of the income distribution, what you see is that it is the people at the bottom who on average have lost the most, followed by people at the very, very top who have lost the most. It can be people on very, very high incomes who have been hard hit by the tax rises, essentially, that have taken place and particularly the direct tax increases and the reductions in generosity of the pension tax regime, but it is working age families in the bottom half of the income distribution who have also lost a lot as their benefits have been cut back.

Chris Philp

You are quite right about the top quintile. Their share of taxation has increased from 49% to 52%. Your comments are not reflected in these figures lower down the income spectrum. I think that was everything, Mr Chairman.

Chair

That is all you want to ask?

Chris Philp

Well, the other question I wanted to ask was a hangover from the previous one on a different topic entirely.

Chair

No, I think we will stick with welfare just for the time being.

Bill Esterson

Do you think that the welfare changes in the Budget are going to help people into work without other measures?

Paul Johnson

As ever with welfare changes, you are trading things off. The particular changes to the tax credit system will have different effects. If you are currently a family with just a single earner, then it reduces to some extent work incentives because the work allowance has been reduced in the universal credit system, so the point at which you start to have your benefit withdrawn comes in earlier. But if you already have another earner in the family, because you lose the benefit more quickly that increases your incentive to move into work. As ever, there are trade-offs. Different people are affected somewhat differently, but for lone parents and those without a working partner, this will have some reduction on the incentive to move into work. It makes relatively little difference to the incentive to work a little bit more or less.

Bill Esterson

Sure. What did you make of what Michael Saunders told us in the last session in relation to young people and the longer term impact?

Paul Johnson

I did not catch what he said, I am sorry.

Bill Esterson

He was saying that he has concerns about the combination of tax credit cuts and the rest of the welfare changes on their ability to gain employment both in the short and long term.

Carl Emmerson

I think the concern he had was about if there was another downturn, looking at what happened over the last downturn. When you go into an economic downturn, you might think that the right policy response might be to, if anything, boost tax credits or not cut them in order to keep labour supply high and, if anything, do not increase the minimum wage, if anything reduce it, in order to keep labour demand up. He was saying that the combination that the Government is now going for, which is a higher minimum wage combined with lower tax credits, might be okay in normal times but he was worried about what that might do in a downturn and how Government might need to think about policy if we were to have another recession.

Bill Esterson

Yes. Is that something we should worry about? That is the question.

Paul Johnson

Yes, in the sense that if the benefit system has less of a clear incentive to move into work in it, then that is an issue. If the minimum wage system is less responsive to the economic circumstances, then that may also be something of an issue. What I am less clear about is how the—well, to some extent it also depends presumably on how median wages change if we are fixing the minimum wage at 60% of the median. We will be to some extent at the mercy of how the distribution of earnings changes over time. Whether this is a big change in terms of the way the labour market works I am not so sure.

Bill Esterson

Okay. Asking about the impact on disabled people and people with long-term illnesses, what is your view on the changes to employment and support allowance on those people?

Paul Johnson

It will clearly make them worse off to the extent of the cut in the benefit. In a sense, there will be more reason for those people to try to get on to the enhanced level, potentially more of them appealing to get on to the higher level, but I think the main effect will be that it will simply make them worse off by the £20-odd a week that their benefit is being cut by.

Bill Esterson

Yes, £30. So is it more likely they will end up in work or not, do you think?

Carl Emmerson

I think the lower educated people who perhaps command less of a wage in a labour market, that is the group where claimant rates on disability benefits have not really been falling in recent years. Among higher educated and middle educated people, claimant rates have been falling. It is the lower educated group that has been going up. Maybe among that group you will start to see some people who are a bit ill but deciding at the margin they would rather stay in work than move on to the benefit that is £30-odd a week less generous.

Bill Esterson

The £12 billion over the whole of the economy has a relatively limited impact. What about the impact on local economies where you have relatively high numbers of people in a particular community who would be adversely affected? What is your assessment of the effect on businesses and on jobs in those areas?

Paul Johnson

I do not think I would like to offer any comment on that. There will be some areas where there are more people affected than others and that might have some effect, but I certainly have no view as to how significant that effect might be.

Mark Garnier

Carl Emmerson, I just want to go back to these 13 million people that you say will be worse off and be absolutely clear about what you said on this. That 13 million people who are worse off, you are just looking at the reduction in welfare, aren’t you? You are not looking at anything else?

Carl Emmerson

Just looking at the benefit freeze for four years, yes.

Mark Garnier

The benefit freeze, exactly right. It is quite a misleading number for the IFS to have put out because, of course, those 13 million people, as we have heard a bit earlier, would have got the benefit from the rising tax-free personal allowance.

Carl Emmerson

Well, the number is in a presentation where we go through each of the measures in the Budget—

Mark Garnier

Yes, sure. It is just a very interesting point. By the time you add all these things together, the picture is very different from perhaps what was suggested. Maybe some of those people will be living in social housing and so you would get a reduction in the rents. Are you comfortable with how you were reported given the fact that it is quite a small sliver of a much bigger picture?

Carl Emmerson

The presentation, which goes through all of these measures and describes how many people are affected, what the average loss or gain is, ends with a distributional picture that takes into account all of the points in the model—

Mark Garnier

Sure, I appreciate that.

Carl Emmerson

—and shows how the effect varies across the income distribution. Most of the broadsheet newspapers I looked at reproduced that graph, which is our most comprehensive analysis that we could do.

Mark Garnier

Yes, I understand that. It is just this 13 million thing is the one that has been picked up on. The other point about this, of course, is that there is an economic effect of what is happening. The idea is that with the increase in the minimum living wage that will create more money in circulation in the economy. As we have heard, it will drive more people into work. Have you taken into account the effect of that, the economic effect of this, or are you simply looking at it from an, if you like, bookkeeping point of view, a mathematical point of view, rather than a qualitative point of view?

Carl Emmerson

We have not taken account of that, although I would point out that the OBR thinks that GDP will be 0.1% smaller as a result of the higher minimum wage.

Mark Garnier

Yes, we have them coming in. We are giving you the chance to have a canter round before.

Carl Emmerson

We do not have that loss that will be experienced across the households in our model.

Steve Baker

Can I return to this point about the distributional analysis? I was just going back and looking at what you have done compared with what the Chancellor has done. The Government has changed the basis of their distributional analysis, as you will know. They have said that if you look at spending on each decile, then borrowing adds to the amount received for each decile and is, therefore, an unreasonable thing to do. Do you accept the basis on which the Government has changed its distributional analysis?

Paul Johnson

We can do these analyses in different ways. The way that we have tried to do it is just by looking at those cash changes that immediately impact on the incomes of households and that in a sense is the most straightforward and most intuitive way of looking at it. That is how much they will be—

Chair

Do you think that the way the Government is now doing it is the right way to do it or not?

Paul Johnson

Well, it is a different way. It tells you something different and it tells you something about the impact of other bits of public spending on—well, not even the impact, the size—

Chair

But is it of equal value or of less value or of greater value?

Paul Johnson

It is a different way of looking at it. I think it will be useful to show what we did as well. I think what the Government has done—

Steve Baker

Do you regret that the Government has ceased to publish the previous distributional analysis on a different basis so that we can see a time series on the same basis?

Paul Johnson

I think it is generally a shame when Government stops doing things that are interesting and stops you seeing things across time, yes.

Steve Baker

Of course, the way we communicate in different ways does communicate something quite different. When I look at your analysis of the impact of tax and benefit changes, it does show a quite different picture and it is, frankly, quite a worrying picture. I just want to return to this point that Mr Philp made. If somebody is on the national living wage, according to the OBR the average gain for a gaining household in the bottom decile looks like about £580, about £550 for the second decile, getting on for £600 for the third decile, and so forth. Does this impact of tax and benefit reforms take into account that analysis of what the national living wage does to people on the lower deciles?

Paul Johnson

No, that analysis does not have the living wage in it. We were not able overnight to model that.

Steve Baker

One of the things that concerns me is that if people, particularly people in the lowest, the poorest deciles, see this analysis without taking into account the national living wage’s impact, then they surely will not have a fair understanding of what the Chancellor is trying to achieve. Isn’t that right?

Paul Johnson

I think I would say two things to that. First, as Carl says, the expectation is that the living wage will reduce national income and, therefore, the average loss in that chart will be bigger, not smaller, if we were taking account of that in terms of its impact on national income. Secondly, the—

Chair

That is national income as a whole—

Paul Johnson

National income as a whole.

Chair

—but we are talking here about the bottom decile.

Paul Johnson

Yes, with—

Steve Baker

I am sorry to interrupt, but the point here is that I think all of us, who are all people of noble intent, are concerned that the people with the broadest shoulders should bear the worst burden. I appreciate there are lots of different ways of looking at these analyses. What I am asking you is: should you have taken into account the impact of the national living wage when showing the impact of the tax and benefit reforms on each decile?

Paul Johnson

What our decile chart does is show, as we always have done going back for a very long time, the changes in the tax and benefit system. So to be consistent over time, that is what it has done. Secondly, we were simply not able to model the additional thing overnight in the way that we do that. Thirdly, we did go through in some detail what we would expect the broad effect of that to be. It is clearly having a positive effect on incomes right across the distribution with an average effect on those bottom deciles much less than the loss that they have received from the changes to the benefit system. Yes, there are different ways of looking at this. It would not change the overall picture. It would change the scale of some of those losses down the bottom. It would not change the overall picture in terms of the—

Steve Baker

I just want to press you on this point because the poorest decile in your impact of tax and benefit reforms between 2015 and April 2019, you show the poorest decile losing £800 a year. Well, the OBR analysis of the average annual gain through the national living wage is almost £600 a year.

Paul Johnson

Among those who gain, if I understand that to be right.

Steve Baker

Among those who gain, that is correct.

Paul Johnson

That will be a relatively small proportion, a very small proportion on a guess, of the bottom decile, so the effect it would have on our chart would be pretty small.

Steve Baker

Well, would you undertake to do the chart again taking into account the impact to the national living wage? I think what we are all concerned to do is to make sure that the Government’s policy is properly understood, aren’t we?

Paul Johnson

We are indeed.

Steve Baker

Yes. The Chancellor has been very clear that we are trying to move from one kind of society to another. I say it with all good intent: would you please undertake to have a look and see if you can get the impact of the national living wage into that chart?

Carl Emmerson

We are going to try to, but I think it is important to remember that the national minimum wage going up is not just a giveaway to households. You cannot just say on average all households are better off from a higher national minimum wage, whereas when you are doing a tax or benefit change we can say, “What is the impact on the public finances and what is the impact on household incomes?” Just as the welfare cuts—

Chair

So you have to make assumptions?

Carl Emmerson

You have to.

Chair

You have to; that is where you earn your crust.

Carl Emmerson

With the welfare cuts we could say it makes certain households worse off, it strengthens public finances, it reduces the burden on public services.

Paul Johnson

The answer to your question is yes, we will have a shot at this and I am not sure exactly when we will be able to do it by, but my expectation is the pattern you will see will be very similar to what you are seeing there, but just a little less dramatic.

Steve Baker

Okay. We will look forward to seeing it. Thank you very much.

Chair

When you say you are not sure when you are going to do it by, I think I am going to press you on that. Last time we asked you to do something in a week or so and we were told it was really impossible. How long is it going to take you to do this, Mr Emmerson?

Carl Emmerson

We have arranged to meet at the IFS next Wednesday to discuss exactly what is possible to do in terms of what is practical, in terms of spare resources, and what is technologically feasible, and then we will decide. We have some funding in place for some work that we have to do for this autumn and we want to make sure obviously how it fits in with that. I am afraid it might not be on the sort of timescale that this Committee will be reporting on the Budget.

Chair

I am going to press you again. You exist partly to support committees like this and to assist Parliament. We really do want an answer to this. This is an important question and we want it as soon as possible. Can you have a conversation prior to next Wednesday to find out what timeframe you could do this in and let the Committee know on Monday? I will put into the public domain your reply. Can you do that?

Paul Johnson

Yes.

Chair

Thank you very much. There is another piece of information I would also like, which is the Government have changed the basis for their analysis and you were asked a moment ago do you think it would be helpful if we had the Government’s previous approach to looking at distributional analysis applied to this Budget, which we no longer have, of course, because the basis has changed. Do you think that is something the Government can or should provide?

Paul Johnson

It certainly can and I think it would be useful to the public debate for it to do so.

Chair

That is very helpful. I think we might ask the Government for that as well. Of course, we have the chance; they are coming to see us next Tuesday.

Helen Goodman

Back to the incentives point, you provided us with some charts on the effective marginal tax rate before and after the Budget for a lone parent with two young children, and that is very interesting. What I would really like would be if you could roll forward the chart that you did in your pre-Budget briefing, which showed the marginal rate changing over the whole income distribution from nought to I do not know what it goes up to, £100,000 or something. I am sure you know the chart I mean.

Carl Emmerson

That is just the income tax and employee National Insurance schedule. It was changed a little bit by the Budget because they increased the personal allowance and the higher rate threshold, so we can certainly reproduce that. The big picture still remains that the system is overly complicated and is in need of improvement. That does not include tax credits.

Helen Goodman

Okay. I am sorry, I have not quite grasped that. Do you have one that incorporates as well the tax credits change? Because the thing that really struck me in the OBR was that the Chancellor was increasing the taper rate to 48% but the top rate of tax is 45%. I guess what I am asking for is a slightly extended version of this where we look at the tax credit marginal rates as well.

Paul Johnson

That is where you have to select a particular type of person because, for example, lone parents are different and that is where I think what we have provided is probably the best that you can do, which is the one that we have done for the lone parent. Because if you were to stick that into the chart that goes up to £150,000, you would see a little bit right at the beginning and then everything else will be the same. What you are seeing there effectively is the impact on that particular individual. The change to the tax credit taper, you are right, does increase the effective marginal rate right at the bottom at the moment for those on tax credits. What we have illustrated in our lone parent example is what this looks like under the universal credit system because, of course, this tax credit change only will apply for the next couple of years until the universal credit is in. Within universal credit the withdrawal rate has not changed. It is the work allowance that has changed, which brings down the point at which you start to take away the income, which is why it has—

Helen Goodman

Yes, I understand that. I have grasped that, but are you saying then that, for example, on the original combined tax and employers’ NICs hardly anybody was paying more than 60% unless they were at about £80,000, but here we have these lone parents and they are paying over 70%?

Paul Johnson

Yes, so if you were to include the tax credits in that chart that you are pointing to, then for that lone parent type person you would have numbers of 70% or 80% right at the beginning, which would then go down and follow the rest of that.

Helen Goodman

I guess what I am saying is could we possibly have a couple, two children, the usual array of stereotypical families—

Chair

Perfectly reasonable approach, isn’t it?

Paul Johnson

You can produce all sorts of examples of this kind.

Helen Goodman

I was just thinking that because you have done it before it would just literally be a question of cranking the machine, not doing a whole new piece of analysis, whereas I know that the problem with what Mr Baker has done is that you do not know the overlap between the minimum wage people and the tax credit people and that is a complexity there. We do not really have that complexity when we are looking at the tax credits and the income tax in anything like the same way, do we?

Carl Emmerson

We do. The graph here is not just a lone parent with two children. It is a lone parent who is in the rented sector at the median local housing allowance rate. She has no assets and no other income, so we have had to make a lot of other assumptions because it includes housing benefit as well as tax credits.

Chair

Still, we like you earning your crust by making these assumptions, so I think Helen is on to a reasonable point. We would like to have a look at that as well.

Carl Emmerson

Possibly paying our crust here.

Chair

We should really be demanding pay by results. We would certainly like Helen’s graph or table, however you want to present it, and also Steve Baker’s.

Helen Goodman

Just a couple, a lone parent and a family.

Paul Johnson

I should say, as Carl said, you can produce immense numbers of examples here, so if we do this we will have to choose something specific.

Chair

We would like some suggestions on Monday on how you intend to go about this with the end date that we are going to get them, and we are not going to take no for an answer. We would like it certainly before the House resumes in September, please. Now, Wes Streeting has to go, so I will bring him in next.

Wes Streeting

I wanted to ask around higher education and student finance, two dimensions. The first is around equity and the way in which the Chancellor is proposing to move student grants over to loans. Could you say something about the impact this will have in terms of the debts of the poorer students but also, given what the Government is considering around the freezing of the repayment threshold, what impact do you think that will have on graduates and which graduates in particular will be most disadvantaged?

Paul Johnson

I can say we will be publishing something on this within the next week because this is a piece of work that is under way. Broadly speaking, yes, the debt of students from poorer families will rise substantially because the grant is being turned into a loan and the result will be that an even higher proportion of them will not ever pay off the full loan from the current 75%. That number will become higher. One result of that, of course, is that because the majority are not in any case paying off the full loan at the moment, the impact after graduation ex post will be zero because they were not paying off the full amount anyway. The fact you are loading more debt on to them does not change the amount they end up paying. The change to the threshold is quite significant in terms of the amount of repayment that students will end up making and so that will over the lifetime of graduates, particularly middling income graduates, make a significant difference to the amount that they end up paying. It will not have much impact on the very lowest income graduates. They still will not get above that threshold. It will not make much difference to those at the top end because they pay it all back anyway, but for those at the lower middle of the earnings distribution, they will end up paying back more. Of course, the flip side of that is that it does mean that the Government gets back more of the loans that it makes and arguably puts the system on to a more sustainable basis.

Wes Streeting

That brings me on to the second issue, which is around the RAB and how it is being treated, not just the long-term consequences for the Treasury but also the way it is driving short-term policy decisions. I think the previous Minister, David Willetts, was always keen to say, “Don’t worry about the RAB, it’s not an issue” but it does sound a bit too good to be true that the Chancellor can put a significant amount of extra investment into higher education but there is no long-term cost to the Treasury or at least an insignificant cost. Do you have a view about that?

Paul Johnson

Yes. I do not think it is the RAB that is driving anything here, but the way in which this accounts for public finance is driving things. You move from the grant system to a loan system for maintenance that has a significant short-run impact on the public finances despite the fact that the large majority of that probably will not be paid back given, as I say, it is layering debt on top of debt, some of which was already not being paid, and if it is the case the poorer students now end up earning less than the average among other students, they are less likely than the average to pay that back. I think the short-run accounting impact on the apparent public finances flatters. The long-run effect on the public finances should be much smaller than the short-run effect.

Wes Streeting

Yes, I think my concern—and feel free to disagree—is two things. One is that we are selling off the student loan book not because it is necessarily the best policy decision but because it has an impact on public sector net debt figures and that is the driver for that policy. Secondly, particularly because of the changes that were made I think around 2014, which was a switch in the rules and the way in which this was given an additional facility from the Treasury through the AME spend and they have agreed that they will cover the costs of 1/30th of extra spending every year, that this is having a greater impact, therefore, on the BIS budget in the short term and that is what is driving the changes to the repayment thresholds. Do you think that is a fair characterisation of the policy drivers?

Paul Johnson

What is driving the changes to the repayment thresholds I think, at least in part, is the repayment threshold was set whenever it was, back in 2011, when there was an expectation that earnings would grow faster than they have. You could argue that it is resetting things relative to where we think earnings will actually be. You are absolutely right about the selling off of the student loan book in the sense that it appears in the national accounts to have improved things, but in truth in the long run nothing has changed. It is simply a feature of the way that we do the national accounting that it appears to have improved the public finances in the short run. In the long run it has not.

Jacob Rees-Mogg

I cannot remember whether you had come when I asked a similar question before on the questions of ring fencing and hypothecation. As you know, the areas of ring fencing were extended to include defence, counterterrorism and all the things that were previously there, and the limitations on tax rises is the other side of that. I wonder whether you think that is now out of control.

Paul Johnson

The ring fencing of spending is really a political statement of priorities. The consequence, of course, arithmetically is that if you are ring fencing and, indeed, increasing spending in some areas and you have an overall budget limit, then the consequence for other bits of spending is very significant. Our calculations suggest that the un-ring-fenced bit of public spending will be cut by about a third between 2010 and 2019, but as one of your previous witnesses pointed out, it is hard to believe that spending on health, for example, would have been a lot different under a world in which you did not have that ring fence. But you put the two together and then in a sense you squeeze the rest of departmental spending out at the other end and the consequences are that the shape of public spending, the shape of the state, will be very different in 2020 to what it was in 2010 and certainly from what it was in 2000 with much, much more going on, particularly health and pensions, and much less on most other parts of public spending. I think that is an important political debate, in a sense, about whether that is the right shape and that is a shape that will become more like that going forward under current policy as the population ages. I think there are some very big political as much as economic decisions to be taken through that. In terms of the tax issues, we have not had an increase in any of the main rates of income tax other than the increase of 50p since 1975, so tying your hands not to do that I suspect makes very little difference to the reality.

Jacob Rees-Mogg

We have on NICs and VAT.

Paul Johnson

We have on VAT and NICs so that is more of a constraint. It feels to me there is a less obvious economic rationale for tying your hands on that than there is on the spending side. The spending side is a clear statement about what Government priorities are. Tying your hands on what you might do to the tax system three years hence, it is less easy to see a reason for that other than a purely political one.

Jacob Rees-Mogg

It does not necessarily mean very much, does it, because it can be reversed when Parliament cannot find—

Paul Johnson

Parliament can reverse anything.

Jacob Rees-Mogg

A wonderful line from the IFS in 1994 calls hypothecation an absurdity and says that spending will be cut during recessions and increased during booms. Do the IFS stand by that view?

Carl Emmerson

Yes. There are two kinds of hypothecation. One is where the tax is paying for part of spending on something, in which case you can never really know whether that tax is paying for that or something else. If you get tax revenue of £100 from some tax and you are spending £300 on some spending item, it is just smoke and mirrors. Or you can have binding hypothecation where the tax is £100 and the spending is £100, and then you are saying that the optimal tax rate on this thing you are taxing in all periods of time, in all states of the world, will equal the optimal amount of spending on this other thing. Do we really think the optimal amount of taxation on motorists, for example, through VED is exactly equal in every single future year to the optimal amount of spending on roads? I strongly suspect not and, in fact, VED revenues seem to be quite a lot lower than what we spend on roads anyway.

Jacob Rees-Mogg

Though historically they were higher, weren’t they, which was why the hypothecation was given up in the first place?

Carl Emmerson

I do not know the answer to that. The one example where we do have hypothecation that is binding and perhaps is a little bit different would be the BBC with the TV licence where the spending and income are equal. Maybe there are different political arguments for why you do it there as opposed to elsewhere in the tax system and your public spending system.

George Kerevan

I am interested in looking at your preliminary assessment of the impact of the shift away from the bank levy to a charge on bank profits. Presumably, given that the tax base is going to shift, it will have some impact on who pays and who pays what. I am particularly interested if new banks are brought into the tax, particularly the mutual building societies who are using their profits for capital rebuilding. Have you had a look at that in a preliminary way? What might the impact be?

Paul Johnson

We have not looked at that particularly. I think there are two or three things to say. One is that, as I understand it, the increase in the corporation tax rate happens quite a lot before the full reduction in the bank levy, which is I think promised not to reach its minimum until after the next election, so there is an issue of timing there. Secondly, the bank levy was in a sense well targeted at risk capital. The issue with it was that it was continually raised as behaviour was changed and because it had a particular base, which was worldwide; it hit a small number of banks very hard. The increase in the corporation tax for all banks will spread that significantly more. My understanding is that the share price of banks following the announcement, some went up and some went down, and that is probably telling you quite a lot about who is winning and who is losing from this change. My expectation would be that this would reduce the capacity of some of those banks who have additional tax to do some lending at some point into the future, but quantifying any of that is certainly not within our expertise.

Chair

Thank you very much for coming to give evidence to us this afternoon. As you can hear, we are very keen to have some more evidence. We are looking forward very much to receiving it and we recognise that we are not making easy requests, but I am sure you understand, given you are a part Government funded body and we are Parliament trying to scrutinise Government, we feel we are making reasonable requests of you, at least to attempt this work.

Paul Johnson

In terms of Government funding, we are arm’s length funded through the Research Council for a small portion of our funding to do a particular piece of research. We are otherwise funded by charitable foundations and others, all of which is to do particular research, just to be clear about that.

Chair

Isn’t just about 80% of your funding via Government sources?

Paul Johnson

No.

Chair

I have the figures in front of me from your 2013 website.

Paul Johnson

Well, it may have changed a little. The ESRC is our most important funder but we do not get 80%.

Chair

Isn’t that a Government source?

Paul Johnson

It is a Government source but I think they would find it difficult if you were to refer to that as Government funding and, therefore, that we were beholden to Government for certain things.

Chair

I was not making that point. There are lots of things that are funded by the Government but they are independent, like the courts, for example. Anyway, thank you very much for giving evidence and we are looking forward to the evidence we are going to get as a supplement. We will adjourn now and resume at 5 pm. Sitting suspended. On resuming–– Examination of Witnesses

Witnesses

Robert Chote, Chairman, Office for Budget Responsibility, Graham Parker CBE, Member, Budget Responsibility Committee, Office for Budget Responsibility, and Sir Stephen Nickell, Member, Budget Responsibility Committee, Office for Budget Responsibility, gave evidence.

Chair

Thank you very much for coming to give evidence to us this afternoon, the first in front of the new Committee, and we are grateful for it. First of all, Mr Chote, are you surprised that no announcement has been made about your successor?

Robert Chote

I have had no discussions with the Chancellor or anything about this. I think obviously time is running slightly shorter so I hope one would hear something relatively soon.

Chair

Just for the record, tell the public what the timeframe is.

Robert Chote

Well, my term ends in October.

Chair

Beginning of October, isn’t it?

Robert Chote

Yes.

Chair

So there is not very much time and if we are to have someone other than a renewal of Robert Chote, we need to find out fairly soon.

Robert Chote

Yes.

Chair

You have nothing to tell us?

Robert Chote

No. No news.

Chair

Sir Stephen, congratulations on your knighthood.

Sir Stephen Nickell

Thank you very much, Chairman.

Chair

Now you carry the particular responsibility of answering this question, which is: is this uncertainty about the leadership doing any harm?

Sir Stephen Nickell

Our leadership?

Chair

Yes.

Sir Stephen Nickell

Well, speaking personally, I think the answer is no because I have a touching faith that everything will come right in the end.

Chair

That was not the sort of informed and thoughtful reply that we were hoping for.

Robert Chote

You will note he did not say which outcome that applies to.

Chair

Yes, I did note that as well. Have you had any political interference in your work? You have to be independent.

Robert Chote

No, none whatsoever.

Chair

You received a lot of information quite late on this occasion for the drawing up of the forecast from the Treasury that you need in order to do that work. How big were the difficulties created by it?

Robert Chote

Yes, I think there was a disappointment in terms of the process here. It was finding out about some things that had implications or would have had implications for the forecast later than would have been ideal and later than the deadlines that had been originally agreed. I am conscious, of course, this was the largest fiscal event in terms of the amount of policy measures that we were having to look at since 2010. They were measures that obviously the Treasury had to deal with, DWP and HMRC, so it was by no means an easy task to get that amount of stuff over the line. However, we did have, for example, three measures that would have affected the inflation forecast, albeit modestly, that were notified to us after the inflation forecast had closed. We did not find out about the announcement that public sector pay bills were to be restrained to 1% a year increases for four years until the day of the Budget and we did not find out or we were not told at all and, therefore, read about it for the first time in the Red Book the decision to delay the annuities measure until 2017.

Chair

Okay. Well, I think the polite thing we can say about all that is that that is sub-optimal, to put it mildly, as a way of doing business. I think rather than pursue this detailed stuff right at the beginning of this hearing, perhaps it would be helpful if the OBR could set it out in a little more detail to this Committee and also give a balanced judgment on the extent to which this has hampered your work or could have hampered your work. It is much more important than if in the event it did not alter the forecast much. That does not tell us very much. What we want to know is whether it could have done and I think we need the Treasury to try to do better. I have one more set of questions. If we take stock now, the OBR has been around for a whole Parliament pretty much. It is set up with two purposes in mind: one to secure independence of the forecast from political or the appearance of political meddling. My first substantive question to you is to suggest that we are certainly succeeding in keeping it independent.

Robert Chote

Yes, I think that is true in reality. Certainly, we have not felt under political pressure to change our views in any way that we would be concerned about. I think the evidence you have had from, for example, the Kevin Page review and the discussions they have had with our consumers is that people seem to be reassured that whether they agree or not with the substance of the forecast they do not see the tell-tale signs of politically motivated wishful thinking in them.

Chair

The appearance of independence, that message is also getting across?

Robert Chote

I think so, yes, as far as one can tell.

Chair

Right. There is a second task, isn’t there, which is while simultaneously trying to produce the highest possible quality piece of work to try to downgrade the importance of forecasting in the public perception since it is the one thing we are all agreed on in this room is whatever you produce it is bound to be wrong since it is about the future. We have not had as much success there, have we, in getting that message across?

Robert Chote

I think that is always a challenge to do that. People are obviously keen to get a very clear answer from you on what your expectations are. There is for us a particular dilemma or a trade-off here because we produce an awful lot of quantitative detail of the forecast, which I think, given the nature of the bottom-up fiscal forecast that we produce, is essential for transparency and credibility and legitimacy. However, the danger is if you produce an awful lot of quantitative detail it can give a spurious sense of precision. I think I would rather err on the side of providing all of that information, but there are things that we can—

Chair

Right. How can we get this message across? Yes, there are some things you can do. How are we going to do it?

Robert Chote

Yes, I think, for example, it has been easier to talk about uncertainty and to illustrate it for the economic forecast than sometimes for the fiscal forecast because the fiscal forecast is made up of so many individual components. You can tell a high-level story about what difference does it make to the forecast if growth is higher or lower or interest rates are higher or lower, but in terms of coming up with ways of shining light on the uncertainty around the revenue and spending forecast, that is harder. One thing I think we would like to do is see whether we can extend the fan chart approach to the revenue forecast. I think it will be harder to do that for the spending forecast.