Finance and Constitution Committee

Meeting date: Wednesday, November 16, 2016

Official Report 581KB pdf

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Public Finances and Economic Performance

Under item 3, we continue our pre-budget scrutiny by taking evidence on the public finances and economic performance. I welcome our two witnesses: Professor Anton Muscatelli, principal of the University of Glasgow; and Russell Gunson, director of the Institute for Public Policy Research in Scotland. We have received submissions from both our witnesses. Before we move to questions, does either of the witnesses want to make a short statement? I take it from your nods that you both do—on you go.

Thank you for the invitation to attend the meeting. The committee will have seen my submission, so I will not detain members too long. I emphasise as an overarching point that the current Scottish budget is being set in an uncertain environment. The United Kingdom’s economic scenario has changed markedly. If we look at what most forecasters expect now compared with what they expected in March or May, we can see that the economic outlook has deteriorated. Some of that has nothing to do with recent events but has to do with a general deterioration in the economic outlook for the world economy and a slowdown, and some of it might be to do with local issues because of uncertainty about the Brexit referendum, but it is difficult to disentangle the two effects.

Scotland has also had a slowdown in its recent relative economic performance that, with the new fiscal framework, will impact on the available finances that the Scottish Parliament will have to decide on in the budget. As I said in my submission, there are other effects because of the depreciation in sterling that will have an indirect effect, through spending decisions, on the economic situation in Scotland and in the UK.

Another key issue is the interdependencies with the UK Government’s and Chancellor of the Exchequer’s decisions in the autumn statement, which now has a tradition of containing a number of budgetary or taxation announcements—there is no longer just the showpiece of the single budget. That is the case even more this year because, in effect, a new UK Government has taken office and we know that the fiscal policy will be reset. How that fiscal policy is set out will be critical for the traditional Barnett effects and for the impact through the interdependencies of income taxation decisions that might be announced ahead of next year.

Those are the main uncertainties that the Scottish Parliament and the Scottish Government face as they set their budget. I am happy to explore those issues in detail, as set out in my submission.

Thank you for having me here. Anton Muscatelli has already used what will probably be the word of today, which is “uncertainty”. We had uncertainty before the Brexit vote in June, we have certainly had it since then, and the US election last week only adds to that for Scotland and the UK.

We have begun to see some of the likely effects. In the short-term, the economic outlook was looking weaker prior to June’s vote, but it has looked weaker still since that. The vote will certainly bring strong headwinds against the Scottish and UK economies, and the effect is likely to take two forms. One is that we are likely to see an inflation shock. Some estimates put it at 4 per cent, but there will certainly be an increase in inflation towards the second half of next year, with reductions in living standards coming on the back of that.

Secondly, we are likely to see a growth shock. The Institute for Fiscal Studies has put a figure of about £25 billion a year on the black hole that the UK Government is facing by 2019-20. That will affect our public finances across the UK and in Scotland. In Scotland, we were already facing significant cuts—let us not forget that, not that any of us round the table would. Those cuts amount to about £2 billion a year for non-protected departments and, by our estimates, cuts to benefits will amount to £600 million a year by 2020. If there are further cuts in the autumn statement next week to fill the black hole, we are likely to see further cuts to the Scottish budget.

Over the medium and long term, there are things that we in Scotland and the UK need to focus on regardless of Brexit, and one of the main ones is productivity. The absence of productivity growth has been at the core of our missing and misforecasting many economic growth targets in the past few years. Regardless of where we sit in relation to the European Union and the UK, a focus on productivity has to be a key thing for the Scottish Government in the current session of Parliament and beyond.

On the public finances over the medium to long term, unfortunately, cuts are likely to continue through and beyond the current session of Parliament, and beyond that, demographic change will hit our finances across the UK and in Scotland. In short, public spending pressures will not disappear any time soon.

That is, if you like, the dismal part. The more positive side is that there are things that we can do about that, and it would be great to get into some of those potentials today.

Some of my colleagues want to ask about productivity and growing the economy, and also about consumer spending and the impact on those who are on lower incomes. However, I will get some of the scene setting done first.

You set out clearly in your submissions the significant challenges that the UK economy as a whole faces but, given that the overall size of the Scottish budget in the future will be linked to the Scottish economy’s performance, I would be interested to know whether you have a take on what the differentials might be between what will happen in Scotland and what will happen in the rest of the United Kingdom, particularly as a result of Brexit. I would like to understand where the performance of the UK and Scottish economies is likely to be similar, where there may be a divergence and, if a divergence happens, which direction we will go in.

The key issue in the Scottish Parliament’s budget is tax revenue differentials. There can be different economic growth rates, but the key is whether tax revenue per head is increasing at a faster or slower rate in Scotland than in the rest of the UK. To answer that question, we have to look at where there might be risks or opportunities in Scotland given the particular make-up of our economy.

On the positive side, the drop in the pound’s value has had a strong positive impact on export industries—such as whisky and tourism—that have quite a lot of the supply chain based in Scotland and which import fewer things from outside. However, energy costs might affect that in the future. On the negative side, I will leave it to Anton Muscatelli to talk about higher education, where there are headwinds—caused by Brexit and other things—that might particularly affect Scotland. We can also talk later about the inflation effects that might affect Scotland a bit more than other parts of the UK.

The concern over the next three years is not likely to be the direct impact of Brexit because, even if it goes according to the timetable that the Prime Minister announced, Brexit is unlikely to happen before the end of the forecasting period. Therefore, we are looking more at the expectation effects of Brexit: the depreciation of the pound and what it does to consumer and business confidence.

Russell Gunson mentioned that the depreciation of sterling will have a differential effect. We would expect food and drink—for which the value chain is largely in the country, so costs are not likely to increase too much because of import costs—to do well.

We would also expect higher education to do well because of depreciation effects making it more competitive. The problem is what might happen on net migration targets and any impact that that might have on student visas. Higher education is interesting because it was outside the top 10 exports from Scotland but is getting quite close to being one of them. However, it could be hampered by any tightening on student visas.

There are some interesting effects on the oil industry because revenues are in dollars and the cost base is partly in pounds. That could help, but it is also connected largely to what might happen to the oil price, so the situation is a bit more complicated.

The depreciation of the pound in the short term and the inflation shock, which might be aggravated by the depreciation of the pound, might affect consumer spending. As I said in my paper, a lot of employment in Scotland is linked to the public sector, and salaries in the public sector might well be constrained by the public finances.

We then have the inflation shock, which might be aggravated by the depreciation. As Russell Gunson said, inflation could reach 3 to 4 per cent next year, depending on which forecast we believe. That will reduce the purchasing power of public sector salaries and have an impact on consumption locally, so it will be an issue for the Scottish economy’s performance relative to that of the rest of the UK, as we depend more on public sector employment than the rest of the UK does.

That begins to paint the picture for us. I will take us to a slightly bigger issue in terms of the numbers, as Ivan McKee has put it: the £25 billion.

I thank Mr Gunson and Professor Muscatelli for coming in to talk to us. I am looking for a bit more background and for you to shed some light, if you can, on the £25 billion black hole, which you both mentioned. A number of issues drive that, such as the growth shock, the inflation shock, the drop in the value of sterling, the anticipation of a reduction in demand and the anticipation of a reduction in inward investment. As far as I can see, all of that is Brexit driven. Is that fair to say?

Not all of that is Brexit driven. As I said, a slowdown was in train even before Brexit, post this year’s budget. Brexit has possibly had an impact on consumer spending and business investment spending in the UK but, to disentangle the two effects, we will have to wait for a few more quarters to see exactly how that has worked.

I will try to disaggregate the £25 billion effect. The Institute for Fiscal Studies report that Russell Gunson and I mentioned in our submissions shows that £24 billion of that is slower gross domestic product growth. Slower growth in the UK economy between what George Osborne said at the time of the budget and now means that, if we look at growth over the next two or three years, there will be a gap in the tax take.

I will show the committee how sensitive the figures are. If the growth projections by the IFS and by other forecasters such as the Bank of England come true, by 2019, we will have reached only the level of GDP that we would have reached a year previously under George Osborne’s forecast—the Office for Budget Responsibility’s forecast, to be precise. Therefore, in effect, we will lose a year of growth, which gives members a measure of the tax take.

There are higher inflation effects, because of taxation.

It is important to say, too, that the IFS is assuming that we will get some money back in EU contributions by leaving the EU by 2019-20. If that were not to happen because we had entered into a deal with the EU on a free-trade agreement, and if we carried on paying between £8 billion and £10 billion, the gap would be not £24 billion but £24 billion plus £8 billion or £10 billion, because people are accounting for £8 billion.

09:45  

I was going to ask whether that had been factored in. I know that £350 million a week must be the true contribution, because I read it on the side of a bus. That amounts to about £17 billion a year, so the black hole might be double that. Has the contribution been factored in?

It has been factored in.

It is possible that we will have to fork out in a kind of pay-as-you-go approach for the EU services that we currently enjoy, so the black hole could easily be £32 billion or £34 billion.

That is an issue, whether we are looking at the Norwegian model or the Swiss model. The Swiss model is a self-standing free-trade agreement, and the Swiss pay quite a lot per capita into the EU budget.

So the Brexit black hole could be £25 billion or as much as £34 billion or £35 billion, depending on the payments.

As Anton Muscatelli said, a chunk of that was in train before June’s vote, but there has been a large effect on the back of the vote.

The previous forecast was made in the March budget, and there were only a few weeks between that and the vote on 23 June. I assume that George Osborne was not so completely clueless that the forecast changed within days or weeks of his budget. Unless you can give me evidence to the contrary, I must assume that the vast majority of the black hole is the Brexit black hole.

Much as I would like to attribute everything to Brexit, I think that we need to wait for a few more quarters to see the effect, but I agree that there is an effect.

It is clear that there are some issues. We potentially face cuts of 20 per cent in certain spending areas and we need to grow our way out of the situation. What extra powers could Scotland get in the short term, in addition to what is coming, to give us levers to drive growth in the Scottish economy?

Two weeks ago, one of the two Davids—David Heald and David Bell—gave members a smart answer when he said that he would not give a political answer to a political question. However, you ask a fair question. In the short term, there are only a few additional powers that the Scottish Parliament could get that would affect the situation.

As I said in my opening remarks, it is productivity growth that underlies the issue whereby making forecasts seems to be more like chasing rainbows. Almost every time the OBR makes a forecast, it says that in 18 months’ time everything will be back to normal, but the trouble is—

That is a UK-wide problem.

It is a UK-wide problem. The trouble is that a budget event happens every six months, but we are always 18 months away, and we have been like that for the past five years or so.

The underlying issue is productivity, and how do we affect that? I have to say that that is a bit of a holy grail. The Parliament already has huge powers that could affect productivity. It has powers in relation to skills and the education system, and it has powers to borrow for infrastructure investment, although the question is whether the borrowing powers are significant enough for such a purpose.

The borrowing powers are there to cover shocks in the fiscal forecast, not to drive significant investment.

There are small capital expenditure borrowing powers, are there not?

The short answer is that this is a long-term problem. Powers in the short term might have some effect, but we need to focus on the long-term issue.

Is there nothing specific that the witnesses think that it would be helpful to have in Scotland?

You will have seen the report from the Council of Economic Advisers, of which I am a member. I strongly endorse the part of the report that covers the issue.

Within the wider UK picture that Russell Gunson described, an issue that Scotland faces is the onshore impact of the decline of the oil and gas industry. We need to look at sectors that are highly innovative. From engineering to life sciences, there is huge potential.

Two thirds of research and development spend is happening in the higher education sector, which has strengths that absolutely are global, but we need to generate the demand pull. The report shows how complex the innovation ecosystem is. Some of that complexity is important, and it is not straightforward to manage. However, how we seed the space around the highly successful scientific base that we have in Scotland, to try to create more demand pull to attract more R and D units to Scotland in major industries, will be absolutely key.

The Scottish Further and Higher Education Funding Council has invested about £90 million—I will need to check that figure; it is certainly tens of millions of pounds—in the innovation centres, but that is still only a fraction of what Germany invests in its industrial strategy. If we look at the UK picture, we find that what Innovate UK—it is supposed to play a similar role—puts in is a fraction of what Germany spends. Germany has increased its research and development spend from the public sector considerably in the past few years, and so have China and France, even at times of fiscal stringency. The UK has not. We need to look at how to get the best possible investment in the interface space between industry and the science base, which is strong in the UK and in Scotland in particular.

Good morning. I have a follow-up to Ivan McKee’s questions to Professor Muscatelli about the £24 billion that he mentioned as the economic shock cost of Brexit. Is that figure predicated on a hard Brexit? Might it vary, depending on the type of Brexit that might occur?

As I understand it, I do not think that the IFS makes such a distinction in its report, partly because it is a forecast up to 2019-20. I was being slightly facetious earlier. The main impact of Brexit that we have seen so far is a slight slow-down in addition to what was happening on consumption and business investment growth. As I have said previously in the press, the real impact will happen after 2019, or whenever Brexit happens, because that is when our trade links will get disentangled, particularly if it is a hard Brexit. At the moment, the IFS is not making a judgment on that. The gap is largely because of the slower than projected GDP growth. That has happened partly in expectation of Brexit and partly because the global environment has deteriorated in the past few months.

Is it fair to say that the UK economy has performed relatively well since June compared with the economies of our European competitors? In the past few minutes, the unemployment figures have come out. Unemployment is now at its lowest rate since 2005 and economic growth in particular sectors seems to be accelerating, so should we be so downbeat about our prospects in the short term?

It is all relative. It was not just the chancellor who in March was forecasting better GDP growth; it was the OBR, too. There has definitely been a deterioration in prospects. You are right that we have not fallen off a cliff, but a number of commentators on Brexit, including me, said that it was not to be expected that we would fall off a cliff before Brexit happened. The effects of Brexit will come once the trade linkages are broken—if they are to be broken, for example through a harder Brexit.

It is good that we are still getting growth in the system, but I come back to a point that Russell Gunson made: the employment figures are good but, given that growth is slowing down, that does not paint a very good picture on productivity. That is a key issue. We are not generating employment through productivity growth.

I should add that what has happened is pretty much in line with the central estimates prior to the Brexit vote in June. It turns out that the experts that Michael Gove disparaged were not entirely wrong. The central estimate of what would happen with the devaluation of the pound has proved to be pretty much spot on. The IFS uses an average of a range of independent forecasts; it is not just a single forecast of its own.

We can look at the economic growth situation and the unemployment figures, but if we look at tax revenue or productivity growth, the picture is a lot more negative.

I want us to move on and paint some of the potential scenarios for that big picture and how they might translate to Scotland. Ash Denham wants to pick up some of those issues.

Mr Gunson, in your interesting submission, you present three different scenarios that you think could affect Scotland’s future public finances. They range from a 15.3 per cent cut in the public finances to a staggering 21.6 per cent cut over the period up until 2019-20. Could you lay out what those three scenarios are?

Yes. First, a large number of cuts are already on their way. We estimated that, as of March, prior to anything to do with Brexit votes and prior to anything to do with the economic shocks, there would be £2 billion of cuts per year in real terms up to 2019-20 compared to 2015-16. That is just in the spending of the Scottish Parliament; there is another £600 million of cuts for those who are in receipt of social security in Scotland aside from anything that comes through Holyrood.

In addition, we looked at how Philip Hammond, the chancellor, could fill the black hole next week in the autumn statement. One option would be for him to fill it entirely from additional borrowing, which would not be a stimulus in that it would just maintain public spending plans as they were in March. In essence, that borrowing would just allow us to stay where we were.

The alternative would be to cut day-to-day spending, which has been done in the past. We looked at three scenarios. In the extreme scenario, the chancellor could use public spending to find the full £25 billion to achieve the surplus that we heard so much about from the previous chancellor. That would lead to £1.3 billion of cuts in Scotland in addition to what is already planned for non-protected departments. If he took quite a balanced approach, but one that would still lead to additional cuts to day-to-day revenue spending, he could fill about a quarter of the £25 billion black hole from day-to-day spending, which would lead to cuts of about £340 million a year in Scotland. In the scheme of a £30 billion budget, that would be a 1 per cent cut, which some might say we could deal with. However, in the context of significant additional cuts having been made already and the Scottish Government having very little to spend, £340 million is a huge amount of money.

Which of those options do you think is the most likely to be chosen?

I fall back on the keyword for today: uncertainty. Two weeks ago, one of the Davids said that he had never felt so unclear about the UK Government’s approach, and I share that view. We do not know and we are receiving mixed messages. We know that a couple of the rules have been thrown away, but we do not know whether we are going to see significant fiscal stimulus or, indeed, any kind of stimulus. We do not know whether the chancellor is going to use the Government’s books to find new forms of innovative funds or whether we are not going to see anything.

Like you, no doubt, I have heard that there might be a delay in achieving the budget surplus. That would take us towards scenario 1, at least for this horizon. The other possibility is that the Government might move towards a golden rule-type arrangement whereby it does not balance the books in total but shifts between current and capital spend. If that is the case, that could help us to offset some of the effects, although it would still mean having to find savings from within revenue budgets. Those are the two scenarios that have been painted by economic commentators as the most likely. The Government might not try to hit the target that was set originally but delay it by a year, and there may a golden rule on top of that to avoid some of the more dramatic additional cuts of scenarios 2 and 3 in Russell Gunson’s paper.

Whatever scenario we have in the environment that is coming, it will impact on consumer spending, wages and those on lower incomes. A number of members want to ask questions about that area.

You have mentioned a few times the issue of consumer spending and the effect of public sector wage constraints. We know that people on the lowest incomes spend more of their disposable income than those who are on higher incomes. Can you expand on the impact that public sector wage constraints would have on consumer spending? What sectors of the economy may be affected? You mentioned that Scotland is more reliant than the rest of the UK on public sector employment. How much more reliant on it are we?

I have not done any calculations of the impact that that could have on Scotland’s growth, but we are quite a bit more dependent on public sector employment. People on lower incomes tend to spend more of their disposable income, so some impact on them would be expected. It would not help our aim of reducing inequalities because we expect that impact over the next two to three years, which is not at all helpful. I have not quantified what the impact would be for GDP growth or tax revenue; it would have less impact on tax revenue, as Russell Gunson has emphasised in his paper. For obvious reasons, that reduction in consumption would probably feed through to the tax base only after a lag.

10:00  

With regard to the inflation effect on poorer households in Scotland, as well as public sector workers there are people who are on fixed incomes, in particular those on social security other than pensions. We should not forget that, although inflation reached around 5 per cent after the 2008 crash, benefits were then index linked so that those who were on fixed incomes and the lowest incomes were protected to some extent from that inflation shock. This time—as of April this year—there is a cash-terms freeze on working-age benefits, implemented by the UK Government, so you could consider public sector workers in terms of the social aspect. It would be a different question if you were considering the economic aspect; if the Government wanted to boost the economy, would it do that through public pay increases? I do not know. However, the social effect on people on benefits of a cash-terms freeze when inflation is at 4 per cent is very different from the effect of a freeze in the low-inflation environment that I believe the UK Government expected.

I want to ask about precisely that area. I understood from your paper that the full inflation shock will be passed on by the UK Government to the poorest people in society. A few weeks ago, I asked the two Professor Davids what the Scottish Government or the UK Government could do to protect those people and mitigate those effects.

David Bell replied that the UK Government could consider not passing on some of the benefit cuts that are planned, but I get no sense that that is a likely outcome of next week’s budget. Although it is saying that it will freeze benefits—and not go any further—it has already committed to a considerable cut in social security budgets. I ask for your thoughts, in particular on whether there is anything that we or the UK Government can do to mitigate the situation, which is pretty dire for the poorest, most vulnerable people in our society.

The place to start is that pensioners should be protected from inflation shocks through the famous—or infamous—triple lock. Pensions go up by whichever is the bigger of earnings growth and inflation; inflation will no doubt be bigger than earnings this time round.

Therefore, we are looking here at people other than pensioners. It is uncertain as to when the social security powers will come to the Scottish Parliament, but it will not be in time for next year’s inflation effect. If that effect is more prolonged, there may be things that the Scottish Parliament can do through those new powers, such as topping up. However, the cost of that would be very significant and would only add to the pressures in the budget that we have outlined elsewhere. It falls to the UK Government in the main. There may be some mitigation that the Scottish Parliament can do—as was done with the bedroom tax, for example—but that will be around the edges compared with what the UK Government could do in its overall social security policy.

If members are getting no sense from the UK Government, there are a good few people who are getting no sense from the UK Government in a variety of ways. On social security, we do not know; there is pressure within the UK Government to abandon some of the cuts that are already planned, whether that is the freeze or, more likely, some of the cuts to work allowance and universal credit.

In short, the cuts to benefits that have yet to happen are greater than the cuts that have happened already. If inflation is on top of that, we can see how those very households that are facing big cuts could be under huge pressure.

I totally endorse what Russell Gunson has said—it is a poor outlook for those on working-age benefits. The only thing that I would add to what Russell said is that some commentators are urging the Government to look at that triple lock, especially for wealthier pensioners. If we are really worried about the effects on inequality, the triple lock is also protecting pensioners who have very good occupational pensions, so something could be tried at that end to alleviate what is happening at the bottom end of the income distribution.

Russell Gunson’s submission highlighted the inflation shock, which he has also spoken about in some of his answers. He looked at the potential impact on the Scottish budget and highlighted two areas where there might be exposure—the national health service and police budgets. Can he expand on that a wee bit?

There are only a few spending commitments—as opposed to policy commitments—within the Scottish Parliament’s spending budgets. Those are, in essence, the protected departments. There is NHS spending, which is pledged to go up by £500 million plus inflation by the end of this parliamentary session, and police budgets, which are protected in real terms throughout the session. There is also a floor on college spending in cash terms; that is not necessarily protection, but it is still more protection than other departments may face.

The interaction with inflation is a relatively complicated one. It is not quite as simple as saying that, if inflation goes up, then, to protect those budgets in real terms, we must match the inflation rate. We use something called the GDP deflator, which I will not go into, but it is slightly different and likely to be a little lower than inflation. However, it is likely to lead to pressures to increase those spending commitments at a higher rate than otherwise.

On the revenue side, I highlighted the potential effect of the inflation shock on the income that is raised through the income tax policy of freezing the higher-rate threshold with inflation. In short, that may mean that the gap between the higher-rate threshold in Scotland and the higher-rate threshold down south is narrower than we expected it to be when we announced that proposal, which may mean that we raise less money, because the differential is the key to how much money we raise from tax policy in Scotland.

It is likely that there will be pressures across all budgets, although they will not be quite as significant as the numbers that we are talking about in relation to the impact of inflation on health and police budgets. That is regardless of whether we are pushing the pressures to deal with higher energy costs and so on down to the departments. There will be pressures across the public sector.

Some of the protected sectors are more dependent on those non-pay costs. In the NHS there is the drug budget, for instance, and energy costs. Those are areas that will experience additional costs, even if it is possible to control public sector pay to avoid that being fully linked to inflation, and they will erode some of the additional spend in protected departments.

Would you expect areas such as the drug budget to rise by more or less than the projected inflation rate?

As we know, those costs tend to rise faster than inflation anyway because new drugs are constantly being introduced. The exchange-rate effect arises largely because those drugs are internationally traded commodities, which will be priced higher in sterling. That would tend to match the exchange-rate effect to the GDP deflator.

Given that the Scottish Government is obviously aware of all those factors, what steps could it take to minimise exposure to those inflation shocks as it is preparing the draft budget that will be published in a few weeks?

That is not easy and they are not easily avoidable because the effects are complex. The Government should probably, as Russell Gunson pointed out, look at the differential effect between different sectors that are more exposed to an inflationary shock. Beyond that, there is not much that you can avoid.

Another effect—it was mentioned earlier, but we have not discussed it yet—depends on what the UK Government does with tax thresholds and whether they are fully indexed. If they are, that would have an interactive effect with the modified block grant that Scotland receives, so it would need to be factored in. The Scottish Government has a difficult forecasting job on its hands in looking at that effect, too, because it will be key in determining certain things. For instance, the effect of freezing the thresholds on higher-rate tax might be eroded if the UK Government announces a change in policy in the autumn statement. Those things have to be properly calculated.

Good morning. I want to return to the question about the differential impact on different groups in society, but I will quickly pick up on one of the points that Russell Gunson discussed with James Kelly about the potential for increased inflation to erode the extra revenue that the Scottish Government hopes to generate by retaining the current thresholds for the higher rate. Presumably, if that were to happen, it would take only a very modest increase to that higher rate to restore the lost additional revenue. Do you know how much that would be?

I am afraid that we have not done the modelling to give you an exact figure for that. However, to give you an idea, if inflation were to reach the levels projected by the independent forecasters that the IFS brought together, it would be likely to bring the higher-rate threshold in Scotland up to something like £47,000 a year by the end of this parliamentary session, as opposed to £46,000, which is what it was projected to be. A difference of £1,000 does not sound like a huge amount, but, back in March, that would have meant a difference of about £150 million a year in revenue. There is not an even distribution at that level of income—you could not simply say, “Reduce it by £1,000 and that will get the money back”. That is the rough ballpark figure for what you are talking about.

It sounds as though only a modest increase to the higher rate would be needed to restore the lost revenue if the Government were to decide that its policy objective was not to freeze the rate for high-income people, but to generate the extra revenue that it had said that it would have.

We are actually talking about a decrease in the threshold from £47,000 to another figure.

Sure, but the Scottish Government is free to set the rate now.

Yes, but the 40 per cent rate—40p in the pound—is not what we are talking about; we are talking about the threshold. Perhaps one would have to be a higher-rate taxpayer to say whether that is a modest amount.

However, you are right, in that the core of your question is whether the Scottish Government should protect, in real terms, the higher-rate threshold or protect the revenues that it was seeking. That is a perfectly good question to ask.

I want to return to the earlier set of questions about people who are at the sharp end of the impacts. They are not higher-rate taxpayers and they are not people on high incomes who can well protect themselves from the effects of increased inflation or from a squeeze on public services. The people who will be most at risk from reduced public sector pay, from the freeze on social security payments or from the impact of inflation and cuts to public services are likely to be the same groups of people who are most acutely affected by all those factors. Have you done any work on understanding the way in which particular groups—women, young people, or disabled people—will be affected, as opposed to the cumulative effect across society as a whole?

I have not done any modelling of that type, but an extrapolation could easily be done. The IFS usually does a very good impact analysis of the income distribution by decile that could easily be looked at for Scotland. I agree that that is where the negative impact is most likely to be felt.

Likewise, we have not done any work on that, but there are a number of studies that show the intersectionality between disability, gender and poverty. From that, you can extrapolate that, if those in poverty or on low incomes are being hit hardest, it is likely to hit hard on those other groups, too.

10:15  

One thing that might be called for in response to that is investment in social infrastructure. Traditionally, if there is a bit of extra cash floating around in the short term—people have suggested that there might be a little bit of short-term stimulus on the capital side—it is hard building infrastructure that gets priority, such as shovel-ready projects and the like. That has a lower economic benefit, particularly for women, as the area that gets the employment benefits is more male dominated.

If we have any loosening in the short term, a case can be made that investment in social infrastructure will have the maximum social and economic benefit. In areas such as childcare, traditional measurements of productivity do not really apply because, if we reduce the number of people working in the area and try to provide the same level of service, we get a rubbish service as a result. The benefit is measured in a less bean-counting kind of way. Will you comment on the case for investment in social infrastructure if, in a week’s time, we hear that there is some short-term loosening?

It is about striking a balance. In the report that we presented as the Council of Economic Advisers to the Scottish Government, we urged it to continue its work on an inclusive growth diagnostic—inclusive growth is at the heart of the Government’s economic strategy—and to look at those areas in which we can have positive impacts on both growth and the distribution of income. You mentioned childcare, which is an interesting example. In that area, we can have a positive effect on outcomes for those groups, not all of which can be measured in terms of productivity and GDP, as you said, and also an impact on growth, because we will potentially improve employment prospects at that end of the income distribution.

However, returning to where we started in our conversation, I balance that by adding that we also need to consider what investments are going to boost productivity and the tax base of the whole economy in the longer term because, ultimately, it is about not just the next two or three years but what happens after that in terms of our growth and tax performance relative to the rest of the UK. I absolutely take your point, but it is about striking a balance.

I agree. We are facing two sides of the same challenge over the long term. One is to do with tax revenues, productivity growth and economic growth and the other is how we afford our public services and, potentially, get more efficiencies out of them. Those things are unified by potential investments that we can make now for the long term that will achieve one, the other or both.

It is about not just employing people to build new childcare centres or new roads—although, as members of the commission on widening access, we would agree that it is important to try to affect the gender balance in parts of those sectors—but the effects on the economy beyond that. Although the people who are employed through the investment might not be balanced, the effects on the economy may well be more balanced in terms of gender or any of the other aspects that you mention.

Thank you.

That is an interesting area. However, from what I have seen and what various commentators have said, if that room develops in the budget, it is likely to be strictly in the area of capital spend. It is less likely to be in revenue spend, which is what some of the areas that Patrick Harvie mentioned are driven from. Are there areas of capital spend rather than revenue spend, which is where the wages would come from, that we can use to improve that social capital?

First, the capital budget, at roughly 10 per cent, is much smaller than the revenue budget, at 90 per cent. Secondly, any stimulus is unlikely to save us from the numbers that we talked about earlier. Any short-term boost may well be much smaller than the cuts that we already face, never mind any others that come.

Thirdly, a lot of the stimulus or investment that we have seen on the capital side in recent years has been not necessarily through cash capital but more through using the Government’s books and the power of Government guarantees and so on. There have been innovative financing investments, and we have seen a lot of that in housing in particular. We get that money to spend, but how we can spend it and what on is quite restricted.

Having said all that, we can make capital investments in areas such as health and childcare that will get our public services and the social side of our country ready for what we need to face over the next 10 to 15 years.

I guess the downside to that is what you said about the productivity and economic driver issues, which might not help as much with the tax take.

They might not be dislocated. Inclusive growth is absolutely the right priority. Investment in childcare is a perfect example of where we can see huge economic benefits while also tackling social inequalities.

That would begin to address some of the longer-term issues that you described in your written submission, particularly that of the demographics out to 2060.

I have a brief follow-up question that is topical, given that we will debate fuel poverty in the chamber this afternoon. If some extra capital money is available in the autumn statement, would it be possible to use some of it for energy efficiency improvements in public or private housing? If so, what would be the economic benefit of going down that route?

Again, as Russell Gunson said, if the money is aimed at the bottom end in terms of social housing to help alleviate fuel poverty, it could have quite a good impact on consumer spending, as long as it was translated into effective consumer spend, and it could alleviate poverty at the same time. It could also have a positive impact on labour supply, because, as Russell Gunson emphasised, the same people tend to be in fuel poverty and in the poverty trap and they probably do not add as much as they could to the economy through the labour supply. I would therefore group money for energy efficiency improvements in social spend if it started at the lower end of the income distribution.

My question is on a slightly different point. Both the witnesses’ written submissions mention that the performance of the Scottish economy going forward relative to that of the UK will have an impact on Scotland’s budget, and recent reports have suggested that there is a divergence in that regard that is expected to continue. A PricewaterhouseCoopers report that came out yesterday highlighted that point. Can you give us a sense of the impact going forward on Scotland’s budget if that divergence continues, given that 50 per cent of the budget will be determined by that relative performance?

Economic growth is obviously a huge determinant, but the key factor here is actually tax revenue growth per head. Across the UK, we have had economic growth that has not been particularly tax rich. Equally, although this is very unlikely, we could have slower economic growth but much quicker pay growth and tax growth. It is important to be clear that, in terms of the Scottish Parliament’s budget and direct effects on it, we are focused on tax revenue growth per head in Scotland relative to that in the rest of the UK.

Recently we have seen slower economic growth in Scotland compared with that in the rest of the UK. A big part of that has been the oil and gas sector in the north-east, which has faced hard times because of the fall in the oil price over the past couple of years. The projections are for the oil price to go up a little from where it is now, and the dollar to pound conversion might benefit at the margins. However, it does not look as though we will reach the oil price levels that we saw two years ago—at least, not any time soon. We might therefore see that drag on economic growth continue for a bit longer. On the other hand, as I mentioned earlier, whisky exports and other export parts of the economy that do not have huge external supply chains to Scotland or to the UK might benefit hugely from the pound’s devaluation.

Again, we have uncertainty, but the signs have been that Scotland’s economy has been growing more slowly recently than the economy of the rest of the UK, and there are signs that suggest that that will continue to be the case in the future. Equally, however, there are positive signs for some sectors, particularly given the devaluation of the pound.

It is very difficult. Trying to forecast GDP more than two or three years out is a graveyard for economists.

David Bell and some of his colleagues at the University of Stirling did a good exercise in which they asked the counterfactual question about how the Scottish budget would have evolved if the current arrangements had been in place when devolution started rather than how it has evolved purely as a Barnett grant. We can see that there are periods when the Scottish economy has grown much more than that of the rest of the UK so, if that can be reproduced, it would clearly be of benefit.

I agree with Russell Gunson on the short term. The challenges on oil and gas in particular will take some time to overcome. Then, after 2019-20, the situation depends on the differential effects of Brexit. If it is a hard Brexit, it has some very serious implications, as has been pointed out, particularly because there are a number of sectors that might be affected although they might not export directly to the rest of the UK. For instance, we have a large volume of exports in legal, administrative and financial services to the UK but those are part of a value chain that re-exports to the EU, so Scotland could easily be hard hit if a hard Brexit causes a dislocation of the financial services industry and the value chain around it. Similarly, food and drink could be hit if there were major tariffs on products such as Scotch whisky.

Those are the things that we need to consider further on. In the next two or three years, Scotland will probably do well to keep pace with the UK. It depends how much of a revival there is in onshore impacts from oil and gas and the other industries that are sensitive to the depreciation of the pound and might benefit from it.

Willie Coffey has issues that he wants to pick up.

We are on the issue anyway—my question is about the pound. Will the witnesses give us a flavour of the other likely impacts of the collapse in the value of the pound? I know of an electronics company in Ayrshire that reports that its costs have gone up by about 13 per cent since that collapse. If that kind of effect is replicated across the economy, it is bound to have an impact on spending decisions that the Government takes. I have just noticed some figures that show that the value of imports to the UK this September topped £50 billion, which is a significant jump, even compared with previous months. What impacts could the value of the pound remaining roughly as it is have?

What you have highlighted shows that the depreciation of the pound is really not good for certain sectors of the economy—particularly if they are part of an integrated value chain and import lots of their raw materials. There is a serious effect.

There is another issue about such a sharp depreciation. As economists always know, there is a lag, even for sectors in which there is a positive effect: it is what economists call the J-curve effect. First of all, the balance of payments deteriorates because, as Willie Coffey said, the cost of imports goes up before the volume of exports has reacted. That is what we will observe for the next little while for the UK as a whole. Our balance of payments will deteriorate as a result, unless our exporting industries are particularly sensitive to the improvement in competitiveness.

To go to the heart of the question, I worry that other factors will stop us taking advantage of that competitiveness effect, even for industries that could gain from it. That is where Brexit comes in. An industry that considers that location in the UK might be a great idea now that the pound has depreciated might nevertheless, despite the competitive advantage, decide not to come here because it will not know whether we will be part of the single market. Such effects could be really dangerous because they would mean that we would rely on industry that is already in the UK to respond to the effect.

I have mentioned higher education, which is another classic example. We could take advantage of the situation, but not if we are going to reduce the number of tier 4 visas, because we could therefore not respond to the increased competitor advantage. I worry that there will be the initial deterioration of the balance of payments and, because of the Brexit risk, that there will be neither domestic nor foreign direct investment in the UK.

10:30  

There is a potential benefit to exporters, but only if they do not import a huge amount of their supply chain from outside the UK, and if we are a much more open economy than we were prior to being in the EU.

As Anton Muscatelli said, business investment is what a company—domestic or otherwise—that wants to take advantage of the exchange rate being where it is, and potentially being there for some time, would do. Unfortunately, although consumer spending seems to be pushing the economy forward and continuing the growth that we have seen since the Brexit vote in June, it is likely—although we have not yet seen the figures—that business investment has shrunk because of the uncertainty that Anton mentioned.

In other circumstances, business investment may be coming to help us through an inflation shock that will affect consumer spending next year, I would guess. That could help us to take advantage of the devaluation of the pound, with the uncertainty around Brexit—whenever that will happen. However, that is less likely.

Is there any prospect of the pound getting back to its pre-Brexit value of about €1.31, which it was at around May? What circumstances would allow it to return to that kind of level, soon or otherwise?

The one set of circumstances that would allow that is the one that would restore confidence that the UK’s competitive position will improve—that is, the UK Government saying that there will be a soft Brexit and that we will remain part of the single market. If that were to happen, you would see the pound rise. You will have seen that when any bit of news suggests a softer Brexit—for example, the High Court ruling—the pound shoots up for several hours before coming down again. An announcement that we will still be part of the single market would take the pound pretty much back to where it was.

That is the positive aspect of restrengthening the pound, if you like. There is a more negative possibility in respect of other currencies weakening; we are seeing the US election potentially having that effect. The pound may strengthen relative to other currencies that weaken. There are things that we cannot really predict: a lot of people did not predict Trump winning in America, for example. Big events such as that, whether in Europe or in the US, could make the UK’s currency stronger relative to others, but for more negative reasons.

Adam Tomkins has questions about employment.

Before I say anything, I remind members of the interests that I have declared in the register of members’ interests—in particular, the fact that I hold a chair in the university of which Professor Muscatelli is the principal.

The panel has painted a gloomy picture: borrowing may go up, uncertainty is increasing, revenues are being hit, there are spending cuts, inflation is rising and growth is flagging. What cheers you up? [Laughter.] Is the answer to that question—at least in part—that we have record employment in the UK? It is record inclusive employment: there are more jobs in the British economy, more women in work and more disabled people in work than ever before.

As far as Scotland is concerned, there is a persistent problem in that the employment growth rate here lags behind the rate of the UK as a whole, which I presume cannot be blamed on Brexit. If that is right, why is the employment growth rate persistently lower in Scotland than it is in the rest of the UK, and what should we as a Parliament do about it?

We did some work in June, part of which looked at that. It looked at what has happened across the UK since the 2008 financial crash, and compared Scotland with the rest of the UK. Scotland went into the crash in 2008 with an employment rate advantage—which it had had historically—that we lost in the crash. Employment in both Scotland and the rest of the UK dipped, but the rest of the UK recovered more quickly than Scotland did. Our employment rates are therefore now about the same, whereas we used to have an advantage.

What keeps me positive? What are we hopeful about other than our personal lives and all the good things that keep us going? [Laughter.]

There is nothing to smile at there.

We could keep to our hobbies. If you are pessimistic, you can be absolutely sure that you are going to fail.

Scotland could do things in terms of productivity growth that would tie right in to employment growth. On demographic change, it is a huge success that we have an ageing population: it is not a negative. People are living longer than ever before, and that is down to us as a society, over many years and many colours of Government, getting it right. Huge opportunities come from that. If Scotland could reform public services, manage the ageing population and grow our way, productivitywise, out of what we face, we would be among the first in Europe and the western world to do so. We could crack that not just for Scotland, but for other areas, too. That view is way more optimistic than the view in the briefing that came in.

Let us return to more pessimistic matters. Why has the employment rate not been as strong in Scotland? There are so many factors. The problems in the oil and gas sector have coincided with the change. In the financial services sector, we have seen the withdrawal of high-skilled jobs from Scotland to elsewhere in the UK and the reduction in employment in financial services in Scotland over the period. Of course, the sector is also now smaller.

There are global factors, UK factors and factors that are in the Scottish Parliament’s control. We have to be cognisant of them all, but focus on those that are in Scotland’s control. I say—again—that productivity growth and public service reform have to be the focus for Scotland.

I do not think that I can add anything to the employment analysis that Russell Gunson has given you, which was very accurate. The answer is about investment and the combination of skills, and about employability, particularly at the lower end of the income distribution, as we have mentioned.

What keeps me positive? I hope that economic rationality begins to take hold at some point in the whole Brexit debate. Over the past two to three weeks, I have written a couple of times suggesting that even the people in the debate who suggest that a harder Brexit is what the UK wants should think of soft Brexit as a staging post.

At the moment, we have so much uncertainty and concern. That has been reflected in what has happened to the exchange rate, because there is no plan and people do not know what will happen. To be frank, if somebody had asked me to devise a rational plan to disentangle us from the EU and asked how long that would take, my answer would not have been two years. It would take seven to nine years to do that in a rational way that considered all the aspects. Something that gives assurance to the economy that there is the prospect of a rational way out of the impasse will be really important. What keeps me positive is that economic rationality tends to come to the fore—not always, but usually. If it does not, people quickly learn the consequences of their actions.

There are not many other things that I can look to, I am afraid. I am probably slightly less optimistic than Russell Gunson. I can give you one other positive effect, although it has a negative tinge to it as well. If there were a rebalancing of fiscal and monetary policy and a rise in long-term gilt yields, pension deficits would begin to come down in the UK. However, we need to recognise that that would have an impact on borrowing rates, which would have an impact on families who are dependent on borrowing for housing. We have not talked much about rebalancing fiscal and monetary policy, although we are beginning to see the impact not only of the Trump election, but of Brexit on gilt yields in the UK.

That would probably open up a whole new session of discussion. In the meantime, I am very grateful to Professor Muscatelli, and to Russell Gunson from the IPPR, for coming along today and giving us their evidence. I hope that members have had the chance ask all the questions that they wanted to ask.

10:39 Meeting suspended.  

10:45 On resuming—