Finance and Constitution Committee

Meeting date: Wednesday, September 27, 2017

Official Report 521KB pdf

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United Kingdom Public Finances (Outlook)

Good morning and welcome to the 22nd meeting in 2017 of the Finance and Constitution Committee. It is the usual story as far as mobile phones are concerned, folks.

The first item on our agenda is evidence from Paul Johnson, director of the Institute for Fiscal Studies, on the outlook for the United Kingdom public finances. Welcome to the meeting. I am very grateful to you for being here, and thank you for providing your slides in advance.

Are there any particular opening lines that you would like to give us?

I will briefly remind the committee of the background on public finances. We have now had seven years of pretty tight spending control following the financial crisis and the very big deficit that we had back in 2010. The deficit is now down to less than 3 per cent of national income, which is a big change from seven years ago, but that has come at a cost of some historically unprecedented levels of spending cuts across much of the public services.

Looking forward, on current policy, the expectation is that the deficit will get down to 1 per cent of national income by the end of the decade, against the chancellor’s self-imposed target of 2 per cent. It looks like he has a bit of wriggle room. However, we also have an unprecedented level of uncertainty about what might happen to the economy over the next two or three years given how little we know about the shape of any Brexit deal and how that might play out.

The chancellor has quite a lot of difficult decisions to make at the moment: how much use, if any, to make of his fiscal room for manoeuvre; how much to worry about the debt, which is now well over 80 per cent of national income; and how seriously to take his target to get to budget balance in the mid-2020s. All that is against the background of very poor productivity performance and very low increases in living standards—indeed, following recent inflation, we probably have falling living standards again over this year. So there are lots of issues on the spending and public finance side.

Then there are some issues on the tax side. In particular, I am sure that the chancellor would like to bring back his proposals to bring taxation of self-employment and employment more into line, which did not get through in the previous budget. However, my guess is that the parliamentary arithmetic will make that even more difficult than it was earlier in the year.

Thank you for that. Murdo Fraser has some questions on borrowing, the Office for Budget Responsibility forecasts and fiscal policy.

Good morning, Mr Johnson. I want to pick up the point that you made about the chancellor’s wriggle room in terms of any policy choices that he might make. The OBR’s latest forecast, which is from March, suggested that the chancellor was on course to meet his borrowing target with some room to spare. Do you think that the economic and fiscal outlook has changed in any way since March? If so, what does that mean for the chancellor’s choices, coming up to the budget?

My guess is that the economic outlook will not have changed very much in the OBR’s view. The economic news this year has not been terribly different from what might have been expected.

As I said in my opening statement, the overwhelming factor is the uncertainty about where the economy might go over the next three or four years. It looks like there is quite a lot of room for manoeuvre up to 2020. However, even given that £20 billion or so of apparent room for manoeuvre, as the OBR also said, there is something like at least a one-in-three chance—I cannot remember the number—that, under current policy, we would still breach the 2 per cent target because the economy may well end up doing less well or tax receipts may well end up coming in less strongly than expected. That probability is just based on historical mistakes in forecasting.

As I said, the chances are that the uncertainty in either direction is greater than normal this time round, so there may actually be a more than one-in-three chance that the target will be breached because of the higher level of uncertainty.

That is the balancing act that the chancellor has to perform. He has to decide how much weight to give to strongly bad outcomes in three or four years and how much to give to the central forecast. If he gives a lot of weight to the central forecast, he may feel that he has more room for manoeuvre than if he puts a lot of weight on the uncertainty.

In the light of what you have said, how likely do you think it is that the chancellor will, in the budget, announce some loosening of fiscal policy, or will he just want to keep the ship sailing in the same direction?

I would not want to put a probability on it. As I said, the chancellor is weighing up two things. On one side, there is uncertainty and the need, potentially, to keep some fiscal firepower back for what may turn out to be bad news on whatever the Brexit deal turns out to be. On the other side, he has apparent room for manoeuvre, and there are clear pressures on public services. A couple of years ago, one could reasonably have said that all the public spending cuts had not really started to push through into very obvious problems with public services, but it is much harder to make that case now.

You may remember that, last autumn, the chancellor found more money for prisons because it was clear that there were big issues in prisons at the time. Back in March, he found more money, partly through an increase in council tax, for social care in England. This time round, it is pretty clear that social care is still an issue; waiting lists in the national health service are growing and so on; and local government is beginning to show significant signs of strain. In addition, the big cuts in welfare benefits are really just starting. There is quite a lot of pressure on the chancellor, therefore, to find a bit of money for those public services. He will have to find a balance between leaving himself some room for manoeuvre later on and responding to some of those pressures, including public pay pressures. My guess is that, if his position is going to move anywhere, it will move towards a loosening, but I do not know how big a loosening that will be.

I want to talk about the potential room for manoeuvre. In your paper, you speculate that there could be a further £3.5 billion budget cut by the UK Government. Does the room for manoeuvre assume that that is going to take place or that it might not happen?

There is a set of spending plans laid out in the budget that includes some significant increases in investment spending and, relative to national income at least, some pretty significant reductions in day-to-day spending. The plan is to get from a 2 per cent—well, nearly 3 per cent—deficit to a 1 per cent deficit, which is a tightening; there will be a fall in the size of state intervention over that time.

That goes back to the choice that we were just describing. The chancellor could decide that he is happy with the deficit roughly where it is, at 2.5 to 3 per cent of national income. That gives him a lot of room for manoeuvre, and the debt could probably bear a few years of 2.5 to 3 per cent deficits. That path would be very different from the one that he is currently planning, which is to get the deficit down to 1 per cent. That is the big choice that he is going to have to make.

What proportion of that £3.5 billion cut might impact on the Scottish budget?

I am afraid that I do not know exactly what the Barnett consequentials of that would be.

The OBR said that, even though the economy has been poor for 10 years, there is no capacity in it to expand. It also said that the economy therefore cannot rely on above-normal levels of growth to help to bring the deficit down further. Does that edge us more towards more cuts being the only solution to bring us back into line?

In a sense, the OBR has drawn a desperately depressing conclusion. We have had seven years of very poor growth, and in terms of national income per head we are barely above where we were back in 2008—we have had a decade with essentially no growth in national income per head. The UK economy is something like £300 billion smaller than we might reasonably have expected back in 2008 on the basis of historical trends, and yet the OBR judges that there is no room for growth because we are basically at the new trend.

If the OBR is right, that means that there is little scope for a fiscal expansion, in a Keynesian sense, to drive additional growth, for example, because we are at capacity. It also means that, in the long run, additional spending will have to be paid for through additional tax, because there is no scope for above-trend growth. That is very different from the situation that we might have been in a few years ago, when we had a big deficit, poor growth and at least the general acceptance that the economy was not at trend. If it is right that we are at trend, that creates a much bigger constraint on Government.

You caveated all that by saying, “If the OBR is right.” What is your professional judgment as to whether the OBR is correct in its assumptions?

It is an incredibly difficult judgment. The Bank of England is in a reasonably similar place, and there is a wide range of views among the macro forecasting community—of which, happily, I am not a part.

Employment levels are one of the key inputs in the OBR calculations, and it is hard to believe that there is a lot of scope for additional employment as we are at record levels. The flip side is that we have poor levels of productivity and earnings growth; part of the judgment is that that has all been lost—there is no additional scope there. Investment has not been strong in recent years, which has reduced capacity. The OBR numbers are also partly down to immigration: if that falls off a bit, that also reduces scope for economic growth.

I do not know whether the OBR is dead right. There may be a little bit of spare capacity, but I do not think that many people believe that there is a lot of the spare capacity that would allow for big differences in terms of judgments.

I have a couple of supplementary questions. You mentioned migration, and discussions are going on around Brexit and European Union nationals. Would you expand on the room for growth in our economy, given the challenge that we will have with regard to the number of people who will be in our pool of EU nationals?

There are a number of parts to that.

First, there is a lot of uncertainty about what Brexit might do to levels of immigration. The OBR’s judgment is that net migration will fall significantly, which will hit the public finances reasonably hard. Its view is that tax revenues will be down by about £6 billion, relative to what they would have been. If the Government gets to its stated target of reducing net migration to below 100,000, there would be an additional £6 billion hit to the public finances through lower tax revenues. The unknown is the scale of potential return movement by European workers. The UK economy looks very different from what it would have looked like had we not had the net influx of about two million European workers over the past decade and a half.

It is important to distinguish two things. One is that net immigration may go down, which would have a relatively gradual effect on the economy. Another possibility is that large numbers of people may decide to leave, so we may get net emigration—at least of some classes of workers and nationalities. That would make certain parts of the economy very difficult to maintain and, in the longer run, may change the structure of the economy.

09:45  

That was brought alive to me this week when I spoke to people at a construction company in my constituency who are already beginning to see some haemorrhaging of people from the United Kingdom, so they are—rightly—taking an aggressive approach to the recruitment of apprentices to insure themselves for the future. If that construction company is going out there and aggressively recruiting and other people in the construction industry react in the same way, that might leave parts of the public sector vulnerable. It is not in the nature of the beast of the public sector to respond in the same way, so where is it going to get its people from in the future?

When I heard that what that company was saying, I became worried about how the public and private sectors respond to the issue. I am not criticising the people at that company, because they are doing the right thing for themselves, but do you think that there is a potential problem for the balance of the economy and there being enough people to work in these areas in future?

There are different parts of the economy—some bits of agriculture, for example—where, historically, the UK has been dependent on migrant labour to do a large fraction of the work. In a world in which that labour is simply not available, my guess is that some of that business will just stop. If, for example, we cannot get people to pick our strawberries at an appropriate wage, we will have made a decision that it is better that our economy does not support that kind of work.

What you said about the construction industry taking on apprentices is interesting. It is very hard to find any economic research that suggests that net migration has had the impact of reducing opportunities for training and higher wages among the native born, but the way in which a lot of that research is done makes it quite difficult to be confident about that when there has been such a big change over a prolonged period. It is at least possible that one effect will be to increase the training opportunities that are available to British-born workers. The economic research does not show that, but it seems to me that it is possible. On the other hand, it is very clear that the total number of jobs that are available will not increase.

There are hot spots in the public sector. Nursing in London and the south-east, for example, has a very high proportion of European and other foreign-born staff, and it is clear that there has already been an effect there. It takes quite a long time to train some groups of workers. That said, despite the end of the nursing bursary, there is still an overdemand for training places at university, but it will cost us more to train more nurses.

I want to explore immigration numbers. It was interesting to hear what you said about the £6 billion that is already baked in. What assumption does that place on where net immigration would be? Do you know that number?

I do not know the number. That is based on the difference between the numbers coming in over the next three or four years and what the OBR would have expected had we not had the Brexit vote. Off the top of my head, I do not know the precise numbers.

The number has been around 300,000 up to now.

Yes. That is the gross figure.

There will be another £6 billion hit to the tax take if it drops below 100,000.

Yes.

Right. So the OBR assumes that that number will be somewhere between 100,000 and 300,000 in future.

Anecdotally, having talked to eastern Europeans here and in eastern Europe, I think that there is quite large potential for net emigration, accelerated by the exchange rate situation that makes it far less attractive for people to work here and send money home as they can earn more by working in another EU country. That has not been factored in at all, and there has been some recent data suggesting that we are starting to move to a net emigration situation with some eastern European countries. Do you have any assessment of where we would be if there was a further hit to immigration and we started to see significant net emigration back to eastern Europe?

You are exactly right about what might happen and what is driving it. The thing that will make the 100,000-or-less target attainable is us just making this a very unattractive place for people to come to live and work in, irrespective of any policies that we pursue. There may be a tipping point at which things start to change very quickly. We are not there yet—we still have significant net immigration—but if we are losing £6 billion now and we will lose another £6 billion if we get below 100,000, we would clearly lose at least that much again in tax receipts if we got to a point of net emigration.

It is also important to think about the composition of the population. Net figures can be misleading. If, given uncertainty about their rights, a lot of British pensioners who currently live in the rest of Europe came back, the net number might not go down so much but we would swap working-age people who pay tax for pension-age people who are in receipt of benefits.

That is clear. You talk about us losing £6 billion, another £6 billion and perhaps another £6 billion. That would have a material impact on the deficit and the debt as a percentage of gross domestic product. I think that £15 billion is close to 1 per cent of GDP.

Yes, 1 per cent is about £18 billion, so that would have a significant impact. Previous OBR reports show that the public finances have been helped by immigration coming in above expectations. That has dug the chancellor out of a hole once or twice in the past six or seven years. So yes, it does add up.

We have been looking at the gross impact on tax receipts as a whole, but it is worth looking at the other side of the issue. There are clearly areas where the impact on public services—local health or education services—goes in the other direction. That impact tends to be very concentrated, whereas the tax receipts are beneficial across the piece. Arguably, the way that local government has been funded in the past seven or eight years, particularly in England, has not compensated adequately for increased population.

The scenario is clearly different in Scotland, where net immigration has traditionally been lower, so the impact might be much bigger. Have you assessed the impact that reduced immigration across the UK would have on the UK’s growth rate?

As a first approximation, the evidence suggests that reduced immigration would have no effect on the growth rate per capita—the evidence does not particularly show that having more immigration has a big impact on the growth rate per person—but the effect on the overall growth rate would be essentially proportional to the reduction in the population. If the population were 1 per cent smaller, the economy would be 1 per cent smaller.

Adam Tomkins wants some clarity on the £6 billion figure.

I know that it is not your figure—it is the OBR’s figure—but is the £6 billion a loss to the economy of £6 billion every year?

It is a loss to tax revenues of £6 billion a year by, I think, 2020 or 2021. It is the cumulative effect of having fewer people. The calculation is that, if fewer people come in this year, next year, the year after and the year after that, the revenue that comes to the Exchequer will be £6 billion less in 2021 than it would have been had net immigration continued at its previous level.

I think that you just said in response to Mr McKee that the figure reflects only lost revenue and does not take into account reduced expenditure on public services in areas of high immigration.

That is correct.

Is there a figure that combines those two things, so that we have a complete picture rather than just one side of the coin?

There are two ways of answering that. One is that, as I said, public spending has tended not to reflect the increase in people, so there is not a direct one-to-one correlation. That has probably been one of the problems—the way in which local government has been financed, particularly in England, has not reflected increases in people.

That would leave spending per person higher than it otherwise would have been, but whether there would be much effect on total spending is more questionable. For example, benefits spending, which is directly linked to individuals, is very low for immigrants. Clearly, there is more spending on health and education. It is some fraction of the £6 billion—it is less than £6 billion. It is probably a couple of billion pounds, but that is a bit of a guess.

Forgive this brain for needing a wee bit more information on the £6 billion. I assume that, over the financial years until 2021, the figure will go from something like £4 billion to £5 billion to £6 billion—it will not be those exact numbers—and then, after 2021, it might go up or down from £6 billion.

The figure is always against a counterfactual, and I suppose that one issue is whether it is reasonable to think that there is a counterfactual in which net immigration remains at the high level that it has been at in the past. If the counterfactual is that we have net immigration of 300,000 a year ad infinitum, it might be reasonable to ask whether that is sensible and whether the figure would have to have tailed off in any case.

I know that there is a general challenge on the public purse because of inflation, but is there a specific challenge because of the sterling crash? Anecdotally, I am told that, when the national health service buys a magnetic resonance imaging scanner, it often does so in a different currency. Is what is happening with sterling having a specific impact on public spending?

I am afraid that I do not know the details of NHS spending in that sense. However, if you are buying big things from foreign providers—I think that the Ministry of Defence does quite a lot of that—the currency will have a big impact on the prices that you pay. I suspect that the biggest impact is on public sector workers. A 1 per cent cap might be manageable if inflation was at 1 or 2 per cent but, if inflation was at 3 or 4 per cent because of the devaluation, that would be harder to manage. We spend £180 billion a year on public sector pay, so an extra 1 or 2 per cent on that probably dwarfs any of the other impacts.

Given that we are on external factors and single market issues, we will come to Ash Denham next. Because Paul Johnson has introduced the public sector pay issue, we will come to Neil Bibby after that.

I saw your tweet on Twitter—I will read it out to you. You said that you were

“stunned both main parties support leaving the single market. This guarantees to make living standards worse”.

Will you expand on that?

I am sure that I did not tweet the word “stunned”.

You did.

Unless you have a parody account somewhere.

It is clear that leaving the single market will reduce living standards relative to a world in which we stay in the single market. In a sense, that is a simple proposition. The European Union is by far our biggest, closest and richest trading partner. We do about half our trade with it and, if we make that trade more expensive, that will on average make us worse off.

The single market is particularly important for the service industries, because it is through the single market that they have pretty free access to the rest of the EU. Very few free-trade agreements, if any, provide anything like the kind of integration that the single market gives for service industries. The customs union is more crucial for manufacturing, where border checks and non-tariff barriers create the biggest issue. Making that trade more difficult will make us worse off.

The depreciation in sterling was partly about an expectation that the situation would become more difficult and that UK goods and services abroad would become more expensive. My guess is that, if we end up with a bad trade deal, sterling will go down again, partly in compensation for that expectation. As we know, the first impact of that is an increase in prices, which makes us worse off.

What impact would leaving the single market and, possibly, the customs union, have on the UK’s public finances? What would be the knock-on effect on Scotland?

10:00  

The OBR has made some fairly modest assumptions about the impact of leaving the EU on the economy and, therefore, on the public finances. The suggestion is that it would make a difference of something like £20 billion to the public finances in the early 2020s.

Is that for the UK or for Scotland?

The UK.

I will take this in three chunks. The first issue is that, in the public finances, we spend about £15 billion a year on EU membership—that is the gross figure; it is about £8 billion net. The difference with regard to the £8 billion net that we spend has not been allocated in the public finance numbers, which means that, relative to the current baseline, there is an extra £8 billion to spend. However, the OBR numbers suggest an overall loss to the public finances because of lower growth. Relative to the status quo ante, there is something like minus £8 billion to spend—I am afraid that I do not remember the precise numbers.

The second issue is the so-called divorce settlement. I do not know what number that will involve, but it sounds as if it will be somewhere between £20 billion and £50 billion. That will be a big number, but one should think of it as a one-off number, which will increase the debt but not increase the deficit each year. In that sense, it is a much smaller number than £10 billion a year, which will accumulate to an awful lot over a long period.

The third issue concerns not just what the public finance impact will be in year 1 but what the impact on economic growth in the UK will be each year after that. Even if leaving the EU has an effect of only 0.1 per cent a year, that dwarfs all the other numbers because, within 20 years, that adds up to a large number. The work that has been done at the London School of Economics and the University of Warwick suggests that the UK economy would be about 5 to 10 per cent smaller after 20 or 30 years than it would have been if we had stayed in the single market. An economy that is 5 or 10 per cent smaller is much poorer in terms of its capacity to manage the public finances.

You have said that leaving the EU is guaranteed to make living standards worse. Can you put a percentage on that? You have said that the economy could be 5 to 10 per cent smaller. Could living standards therefore be 5 to 10 per cent worse?

If that was the effect on the economy, that would be the effect, on average, on living standards. I think that there is genuinely no uncertainty about the direction of the impact, but the scale of the impact is difficult to know.

The percentage of workers who are in the public sector is higher in Scotland than it is in the rest of the UK—it is about 21 per cent in Scotland and 17 per cent across the UK. If the UK Government were to relax the public sector pay cap, what would be the impact on departmental spend and on the Scottish budget? Would it be fair to say that lifting the pay cap across the UK would disproportionately benefit Scotland and the Scottish budget, because of the higher number of public sector workers in Scotland?

The big question is what the Chancellor of the Exchequer means by lifting the public sector pay cap. As we have seen in relation to the recent announcements on the police and prison officers, it could be said that we are going to pay them more but without giving the services more money. That would not flow across into the Scottish budget at all, because the same amount of money would be going in.

You could imagine the chancellor saying in the budget that he will no longer ask pay review bodies to keep within a 1 per cent cap and that he will take note of their recommendations. It is interesting to see the attitude of the NHS Pay Review Body this year to the 1 per cent pay cap. In the introduction to its report it says, starkly, that because it has to take account of how much pay should rise in the context of all the pressures on the NHS, it had to think hard about whether to recommend a zero increase, because it was a pretty fine judgment as to whether the £1.5 billion—or whatever it would cost—for the 1 per cent pay rise was the best way of spending the money. It would be quite possible for the chancellor to say that the Government will get rid of the pay cap but not give any more money and for the NHS Pay Review Body to come back with a suggestion of 1 per cent anyway. As I said, that would have no impact on the Scottish budget.

It is also possible for the chancellor to say that he will get rid of the 1 per cent pay cap and as a result give a certain amount of money to the key departments that are responsible for such services. In that case, the pay review bodies will need to make a judgment on how much of that should be spent on pay. If there were more money for services, that would have a knock-on effect on Scotland.

There are clear significant differences by region and by the type of public sector work but, if we put the whole lot together, it is not just the politics that is pushing for higher pay—public sector pay is now about back to where it was in 2008 relative to private sector pay. If the 1 per cent limit continues, pay in the public sector will fall quite rapidly relative to pay in the private sector and go to historically quite low levels. We will probably have to do something about public sector pay in the next couple of years.

The point about public sector pay now being where it was relative to private sector pay in 2008 is important. We tend to talk about such things separately. We talk about living standards and earnings having done really badly and then, completely separately, we talk about public sector pay having done really badly. However, public and private sector workers have gone in lock step. They have got there in a different way, but public sector workers have not done any worse than private sector workers over the period, on average.

You say that, in the short term, there might not be a disproportionate impact on the Scottish budget. However, in the longer term, because of the higher proportion of public sector workers in Scotland and the fact that raising revenues in Scotland is now vital to the Scottish budget and economic growth, do you accept that lifting the public sector pay cap would help the Scottish economy?

That depends on how the increase is funded. If more Barnett consequentials came to Scotland because more money was being spent in England, that would help the Scottish budget. The fact that the proportion is higher means that the knock-on effect would be higher than the Barnett consequential would necessarily fund but, as you said, if the public sector has a greater proportion of the Scottish workforce, it is a more important part of the Scottish economy.

Obviously, lifting the public sector pay cap would cost money. Your submission says:

“To give one example the government could choose not to implement the planned cut to the corporation tax rate from 19% to 17%. That would raise an additional £5 billion”.

Given that £5 billion is a huge amount of money and given the pressures to increase public sector pay, how likely is it that the corporation tax rate will be cut and the public sector pay cap will not be lifted?

I would not want to put probabilities on that. If I were the chancellor, with the current difficulties and with the knowledge that the parliamentary arithmetic makes most tax rises quite difficult, and if I was looking for additional money, not implementing something would look a lot easier than raising something. The problem is that the corporation tax cut is legislated for, so the Government would have to legislate not to bring it in. I do not know whether the chancellor will do it, but he is bound to be considering it.

As you said, part of the trade-off is that the extra £5 billion would help with public sector pay and other priorities. However, the chancellor might not reverse the corporation tax cut precisely because of Brexit issues. We know that the uncertainty around Brexit is reducing the long-term investment that some big companies would have made and, although small cuts in corporation tax do not have big impacts on such things, they might be seen as a signal of support. The choice is not straightforward but—I am sorry for repeating this—if I were the chancellor and I wanted an extra £5 billion of revenue, that option would be pretty close to the top of my list.

Before I bring in Patrick Harvie, I have to say that you have in the past made some very strong comments about pay levels in general. Last November, you said that one

“cannot stress how extraordinary and dreadful”

the situation is.

Moreover—I hope that I have got this right, and that people have given me the right briefing—I think that you said yesterday that we now have the lowest wage growth “since the 1750s”.

I was quoting Mark Carney.

It was Mark Carney who said it. What concerns me is the cumulative impact on people’s living standards of the stuff that you were talking about with Ash Denham with regard to the single market and that low wage growth. Would you like to say a bit more about that?

It has been an extraordinary decade in all sorts of ways. Average earnings today are still below what they were in 2008, which is astonishing. People dispute whether the last time we had a decade this bad was in the 1750s, the 1800s or the 1850s, but as far as earnings are concerned, it was certainly a very long time ago. I also point out that younger people have been hit worst: the earnings of people who are in their 20s now are still significantly below the earnings of people in their 20s in 2008, whereas the earnings of older workers have generally recovered. There was a period in 2014-15 when real earnings were beginning to rise, but the spike in inflation that we have had this year means that, over the year, real earnings have started to fall again. As we have discussed, that is directly related to the fall in sterling.

We hope that earnings will start to rise again, but given the discussion about the economic uncertainties around Brexit, I presume that they will rise less quickly than they would have done in a different world, in which we were not leaving the European Union. The OBR’s projection is that average earnings in 2020 will still be below where they were in 2008. In a sense, that does not really matter, because it is just a statistical artefact, but in the OBR’s judgment, that is something that tipped after the EU referendum. In March 2016—before the referendum—the OBR thought that, by 2020, earnings would go above their 2008 levels, but after the referendum, it thought that they would not.

Good morning. I want to explore some of the figures that you have given us on public sector pay. I am glad that in your comments in the last few moments you acknowledged the difference between people’s real experience and the average, because I hope that we would all be concerned about the level of inequality rather than just the average.

You have suggested that

“Increasing average public sector pay in line with either prices or private sector earnings would increase the cost of employing the 5.1 million public sector workers by around £6 billion per year by 2019-20.”

I assume that those figures are based on the full UK-wide public sector, and not just people who are directly employed by the UK Government and subject to pay negotiations on a direct basis. Are you talking about all the other public sector bodies?

Yes.

Does that figure take account of the additional income tax that would be paid, or of other indirect effects? In other words, is it a measure of the affordability of such a move, or is it just to do with the pay bill itself?

That is a really good question. The answer is yes—we have tried to take account of the effect of income tax, national insurance and pension contributions.

The gross number is about £9 billion, which is a number that we are quite confident about. The net number, which is a lot more difficult to calculate—that is why we use words such as “around”—is around £6 billion. That is the number for affordability across the public sector, and it is really important from the point of view of any individual department. The health service, for example, will feel the gross cost, whereas the Treasury will feel the net cost.

10:15  

That relates to Neil Bibby’s point about the size of the public sector in Scotland relative to the UK as a whole. If more income tax revenue is being generated in Scotland, that can have an effect on the block grant adjustment mechanism.

Yes. It would possibly ensure that income tax revenue in Scotland rose a bit faster than that in the rest of the UK.

Not massively, but it could be—

On the other hand, the UK Treasury could get your higher national insurance contributions, for example.

Other indirect effects might include reduced demand for social security payments of various kinds, or reduced demand on the health service—if we are talking about public sector workers, many of whom are low earners. A reduction in the amount of direct poverty that many of those workers are in would have a positive effect in other public service areas. Have the indirect effects that are one more step removed from the direct pay bill been taken account of?

No. We cannot take account of those effects. Clearly, there are low-paid public sector workers and some of them are on benefits, but about two thirds of public sector workers are graduates. The average pay of a public sector worker is actually much higher than that of a private sector worker, because the public sector is such a graduate and high-skilled workforce. The lowest-paid public sector workers—the least-skilled public sector workers—command the biggest premium over the private sector. Poverty pay is much more a private sector problem than it is a public sector problem.

Sure.

Finally, is the Scottish Government, in its response to whatever the UK Government does in its budget, in a position to easily calculate the total cumulative affordability of increasing public sector pay by inflation or above inflation, taking into account not only the direct effect on the pay bill to itself and the other public sector bodies that it funds, but the knock-on effects on taxation and devolved elements of social security or other public services? Is that an achievable calculation?

Yes. That calculation ought to be achievable.

Is anybody other than the Government in a position to do that calculation? Can it be done based on information that is already in the public domain?

It is probably best to ask the people who are sitting behind me—Professor David Bell and Professor David Heald. It may well be that the Fraser of Allander institute or David Bell or somebody else can do that calculation—I do not know.

Thank you.

This is a change of direction, to an “If you were chancellor for a day” type of question. You have written at length about how you would improve the UK tax system to make it more efficient and effective. You are here in Scotland, so can you put yourself in the Cabinet Secretary for Finance and the Constitution’s shoes and suggest any obvious ways in which the Scottish system could be similarly improved—bearing in mind that you would have to get cross-party support for any such suggestions?

Scotland obviously has many more constraints on what it is able to do. A lot of the big problems with the UK system sit with capital taxation, national insurance contributions and the VAT system, none of which can be changed in Scotland. Structurally, many of the problems are not within the Scottish Parliament’s purview—certainly, many of the biggest ones are not.

On the things that are within the Scottish Parliament’s purview, taxation of housing remains a huge issue across the UK. Our view is that there is a strong case for a rebalancing away from stamp duty in England and from the land and buildings transaction tax here, and towards council tax. I know that council tax was frozen here for a long time.

There is a strong economic argument for council tax to reflect more closely the value of properties, rather than being regressive in terms of its being based on an out-of-date valuation of a property. I might, if I was chancellor for a day, reduce the transaction tax and reform and increase council tax, which would help with the functioning of the market and with the inequalities between generations, which we have not talked about. The current system benefits those who own expensive properties and is a problem for those who want to get into the housing market. The tax system makes that situation worse. There are definitely things that you can do within taxation of housing.

Scotland also has choice in the income tax system, obviously. There is not much that you could change structurally—a lot of the problems are about how the income tax system treats earnings relative to capital income, which I understand the Scottish Parliament cannot shift. One thing that you could do, for example, is move away from the rather silly 60-odd per cent rate on earnings between £100,000 and £120,000 that we have under the current income tax system. You may or may not decide to do that.

Could you expand on what you mean by “move away?”

At the moment, as you know, the personal allowance is so-called taken away for people who earn between £100,000 and about £120,000 a year, which creates a 62 per cent marginal tax rate for those people, when national insurance is included. You could just stop doing that, at some expense and—obviously—in a way that would help high earners. You could, instead of having the 60 per cent rate over that £20,000 range, have a lower rate over a £50,000 range, for example. I do not present that tax rate as being a big priority, because it does not do any great harm—although a person who earns £120,000 probably thinks that the situation is a little unfair.

You said that the significant levers in the economy remain with Westminster and the UK Government. Given that the new fiscal framework means that we have to match or outgrow the UK economy if we are to have a net benefit to our settlement, what is available in the basket that we have that would start to make a difference?

The issue is between the short run and the long run. My view is that Governments can do quite a lot in the long run by investing in appropriate infrastructure, having a good education system, having an effective planning system and things like that. Things that focus on long-run economic development will pay dividends in the end.

In England, the slowness over making big infrastructure development choices—whether it is about Heathrow or anything else—clearly holds the UK back because of the trade-offs that are involved. A Scottish system that is better at choosing infrastructure projects and doing them quickly would help.

England has a dreadful education system for anyone who wants to move on from school at 16 or 18 and do anything other than go to university, and that holds the economy back. If Scotland were to get that situation working better, particularly in the further education sector, that could have a significantly positive impact relative to the rest of the UK.

Immigration is the other thing. Someone said earlier that Scotland has much less net immigration than the rest of the UK. I find that quite surprising in some ways, given that you have some of the world’s best universities and so on. Anything that attracts more people—not just high-skilled people, but certainly including high-skilled people—to Scotland over time would clearly help the economy to grow, particularly given overall immigration policy. Given how the formula works, that would have a big positive benefit.

Thank you. That is very helpful.

Something dawned on me as I was listening to all the discussions this morning. I am aware that the UK’s credit rating has been downgraded. What impact is that likely to have on the public purse, given the cost of debt? Are there any predictions about where that is likely to head in the future, with the shrinking of the economy that we have been chatting about this morning?

I do not think that the downgrading will, in itself, have any impact. I am not sure that people who buy gilts take much notice of such things, so I wonder what the point of that is, if I am honest. The downgrading could be taken as a symptom of increased uncertainty about where the UK economy is going. Without making any judgments, I say that we clearly have quite a lot of political uncertainty. We have a UK Government that barely has a working majority, which will, for example, make increasing tax very difficult, should it become necessary. I have said that one of the big constraints on the chancellor will be the difficulty that he would have getting any tax increases through Parliament. Political uncertainty clearly creates risk.

The uncertainty around what the Brexit deal will look like also creates risk. Again, without making judgments, I say that the UK Opposition party has a set of economic policies that are very different from anything that we have seen in a couple of generations, so people will see that as creating some kind of risk as well as potential opportunities.

Put together, all the concerns about political capacity and uncertainty over growth will, or might, eventually weigh on people’s willingness to purchase UK Government debt. However, let us be absolutely clear: at the moment, people are still desperate for this stuff and the interest rate that is being paid is extremely low by historical standards. That is partly a good thing, but it is also partly a reflection of the concerns about the world economy. The fact that people are still willing to buy this stuff when it has negative real returns is an indication of how worried people are about where the world economy is going.

What would be really worrying for the UK—this might be where we are going—is a world in which investors become more confident about the rest of the world: we know, for example, that euro zone growth has been quite strong recently. If investors start to get more confident about the rest of the world and less confident about the UK Government, at that point, the cost of the debt might start to rise.

I see no one else indicating that they have a question. That hour of your time was useful. I am grateful to you for coming along this morning and giving us your thoughts, in order to set the context for us as we begin to drive towards the setting of our budget at the end of this year and the beginning of next year. The context is important in that process, so we are grateful to you.

10:28 Meeting suspended.  

10:33 On resuming—