Official Report 862KB pdf
The second item on our agenda today is an evidence session with witnesses from the Office for Budget Responsibility, in relation to the UK context for the forthcoming Scottish budget for 2026-27. I welcome the following witnesses: Tom Josephs, a member of the budget responsibility committee; Laura Gardiner, chief of staff; and Rosie Colthorpe, deputy director for economy. Good morning and welcome to the meeting. I intend to allow about 90 minutes for the evidence session, although that might slip a little, and I invite Mr Josephs to make a short opening statement.
Thank you very much for the opportunity to speak to the committee today and for your flexibility in agreeing to change the date of this session following the resignation of Richard Hughes after the UK budget. That change of date means that you will benefit from the considerable expertise of Laura Gardiner and Rosie Colthorpe and that you will not have to listen to me for 90 minutes, which is definitely preferable.
You will be aware that Richard Hughes resigned due to people being given early access to our report on budget day, which was a serious issue and a serious breach of budget confidentiality. We launched an immediate investigation into the causes of that breach and are currently in the process of implementing all the recommendations of that investigation, to ensure that it does not happen again.
I will run through some of the key points in the content of our November budget forecast. The biggest economic judgment that we made in our forecast was to downgrade our view of UK productivity growth by 0.3 percentage points per year, following a detailed study of UK productivity performance that we carried out last summer. We also made other important economic judgments. Most notably, we increased our view on growth in nominal earnings and inflation on the basis of recent outturn being higher than we had anticipated. That is an important driver of tax revenue, and therefore, despite our productivity downgrade, we actually forecast higher tax receipts than in our previous budget forecast, in March.
We also quite significantly increased the forecast for public spending, particularly in the three key areas of welfare, local authority spending and debt interest. That meant that our overall view on public sector borrowing was a bit higher than we previously expected back in March last year. In the medium term, the change in the borrowing outlook is for a relatively small £6 billion increase in the context of a £3 trillion economy within which there is roughly £1.5 trillion of public spending and taxation. The figure of £6 billion is actually a relatively small change in the outlook.
You will be well aware of the Chancellor of the Exchequer’s policy decisions. Briefly, she decided to increase spending, which was largely a reversal of previous welfare policies, and to quite significantly increase taxation, primarily through extending the freezing of personal tax thresholds, although there were a number of other tax measures. Overall, that meant that the chancellor met her fiscal rule with an increased margin of £22 billion, compared to the £10 billion margin that she had back in March of last year.
To take a step back, it is the case that the UK’s fiscal position remains challenging. Our debt is at elevated levels, having risen more quickly than in most other advanced economies over the past 20 years, and is now at around 45 per cent of gross domestic product, which is higher than the average for advanced economies. Our deficit has also remained at a high level since Covid and is higher than the advanced economy average, and UK Government borrowing costs are also relatively high.
We have a challenging fiscal environment, and there are many risks and uncertainties around our central forecast. Those risks are to both the upside and the downside. We discuss a number of them in detail in the report, including the outlook for productivity and the risk of an equity price correction. We look at pressures and risks around particular areas of public spending such as health, local government and defence, and we look at some of the risks from the rising tax to gross domestic product ratio in the forecast.
Focusing on Scotland and the devolved tax forecasts, I note that our latest forecast includes slightly higher Scottish tax revenues in the medium term, which are mainly driven by higher Scottish income tax receipts. That is due to our view that nominal earnings will be a bit stronger than we previously thought, and it is also a result of the UK Government policy to extend the personal tax threshold freezes. We assume that the personal allowance freeze applies to Scotland.
This time, we have expanded our analysis of the Scottish net tax position. That is the difference between the block grant adjustment and the forecast Scottish tax revenues, and it is therefore an important indicator of Scottish Government spending power. We expect that position to widen over the short term, essentially because of the different structure of Scottish income tax rates compared with those in the rest of the UK. We expect it to then fall slightly in the medium term. That is driven by the demographic outlook for Scotland compared with the rest of the UK and also the policy of threshold freezes in the UK. The assumption in our forecast is that, after 2026-27, the thresholds in Scotland will rise in line with the consumer prices index.
I hope that that is a useful overview of the forecast. I will stop there, but we are very happy to take questions on any of those issues or answer any other questions that you have in mind.
Thank you. It is not the easiest task to boil down a 200-page report to maybe 20 minutes of questions and answers that will pick out some key points. My colleagues will have a number of questions that they want to ask, but first I will touch on some of the things that you mentioned in your opening statement.
Accuracy is obviously highly significant and important to forecasts. Where are you on that relative to the Scottish Fiscal Commission? Who has been the most accurate in forecasting with regard to, for example, productivity, overall growth and income tax?
That is an interesting and important point. Both we and the Scottish Fiscal Commission are very transparent about our forecast performance and the risks around every forecast that we produce. We produce an annual forecast evaluation report, which looks back at our forecast performance and assesses reasons for differences between the forecast and the outturn. We use that to learn lessons and to look to improve our forecasts in the future, and I know that the SFC follows a similar process to learn from its forecasts.
At the moment, the biggest difference between our two forecasts lies in our different views on earnings growth, which mean that there is a divergence in our views on Scottish income tax revenues over the medium term. In the short term—if we look at the past couple of years and the next couple of years—we have similar views on Scottish income tax receipts, on the basis of our current forecast and the SFC’s previous forecast.
Historically, who has been the most accurate? We have the SFC coming in next week, incidentally.
Yes. I am not sure whether I have any analysis on relative forecast performance to hand.
The SFC would suggest that the OBR has always been a bit too optimistic on productivity. Would that be a fair assessment? I am aware that, as you have reiterated today, you are reducing your productivity forecast.
11:15
It is definitely the case. One of the things that we identified through the exercise that I talked about, which looked back at our forecast performance, is that we have been too optimistic in our view on productivity. As a result, we have made the adjustment that we have made in this forecast to reduce our productivity growth assumption.
Could I finish the point on nominal earnings?
Of course.
In this forecast, we have increased our forecast for nominal earnings, recognising that recent outturns for nominal earnings and inflation have been higher than we expected. We expect nominal earnings growth to then fall back over the medium term, whereas the SFC expects it to be sustained at slightly higher levels, which drives its stronger medium-term outlook for Scottish income tax revenue.
For Scottish budget-setting purposes, what matters is the view over the next couple of years. We will obviously get a new forecast from the SFC very soon. The forecasts are not that different. You could see the difference in the medium term as useful information for policy makers on the range of possible outcomes, because nominal earnings growth is very uncertain—we are making a judgment, the SFC is making a judgment and we are coming to slightly different conclusions. That is helpful for policy makers. Over time, as new outturn information comes to light, you would expect those differences to narrow as the budget-setting window moves forward.
I realise that we have an ageing population, but the point about downgrading productivity is astonishing when one thinks of all the new technological innovations that are coming in.
I want to ask you about the chancellor’s fiscal headroom. I do not think that the phrase “fiscal headroom” has been used as much in recent years as it has been in the past few months. The chancellor has taken on board concerns about that headroom and has increased it from £10 billion to £22 billion, but your analysis says that that increases the likelihood of her meeting her fiscal targets only from 54 to 59 per cent—which means that there is still a 41 per cent risk that she will not. Why is a £12 billion increase in headroom providing her with only a 5 per cent greater chance of meeting targets? That seems quite strange to me.
As I mentioned in my opening statement, the context is that the binding fiscal rule for the chancellor is to balance the current budget in 2029-30. The current budget is the difference between tax revenue and all of Government’s current spending. Those are two very large numbers—around £1.5 trillion each—so there is a huge amount of risk and volatility in our projection of both tax receipts and public spending. In relation to the difference between those two numbers, a margin of £22 billion is relatively small in the context of the size of the tax and public spending streams that we are assessing.
Moving from a £10 billion margin to a £22 billion margin makes a significant difference—indeed, with regard to the average change in our forecast from event to event, £22 billion gives you a lot more headroom against the risk. However, in the wider context of the risk and uncertainties around the public finances, it is still a relatively small number, which is why the probability of meeting the rule does not increase that much, even with that extra headroom.
We have talked about the fact that, 20 years ago, we had one of the lowest debts—if not the lowest—of all the countries in the G7, yet now we have the highest, proportionately. Table 5.10 of your report says that central Government debt is forecast to increase from £105.7 billion in November 2024-25 to £136.6 billion by 2029-30—a whopping increase of around 30 per cent over the next five years—and that the proportion of debt in the UK will ratchet up a little, from 95 to 96 per cent, even though the amount being borrowed will decrease towards the end of the forecast period. Can you talk us through why the interest rates, which represent about £2,000 for every person in the UK per year, will be so high?
If you look at UK public sector debt over the past 20 years, you will see that it has increased rapidly. That has largely been the result of big shocks that have hit the UK economy—the financial crisis, Covid and so on—and pushed up Government debt due to the impact that they have had on the economy through the reduction in tax revenue and an increase in public spending, but also due to the Government’s policy responses to those shocks, which have involved a large amount of public spending.
We have also seen that, essentially, between those big shocks, Governments have looked to consolidate the public finances, although they generally have not done so in a way that has meaningfully brought down debt in the periods between shocks. Essentially, over the past 20 or 30 years, debt has ratcheted up in the face of big shocks, has stayed broadly at that level and has then ratcheted up again when the next shock has hit.
As I said in my opening statement, that has led to the UK having a relatively elevated level of public sector debt. It is now much higher than the average of the advanced economies. As a result, the interest payment bill that is associated with that debt has also increased substantially.
Of course, what has also happened in the past five years is that the interest rate that the Government has to pay on that debt has also increased substantially. We had a period of very low interest rates in the 2010s, in particular, but then we were hit with the inflation shock following Russia’s invasion of Ukraine. Interest rates increased substantially as a result of that and have remained at those relatively high levels. That means that the Government is having to pay a lot more to service that elevated level of debt than was the case in the past.
Looking forward, the additional borrowing over the forecast period adds to debt in the short term. We forecast that debt will broadly stabilise in the medium term but will not start to come down in any meaningful way. In essence, the stock of debt will stabilise at that higher level rather than coming down, which results in an increase in the debt interest costs that you were talking about.
The UK Government is keen to encourage people to move away from cash ISAs and invest in equities instead—there were articles on the subject in The Sunday Times business section and so on. You have devoted quite a bit of your report to looking at the equity market and you have said that, over the next five years, equity prices are predicted to grow from 4,526 points in 2024-25 to 5,915 points in 2030-31—a 31 per cent increase. You have also talked about the potential for a correction—a shock—that could reduce that substantially. The FTSE this morning was at 10,146 points, so it is already massively over your figures—double, essentially. Where are we in that regard? What is the risk and what are the implications?
We identified the risk of a correction in global equity prices as a key risk at this forecast and ran a scenario that looked at that and the implications for the public finances. Rosie Colthorpe can talk a bit more about that.
We made some scenarios, which are based on global equity prices. In the US, the price-to-earnings ratio is at its highest level since the dotcom boom in the early 2000s, and it is also higher than during the post-pandemic rebound. That might suggest that valuations are quite stretched. In the UK, the price-to-earnings ratio is much more closely aligned to historical averages, so the UK valuations may be less stretched.
However, because global equity markets are interconnected, we wanted to look at the potential of a fall in equity prices and the impact that that would have on the UK. Therefore, we considered two different scenarios. In one scenario, equity prices fell across G7 economies by about 35 per cent in the near term and remained about 10 per cent below our forecast in the medium term. That would have a relatively significant impact on GDP, taking about 0.6 per cent off in the short term. there would also be a small impact—about 0.1 per cent—in the medium-term. That is because business investment would be a bit lower due to the net worth of businesses being down and consumers spending a bit less due to their household wealth being down.
That figure of 1 per cent of GDP would be £30 billion—
Sorry, it is 0.1 per cent.
Oh, 0.1 per cent—sorry, I thought that you said 1 per cent. So, 0.6 per cent would be £18 billion.
It is something like that.
In the second scenario, a fall in equity prices occurred in other countries but there were spillovers into the UK because equity markets are interconnected. That scenario would have a similar impact on UK GDP, because lots of households invest in overseas equities, not just UK equities—we are not an isolated market. Lots of businesses in the UK are also international. There are lots of connections between countries. If prices were to fall drastically in the US and other advanced economies, there would be an impact on the UK’s GDP; it would not depend on just our equity market coming down.
The UK Government is trying to disincentivise people from using ISAs. Instead, it wants people to invest in equities because it considers that to be better for stimulating economic growth. However, if you are predicting that there is the potential for a 35 per cent reduction in the value of those equities, it might not be the best time to suddenly move money out of a bank account into those equities, particularly given the fact that, as I mentioned, equity prices are already double the level that has been forecast.
That is just a scenario to illustrate the impact of falling prices; it is not our central prediction of what will happen. As you also mentioned, equity prices have gone up a bit since we produced the forecast in November. There are a wide range of risks around that forecast—to the upside and to the downside.
One of the key issues regarding the UK budget is the increase in the amount of taxation; some £26 billion in extra taxes will be imposed, with a significant number of people moving into higher rates of taxation. Have you looked into the behavioural response that that will cause? When we take evidence from the SFC, we often talk about the behavioural impact of, for example, increasing taxation on people in Scotland who are in the higher bands. That behavioural impact can reduce the take by as much as 83 per cent. What is the likely behavioural impact of the tax changes in the UK budget?
Laura Gardiner can answer that question.
There are a range of taxation increases in the budget. We have talked about income tax, so I will start there and maybe touch on other taxes. As members will know, this is not the first time that a policy to freeze income tax thresholds has been introduced—it is a kind of repeat visitor to the OBR’s policy costings process. When we consider the Government’s estimates for the amount of money that policy measures will yield or save, we always have a particular focus on behavioural responses. With any kind of policy that increases income tax, we will consider the different ways in which people might change their behaviour in response to those tax increases which typically reduce the yield.
I do not have the numbers to hand, but we have a well-evidenced set of taxable income elasticities that essentially reflect people changing the mix of income that they get from their labour and changing their behaviour in other ways in response to changes to tax rates, including freezes to the thresholds.
There are other areas of the tax increases in this forecast where we take a similar approach. For example, there are a number of aspects of the change in taxation of salary sacrifice pension contributions where we have considered the behavioural responses with regard to individuals and employers changing the structure of pension schemes in firms, the amounts of money put in and the amounts of money earned.
There is also the change in taxation of property income, which we might talk about a bit more. In that respect, we considered within the costings the small effects of any changes to rents and house prices and the yield there.
It is a typical part of our process with every tax and, indeed, welfare policy to think about those sorts of behavioural responses, and it is typically the case that, with all the tax increases that we have looked at in the budget, those responses will net offset some of the static increase in yield. In recent years, we have been not only thinking about individual tax costings but looking at this from a whole-economy macro perspective and asking, “Does this policy measure, or package of measures, change our view on, say, the employment rate and the willingness of people to supply labour, on investment in the economy and so on?”
11:30
In paragraph 3.16 of the report, you say:
“Real household disposable income ... is lowered in medium term by the rise in personal tax rises announced in this Budget, which decreases household consumption significantly ... This disincentivises saving”,
and you also have a graph setting out the impact on GDP. The SFC, as I have said, will say, “This tax will nominally bring in £100 million, but because of behavioural change, it will actually bring in £5 million, or £10 million, or £15 million.” Where are we with this tax package? Have you looked at which specific taxes will have the biggest impact on, say, behavioural change? I suppose that the smallest impact will be from those assisting fiscal drag, but which of the other taxes will have the biggest behavioural impact?
I might ask Tom Josephs to help me out, because I do not have those figures to hand—[Interruption.] Here we go. With the freeze to income tax thresholds, the behavioural offset is quite small. For example, in the final year of the forecast, the policy package raises just over £10 billion and we estimate the behavioural effect to be quite small, at £0.5 billion.
With a more novel change, such as that to salary sacrifice pension contributions, where individuals and employers have quite a lot more flexibility in how they respond—Tom will pull the figures up for me in a second—the behavioural response was much larger than the 5 per cent from the change to income tax thresholds. It was, from memory, much closer to 30 or 40 per cent.
Behavioural responses depend on the range of options that people have for responding and with something like the structure of pension contributions, for example, and the salary sacrifice element, which is concentrated among higher earners, there are quite a lot more avenues to respond. That is why the behavioural response is larger.
The other thing that we highlight in the economic and fiscal outlook is that we are, again, forecasting the tax take—that is, the tax to GDP ratio—to reach record highs of about 38 per cent by the end of the forecast period. That is not a particularly unusual rate, internationally speaking; other countries manage that sustainably, so I am not saying that it will make the UK an outlier internationally. However, it is uncharted territory, and our forecast suggests that it is being achieved through a number of different changes to taxation in a number of different areas. Therefore, the risk and uncertainty around that are quite high, with quite a high likelihood of different behavioural responses that it is harder for us and the Government to anticipate as we reach those levels.
We highlight the uncertainty around our estimates of the yield from individual tax measures, particularly with regard to the behavioural responses, and around the overall tax take reaching record highs via quite a wide range of changes to the tax system in the round. It is tricky for anyone to think about the cumulative behavioural effects of that kind of change to the structure of the tax system.
Thank you.
The increase in employer national insurance contributions has been a big issue over the past year. In its report last year, the OBR predicted that that would have an impact of some 50,000 jobs, but the hospitality sector alone has said that it has cost something like 169,000 jobs. Is that an accurate reflection of the impact on that particular sector, or have there been other things at play, such as the increase in the minimum wage or whatever, that have exacerbated that situation? In other words, having looked at this over the past year, can you tell us what the actual impact from ENICs has been, relative to the overall impact on that sector and the wider economy?
You are right that we thought that eventually, after five years, employers would pass the higher costs on to their employees—about 75 per cent through lower real wages—and that the other 25 per cent would be absorbed by lower profits, with a bit more absorbed in profits, and maybe prices, in the short term; it is a bit easier to adjust prices and profits than it is to lower wages. You are definitely right that the minimum wage increase coming in at the same time has made it slightly difficult to isolate the different impacts. They are both impacting similar sectors, being more concentrated on lower-paid workers.
Since then, we have not changed our estimate of the overall impact on the economy. Some initial survey evidence suggests that perhaps more of the impact is initially being absorbed by profits rather than real wages and employment, but that was only one survey and it is quite hard to draw firm conclusions from it about the medium term. We have kept our assumptions as they are for now, but we will continue to review all the evidence as it comes in for our next forecast.
Your October 2024 EFO report predicted 50,000 job losses. Do you still think that that is accurate, despite what the hospitality sector is saying about the impact on it? That is an impact on just that one sector, incidentally.
Yes. I am not familiar with how the sector got to its estimate, but 50,000 is still our central estimate.
There is only one more question from me, because colleagues are keen to come in. As a result of the budget, the Scottish Government will receive an extra £510 million in resource funding during the next four years and an extra £310 million in capital funding over five years. That represents about 0.2 per cent of resource funding and 0.7 per cent of capital funding. The report goes on to say that although that will create a boost in the short term, it will erode very quickly and there will be a small cut in day-to-day spending by 2028-29.
That certainly matches our understanding of what the UK Government said about the consequences of its decisions on departmental spending. You highlighted some percentages that emphasise that the changes to the Scottish budget as a result of spending changes that were announced at the UK level are quite small. We should see them in that light. As previous witnesses have highlighted, they are particularly small in the context of our November forecast for higher UK inflation.
You also highlighted the time pattern, which is quite lumpy. There is an increase in the near term and the amount will be slightly lower in the medium term. We highlighted in the medium-term part of our EFO some of the risks with the Government’s spending assumptions, particularly when we get beyond the period in which current detailed spending plans have been set, which was done in last year’s spending review.
We also talk about things such as higher inflation—which I have mentioned—and the policy on special educational needs and disabilities in England, where the policy decision to absorb the cost of SEND provision from 2028-29 within the existing spending envelope has not been accompanied by specific plans as to how that will be accommodated and what will give elsewhere, so to speak.
We are talking about special educational needs and disabilities potentially absorbing 4.9 per cent or £6 billion of the education budget down south. Am I right?
We actually corrected that figure after the EFO was published, but it is definitely going in that direction.
The main point is that, beyond the impact on the mainstream schools budget, in the context of the UK budget, that is £6 billion that has been effectively absorbed within the overall spending envelope without any plan for how that will be done, whether within the Department for Education budget or more widely.
We then look at risks around spending on things such as asylum accommodation.
The budget for that is increasing, despite the Government’s proposals. During the past couple of years, it has increased quite significantly.
There is certainly some evidence of pressures on the amount of money that has been set aside for asylum accommodation.
Similarly, within the Department for Health and Social Care there are risks around the on-going negotiations on branded medicines. We also look at the digital ID cards programme.
That is not an exhaustive list, but it is a set of examples that we have highlighted of the areas in which there are pressures on the UK Government’s plans for spending, particularly beyond the period for which detailed plans have been made. In the Scottish context, given the history of lots of previous spending reviews and the point at which the UK Government comes to set detailed plans for the years concerned, the direction of travel has more often been up than down, in terms of moving from an overall envelope assumption to detailed plans. Should that come to pass, it will have similar knock-on consequences for the Scottish budget.
We can talk in more detail about any of the pressures that I have mentioned. We spend quite a lot of time on some of them in the “Economic and fiscal outlook”. On the one hand, the slight squeezing of the UK spending envelope makes the medium-term position for the Scottish budget look a bit tighter than it already was prior to November 2025. On the other hand, we highlight the risks around the picture at the UK level changing over the coming years, given some of the pressures that are present in the data that we had when we produced our forecast in November.
Okay. I have lots more to go on, but I am keen to bring in colleagues.
You examine various issues in paragraph 1.13 of the “Economic and fiscal outlook”, including increased
“projected spending on welfare by £8 billion by 2029-30”
in England. Over the same period in Scotland, there is a projected increase in welfare spending of £4 billion, which is almost half the number for the whole of the rest of the UK. What are the risks to the Scottish budget of per capita welfare spending continuing to increase at a far higher rate here in Scotland than in the rest of the UK? What impact will it have on the Scottish budget, Scottish productivity and Scottish growth if the Scottish Government continues that trend?
That is a very interesting set of questions. I will start with the UK, and then I will talk about Scotland.
Regarding the UK picture, as Tom Josephs mentioned in his opening statement, there is a sizeable upward revision in our welfare forecast relative to last March of around £16 billion by 2029-30. Some of that—perhaps around half of it—was driven by policy changes, in particular reversals of previously announced measures on the personal independence payment gateway and winter fuel payment and the abolition of the two-child limit.
The other half was what we call forecasting changes. That was a mix of things, including higher uprating due to higher CPI inflation, higher unemployment in the near term and higher disability benefit case loads and awards. The last of those gets to the big-picture point in what we have seen in our welfare forecasts. This applies to Scotland in recent years, too. People can sometimes overplay what has been going on in welfare, but it is important to remember—putting pensioner spending to one side for a moment, given that it has different drivers—that working-age welfare spending as a share of GDP has been not totally flat but fairly flat over recent years, perhaps just rising a little bit at times, with some temporary spikes around Covid. Spending has been much more heavily skewed towards health and disability-related spending and away from other working-age spending. More has been going on unemployment-related, child-related and housing-related spending—that sort of thing.
That is particularly relevant to Scotland. There is quite a large health bit within universal credit, but the disability part is devolved via the adult disability payment. Noting the slightly different structures of the adult disability payment and PIP in England and Wales, in recent years our forecasts for PIP have included a very strong increase in new claims, although that has started to ease a bit in the latest forecast, as is consistent with our judgment that it is partly cost of living pressures, as well as disability prevalence, that have been driving that, particularly since 2022. Some of that might be starting to ease off a bit.
I would also mention people leaving those two benefits in England and Wales and in Scotland. There is huge uncertainty about the picture for the benefits, both in Scotland and in England and Wales.
11:45My understanding of the latest picture, on which the likes of the Resolution Foundation and Audit Scotland have done good work, is that there might be some normalisation with regard to adult disability payment as it beds in, in the sense that it might be coming back towards some of the patterns that we see on PIP. Indeed, in some cases, the rate of new claims and the rate of awards for adult disability payment are now a bit lower than the rates for PIP in England and Wales.
Although concerns have previously been raised about the rate at which people flow off adult disability payment and the rate at which people ask for things such as redetermination, which involves challenging decisions made at reviews, the Resolution Foundation has highlighted that the situation in that regard is converging with the situation with regard to PIP, too, although it is quite early days to assess that in the context of what the policy intent is and how the design of the benefit is delivering that.
It is important that I give a detailed answer, because the disability aspect of the system has been the big driver of changes in our forecasts at UK level in recent years, and although the award rates for the two benefits are quite similar, conscious design decisions have been taken to ensure that the adult disability payment in Scotland operates differently from the UK system. Previous work that we have done in our “Welfare trends report” has highlighted how important some of those very detailed and technical aspects of how the system works with individuals are in driving spending.
As I said, I think that we might be seeing some bedding in and convergence with regard to how adult disability payment compares with PIP from the point of view of on-flows, off-flows and award rates, but it is still quite early days, so I would highlight that as a big risk for the Scottish budget and the funding gap.
The most recent available data, which was provided to the committee by the Scottish Fiscal Commission, said that, in the rest of the UK, 16 per cent of people were coming off the benefit at the annual review, whereas, in Scotland, the figure was 2 per cent, which is a very significant gap to close. What are the long-term budgetary risks if Scotland does not manage to perform broadly in line with the rest of the UK?
Those are figures from others—we do not estimate that. Last year, Audit Scotland highlighted that, on current projections, there was a risk to the Scottish budget of a funding gap of around £150 million by the end of the decade as a result of the difference in outcomes between PIP and the adult disability payment. That is Audit Scotland’s figure. We do not update that information.
As I said, my understanding of the latest evidence is that some of that gap, particularly in the off-flow rates, which you highlighted, is starting to close. Essentially, that is because the off-flow rate for PIP is coming down, which is one of the reasons why we increased our welfare spending forecast in November. There may be some early signs that it is going in the other direction—in other words, up a bit—for adult disability payment.
You said that the number of applicants might be being driven partly by cost of living pressures. Are there people who would have qualified for the benefit before who now feel the need to apply because they need more income? Is that what is happening?
I should say that our understanding of such matters is driven by looking at the UK-wide picture and having a focus on PIP, rather than by looking specifically at Scotland. However, in general, in relation to both PIP and the health-related channel within universal credit, which is common across the UK, we have repeatedly highlighted that it is a mix of labour market and economic factors, health-related factors—in other words, the prevalence and severity of disability and health problems within the population—and the structure and operation of the benefits themselves that drives claim rates, on-flows, off-flows and spending.
The labour market and economic factors, which relate to the point about cost of living pressures, have been driving factors in our understanding of why new claims for PIP have gone up quite rapidly in recent years and in our forecasting assumption that, as cost of living pressures ease over the coming years, there will be a drop-off in the rate of new claims. As we highlighted in the EFO, in recent months we have seen some early evidence of that judgment bearing out.
Although our forecast for welfare spending increased, because people are not flowing off PIP as quickly as we thought they would, we have started to see the rate of new claims easing off. That is consistent with our judgment that some of what has happened over the past two or three years has been driven by cost of living pressures, and some of those pressures are starting to ease. We will definitely be keeping an eye on those in upcoming forecasts, because they are quite a big driver of what we think can happen to welfare spending.
That underscores the reasons why—this applies in Scotland as well as the rest of the UK—when we produce the spending forecast on the health-related UC side and the disability side, we always need to look at the intersections of people’s health, their experience of the economy, their incomes and costs, how they interface with the system and what incentives the system gives them.
It strikes me that we are doing a lot of research into behavioural change around tax. Is there more that we could be doing in relation to behavioural change around the benefits system and whether it incentivises, encourages or discourages people to go into work?
My background is as a welfare geek, so my answer to that question is always going to be yes. I would be delighted about more research in that area. We produce a “Welfare trends report” once every couple of years, so we work quite closely with the research community in the welfare space around the UK to try to influence some of the things that people are looking at.
Some good research is out there on that question already, and it has driven some of our judgments in recent years. We have drawn quite a bit on research by the Institute for Fiscal Studies and others that shows that changes to the welfare system have a bit of a whack-a-mole effect, in that clamping down, restricting access or reducing generosity in one part of the system often just drives people towards another part of it. For example, there is good evidence that eligibility restrictions on single parent-related benefits in the 2010s drove up claims, case loads and award rates in the parts of the system that deal with unemployment and disability. We have seen some evidence that increases in sanctioning and tightening the conditionality regime in the unemployment part of the system has been a factor in driving health and disability claims in recent years.
That relates to one aspect of your question on behaviour. There are loads of other aspects of how people—particularly those on lower incomes and with constrained resources—interact with and respond to the incentives that the welfare system gives them.
Therefore, I think that my answer would be yes. I would always love there to be more research in that area, although there is some good stuff out there and we have been able to draw on it in our forecasts and analysis in recent years.
One of the dominant themes running through the Scottish budget and the UK budget is the on-going issue of the cost of living. In paragraph 1.9 in the “Economic and fiscal outlook”, you say:
“Growth in real household disposable income per person is projected to fall from 3 per cent in 2024-25 to around ¼ per cent a year over the forecast”.
Given that many households still feel that there is more month than money, is that a reality check to the effect that people are not going to feel better off for the foreseeable future?
That is right about our forecast. Behind that is the fact that real wage growth is slowing. Tom Josephs talked about normal earnings. Our forecast is that that growth will slow down and rising taxes will bear on real household disposable income. We thought that the policies in this budget would lower real household disposable income per person to growth of around a quarter of a per cent a year. That is due to rising taxes—primarily the threshold freeze, which is the big one. In the near term, that will be slightly offset by some of the welfare increases that we have been talking about.
To put that quarter of a per cent growth in context, which is forecast to happen from 2026-27 onwards, it compares with growth of an average of 1 per cent over the past decade, which has generally been seen as quite a weak period for real household disposable income growth. In our forecast, that will be even weaker, so yes, it is quite a dismal forecast for real household incomes.
It is very gloomy. In paragraph 1.4, you say that you
“expect quarterly growth to pick up only gradually in the near term as geopolitical uncertainty persists and domestic business and consumer confidence remains subdued, including in anticipation of further tax rises.”
Do you have any assessment as to what the scale of those potential tax rises would be and upon whom they might fall?
That was largely referring to the point that, in 2025, GDP growth was quite strong in the first quarter, which was due to some temporary effects—there was maybe some front loading before tariffs came in and before changes in stamp duty thresholds—but it has been very weak since then. There was a bit of payback for that front loading and also a general slowdown and weakness in sentiment. That statement was largely referring to some of that weakness in sentiment, which is leading to weaker GDP growth in anticipation of the budget and because of the speculation around tax rises.
Actually, since we produced our forecast, GDP growth was 0.1 per cent in Q3, which was even lower than our forecast. That suggests that there were several factors weighing on GDP growth at the back end of last year.
Thank you for coming north to cheer us all up.
John Mason is next.
Thanks, convener. I thank the witnesses for their input so far.
Cheer up a bit—you have not even asked your questions yet.
I will build on some of the things that have been talked about already. The figures on debt jumped out at me, and you have already talked about that, Mr Josephs. How did we get into the position in which, if my understanding is correct, we now have twice the level of debt of some other advanced economies? You explained how we had Covid and the debt went up, and we had the banking crisis and the debt went up, but those things were worldwide and affected other countries as well.
That is right. There is a combination of factors. One is that the particular set of shocks that the global economy has experienced hit the UK relatively harder than it hit many other countries. In relation to the financial crisis, for example, the UK has a very large financial sector, so the impact of that crisis on the UK was larger than in many other countries. Also, the cost to the Government of resolving the financial crisis was much higher than in many other countries. That pushed up debt relatively more than in many other countries.
One of the shocks that I did not mention but which has clearly had an impact on the economy over this period was Brexit. Clearly, that affected only the UK and not other countries. Also, the impact of Covid on the UK economy was larger than in some other countries, and the Government introduced a relatively large package of support. That was not completely out of line with the support in many other countries but, again, it pushed up the debt level by more than happened in other countries.
As I said, between those shocks, successive Governments have basically kept debt relatively stable rather than bringing it down significantly. Some other countries have been more successful in bringing down debt a bit in those periods. Not many countries have done that but, among the group of advanced economies, it is quite a large number of countries. Some countries have been more successful in reducing debt in the periods between shocks.
That is helpful. Obviously, we are also thinking ahead. If we hit another pandemic or have some other kind of crisis or a war, all of which are possible, can we handle that? We would then be talking about debt going up to 120 per cent of GDP or something. Should we be worried about that? It would obviously affect the Scottish budget as well.
One reason why we flag the risks about the elevated level of debt is that, potentially, it means that, when the next shock comes along, Government has less fiscal space to deal with it. I am certainly not saying that that will happen when the next shock hits, but each time debt ratchets up, you increase the risk that you have less fiscal space to deal with the next shock.
Is there an ideal level of debt, or is that just entirely subjective?
12:00
Well, no. A lot of international research has been done on the question whether there is an optimal level of debt or a debt level above which things get unsustainable, and, broadly, the answer is no—it is not as easy as that.
A huge number of factors go into determining the sustainable level of debt in individual countries. It depends a lot on matters such as the wider economy, access to financial markets and the resilience of the political and economic institutions. Generally, the advanced, more stable economies are able to sustain higher levels of debt than lower-income countries with less strong institutions.
In our long-term analysis of fiscal sustainability, which we produce once a year, we project forwards over a 50-year horizon on the basis of current Government policy settings, factoring in the pressures from demographic and climate change and from other long-term trends that we know for sure or think are coming along in the next 50 years. That analysis shows that, in the absence of policy action to change things, debt is on an ever-upward trajectory, which is clearly unsustainable. An upward trajectory of debt over the long term clearly signals that long-term fiscal policy is unsustainable.
Linked to the debt is the interest. You have made a few points, especially around gilts. If I understand correctly, the Government is selling shorter-term gilts—maturities are shorter term than in the past—which means that the interest rates have gone up from 2.9 per cent to 4.4 per cent, as I think you say in your outlook document. Could you explain what all that means and what the impact is?
All Governments sell debt at a range of maturities—that is, the time period over which a debt needs to be paid back. That varies from relatively short-term debts of up to one year through to some very long-term debt instruments that go out to at least 50 years.
In the past, the UK has had a much longer average maturity of debt than most other advanced economies—it sells a lot more of that longer-term, 10-year-plus debt. A big reason for that is that there has been a big demand for longer-term debt from the UK’s defined benefit pension sector. Long-term debt is a very good match for the liabilities of defined benefit pension schemes—indeed, they want to hold those long-term gilts because they match the long-term pension liabilities that they will have to pay out in the future.
Analysis in our last fiscal sustainability report shows that the defined benefit sector has been shrinking in favour of defined contribution pension schemes, which hold a lot less Government debt and a lot less long-term Government debt. It is a long story but, essentially, the headline is that the demand for long-term Government debt from the UK pension sector has declined quite significantly and that we expect it to continue to do so in the future. In response to that situation and some other factors, the Government has therefore been issuing much more short-term debt than long-term debt.
Is it then a response to demand in the market rather than a Government choice?
Yes, it is largely a response to demand in the market.
The implications of that are, first, that the Government needs to roll over its debt more often. When those kinds of short-term instruments come up to maturity, the Government essentially needs to refinance them, which means that it is more exposed to short-term volatility in interest rates. If the interest rate rises, the Government will have to refinance more debt at that higher interest rate. Of course, the opposite could happen; interest rates could fall and the Government would benefit from refinancing at the lower rate. Essentially, though, the move to the short term increases the risk of the Government being exposed to interest rate volatility.
And did I pick up that, in the long term, interest rates are expected to rise again?
Rosie might well correct me, but the current shape of the gilt rate curve is that it will fall over time, reflecting the expectation that the interest rate set by the Bank of England is going to fall in the short term. There is a rise in the longer term, reflecting wider factors such as interest rate and inflation expectations and issues around the demand for gilts.
You have mentioned inflation, which is the next thing that I was going to ask about. Inflation might go up or down over the next few years, but you are kind of confident—or you expect, I should say—that in the longer term it will drop back a bit. How confident are you? I presume that inflation and earnings are linked. Are we quite confident that they are going to keep coming down? After all, I think that you are saying that inflation has been higher over the past year or two than we were perhaps expecting.
Rosie, do you want to talk about that?
John Mason is right—inflation has been a bit stickier than we had been expecting and in our most recent forecast we increased it a little bit in 2025-26 to reflect slightly stronger domestic wage growth feeding into it, as well as higher food prices. I should say that, since our forecast, the latest reading on inflation has actually been a bit lower, with those factors coming in a little bit lower than we had expected. That might suggest that it is coming down more quickly.
We think that inflation will return to the 2 per cent target in 2027, because of a loosening in the labour market. With unemployment staying a bit higher and vacancies falling, you would expect workers to have a bit less bargaining power over their wages. Therefore, it should start to drop off; if nominal and real wages start to come down, that should feed into slightly lower inflation.
We also think that it will return to the 2 per cent target because we project the output gap to close by the end of the forecast and potential output to come into line with GDP growth. If there is no spare or excess capacity in the economy, that typically means that inflation is around target—so, the Bank of England gets it back to 2 per cent.
I should also add that, in the budget, there was a policy impact on inflation. We therefore think that, next year, the total impact of policies on the budget will take around 0.3 percentage points off inflation in 2026. That will help bring it down a bit, although there is a little bit of upward pressure next year as fuel duty rises.
Thanks. Finally, the UK Government is committing to just one fiscal event a year, but you are still going to do two forecasts. Is that how it will work?
That is correct. The chancellor has announced that the spring forecast, which will be on 3 March, will be a full forecast from us, and we will produce a full five-year forecast covering everything that we currently cover—that is, the economy and the public finances. However, we will not make a formal assessment of whether the Government is meeting the fiscal rules; we will do that only at the time of the autumn budget.
The chancellor has also said that she will not announce policy alongside the spring forecast, except, I think, in exceptional circumstances—or language similar to that. Such an approach is quite common in lots of countries, with one major fiscal policy-setting event a year and more of a preliminary forecast that, if you like, sets the context, provides an update on the position of the economy and the public finances and allows the Government, Parliament and the public to start thinking about the wider context of the public finances and policy options ahead of the main budget event.
So, it is a bit of a technicality. It is not going to have any real practical impact.
The main practical impact will be that there will not be a policy announcement, as the chancellor said—
So the focus will be on the autumn.
—other than in exceptional circumstances.
In the UK, over many years, there have, essentially, been two major UK fiscal policy-setting events per year, and the chancellor has said that her intention is to move to only one. That will be the main practical impact.
When will the UK national debt top £3 trillion? We are about 99 per cent of the way there, I understand.
There are various measures of public debt; in our forecast, all of those remain below 100 per cent of GDP over the forecast period, but they are very close to it. As we have said, there are a lot of risks around those forecasts. There is a risk that debt will rise more quickly and top that number.
There is nothing particularly magical about that number—
However, the media will jump on it.
From the point of view of economic and public finance analysis, there is nothing particularly special about debt being 100 per cent of GDP. However, in our forecast, as I have said, it is already at a very elevated level in the UK compared with the past—in peacetime—and is high compared with many other countries around the world. It therefore represents a significant risk.
Good afternoon. Thank you for being with us today. You might have noticed that the Parliament is controlling its costs by keeping the temperature in this room dramatically low. [Laughter.] It is absolutely freezing—again—this morning.
You will know that there is to be a Scottish budget announcement this afternoon, and that there are lots of demands on and concerns about the state of public services in Scotland, in common with the rest of the UK. Obviously, further increased funding for the Scottish Government, to allow it to do other things, would help. If, for instance, the UK Chancellor of the Exchequer decided to spend an additional £50 billion on public services, what would be the impact on the UK finances?
The answer to that question would depend on whether such an increase in public spending was funded.
Assume that it was unfunded.
Obviously, an additional £50 billion a year on public spending without any increase in taxation would translate to an increase of £50 billion in borrowing, which would be very significant.
As I pointed out in my opening statement, it is interesting that the UK deficit—UK borrowing—has been relatively elevated since Covid. During Covid, borrowing shot up very high. It came down immediately after Covid but has remained at around 5 per cent of GDP since then, despite the expectations in our forecasts—which were based on Government plans through successive budgets since Covid—that borrowing would fall from around 5 per cent of GDP to around 2 per cent. That has not actually happened, which is the result of subsequent economic shocks that have come along after Covid—most notably, the energy price shock—and decisions by successive Governments not to consolidate the public finances as quickly as was previously planned.
What you are talking about would involve repeating that approach, which would increase the risk around the position of the public finances in the UK, lead to even higher debt than is in our current projections and increase the debt interest cost that the convener talked about at the start of the meeting.
What if that was £90 billion?
That would represent an even bigger risk.
Michael Marra wants to be President of Argentina. [Laughter.]
12:15
The Government has shown a great deal of commitment to its fiscal rules. If we are focusing mainly on public services, as you mentioned in your question, that assumption of an unfunded increase translates directly to the margin against the meeting of the binding fiscal rule, which is to have a current surplus in 2029-30. As you know, the margin in the latest forecast is £22 billion. The numbers that you are talking about are well beyond that margin and would result in the Government’s not meeting its fiscal rules.
The question would then be how those who lend to the UK Government would respond to that. This is a what-if game, so I have no idea of the answer to that. As we have said previously, the current fiscal rules are comparatively loose compared with previous iterations, although they are tightening in the sense that the target year is coming forward—which is a commendable aspect, particularly given that the target year falls within a period in which there are detailed plans for current as well as capital spending. However, your what-if scenario also raises the question of whether that might completely erode whatever fiscal space the Government has and cause an adverse reaction in the gilt markets in people’s willingness to lend in respect of something that would push the Government’s fiscal position well beyond its stated fiscal commitments.
We could assume that that would happen. We have had an experiment under the previous UK Government whereby £45 billion pounds of fiscal expansion had no funding attached. There was a reaction in the markets over that period, it is fair to say, and there were consequences as a result. Was that not the case?
These things are highly context specific. It would absolutely depend on the way that the Government described it, what it said about its fiscal intentions, whether it was changing its approach and the circumstances that had driven such a change.
We are very much in the hypothetical space, now, and I am absolutely not advocating for any approach. Let us give an example of when public spending rose massively and unexpectedly very quickly, in recent years—the Covid pandemic. There was total consensus among different political parties, commentators and market participants that that was an emergency that warranted direct public spending support for households and the economy. The fiscal rules were put to one side—as was everything else in that context.
There are totally different reasons why you might massively increase day-to-day spending and, as a result, totally different ways in which you could contextualise that against your fiscal strategy, particularly when it comes to the fiscal rules—and the markets would absolutely react with the context in mind. It could play out in a range of different ways.
Your comments point to 2022 as an example of circumstances not being as I described those in Covid, and we have seen evidence of how markets can react. It is not clear, therefore, that we have acres of fiscal space in the UK to delve into in any context.
Are those kinds of demands viable or reasonable, then?
Obviously, there is an option of funding any changes in public spending via changes in taxation. We have talked about taxation a little. As I said, the ratio of tax to GDP is forecast to reach record highs in the UK; however, there are countries that have sustained higher ratios, and any change of that nature would be consistent with the Government’s fiscal rules. The public services that you want and the level of taxation that you are willing to have to fund them is just a policy choice. If you move from the unfunded space to the funded space, it is much more a policy question.
The challenge is that, since the current UK Government was elected in 2024, the Scottish Government has demanded an additional £95 billion of expenditure and has opposed £45 billion-worth of revenue raisers, which is a fiscal shift of £140 billion in Scottish Government demands on the UK Exchequer. What it is asking for is unfunded. What would be the consequences for the UK economy of a fiscal expansion of £140 billion?
We have done £50 billion, £90 billion and now £140 billion.
I agree that that is ridiculous, and it is at Argentina levels, but the Scottish Government is making those demands, so what would the consequences be?
It is not really possible for us to comment on that. It is clear in our remit that we are not to comment on political policy positions and that we are tasked only with assessing the consequences of announced UK Government policies. We are careful to avoid commenting on alternative policy positions of the sort that you are setting out.
I am trying to explore the policy space, as you have set out, and the Scottish Government has made a proposition. You are talking about fiscal headroom and what the impact of that would be, so the OBR must have a view of what might happen and what the impact would be if there were to be a sudden expansion in the Government funding of public services without any commensurate increase in taxation. That is a reasonable question.
Laura Gardiner and I have both spoken clearly about the potential risks associated with increases in borrowing, but it is just not right for us to comment on specific alternative policy proposals. Our legislation clearly says that that is not something we should do.
The Scottish Government makes those demands publicly, and they are clearly political demands. The permanent secretary of the Scottish Government wrote to me saying:
“In making representations at UK fiscal events it is not for the Scottish Government to undertake costing of UK Government reserved policies, nor to identify or quantify alternative revenue-raising options.”
Apparently, it is not the job of the head of the Government civil service to make those demands. It is not on you to cost them. I get that you are responsible for costing UK Government policies rather than commenting on the politics of what is happening here, but there is a missing space when one constituent part of the UK is making unfunded demands of the Government and no one is actually costing that out. Are the politics of that not a problem for the operation of the fiscal framework?
I have not seen that, so it would not be right for me to comment on it.
Okay. You will be glad to hear that I am moving on to a different area—I am sure that colleagues will be glad, too.
There are issues with productivity and it is fair to say that the picture that you paint is quite a gloomy one, and not only because of the downgrade that you have made. The picture is of significant exogenous factors impacting the global environment and it seems to me that you can see little prospect of an uptick in productivity. Is that a fair assessment of what you have set out?
Do you want to answer that, Rosie?
Sure.
As you said, we have downgraded our medium-term assumption for productivity growth from 1.3 per cent to 1 per cent. To put that in context, the average in the decade before the financial crisis was just over 2 per cent and the average since then has been around 0.5 per cent. You could see it as being relatively optimistic if we say that productivity growth is going to pick up towards 1 per cent, because that is double the rate that we have seen in recent years, or you could see that as being relatively pessimistic because it is less than half the rate from before the financial crisis.
One reason why we think that it will actually pick up from the recent lows of around half a percent is that, as we touched on earlier in our discussion of debt, the UK has experienced quite a lot of shocks that have impacted productivity, most recently the European energy crisis and the impact of Covid. Those shocks had an impact on UK productivity, so, as those fade, we should see the productivity in our central forecast picking up a little bit and moving back towards the averages from before the financial crisis, although not all the way towards them.
Our forecast also reflects the growing impact of artificial intelligence, which we see as the next general-purpose technology. Before the financial crisis, we had the revolution in information and communications technology, which contributed a lot to productivity growth, and we think that AI will be the next of those revolutions and that its impact will pick up a bit over our forecast.
The 0.2 per cent that we have for growth in our five-year horizon is quite a lot less than the information and communications technologies revolution did before the financial crisis, and we see that picking up a bit during the rest of the decade. There is a lot of uncertainty around that. External estimates of the impact of AI on the UK and advanced economies range from something like 0.1 per cent on the level to about 3 per cent on the growth rates. We have therefore gone for something that is broadly in the middle and that is not too optimistic but is also not at the pessimistic end because there is a lot of uncertainty around it.
I should also say that there is a lot of uncertainty around the central forecast for productivity. It is a difficult judgment to make because it depends upon these big waves of technology that can be hard to predict.
In our EFO and in the productivity paper that we published, we did some scenarios, one of which shows the downside if productivity growth remains at around 0.5 per cent, which follows the average of the past decade or so. That would obviously lead to much lower growth in the UK and put us in a much worse fiscal position. An upside scenario could be that productivity growth returns to about 1.5 per cent, which is more like halfway between the pre and post-financial crisis decades, so it could be seen as an average of those two periods. That might be down to AI having more of an impact and more of the recent weakness being a result of the shocks that have hit the economy rather than reflecting the underlying structural factors that we expect to continue.
There is quite a wide range of impacts to consider, but we have gone for something in the middle for our central forecast.
You are leaning quite heavily on technological waves rather than a total productivity measurement. The Scottish Fiscal Commission has been talking more about the latter rather than just waiting for technology moments to arrive. It sounds as though you are saying that, at the policy level, we are just hostages to fortune. The other issues that you identify include the ageing population, which is more acute in Scotland. I am trying to explore what we, as a set of institutions in Scotland, might do to change our productivity pathway, but the message that I am getting from your report is that, rather than making a policy level adjustment, we will just have to wait and see if a major technology comes along and changes our direction.
It is definitely right that these waves of technology are important drivers. As we show in our paper, there is slower productivity growth across advanced economies, so it is not just a UK-specific issue. As we have just talked about, the OBR is not here to comment on specific policy appraisals or alternative policies, but if we look back at the past few years, there are examples of Government policies that have increased productivity growth that we have incorporated in our forecasts.
I will give a couple of examples, one of which is trade. On the downside, Brexit has impacted productivity. On the upside, the UK has signed a number of trade deals with different trading partners since Brexit that we expect to uplift productivity, in the long term, by around 0.25 of a percentage point, in total. That is a positive but, unfortunately, it is outweighed by the Brexit negative, which is around 4 per cent in the long term. We have also increased our productivity through the impact of the UK Government’s planning reforms that are allowing the construction sector to make more productive use of the land that has been released for development.
On the capital deepening side, the big increase in public investment from the Government last November meant an increase in productivity of around 0.1 per cent to 0.2 per cent at our forecast horizon. We have also seen increases or decreases from policies that impact business investment, such as corporation tax and the super deduction, which affects businesses’ cost of capital and their incentive to invest.
We can therefore draw upon lots of examples of Government policies in the past five years that have impacted on the rate of productivity growth in our forecast, so there are ways that we can do that in the way that we forecast.
As some colleagues have said, the analysis that you have given us this morning is a bit depressing, but do you think that there is a real commitment in the UK Government to reform the tax system in particular, because it obviously has complexities that other countries do not have? Is that commitment there?
What we have seen in the past two budgets from the UK Government is a large set of tax changes. We cannot speak for the Government on its objectives, but it has clearly been reflecting on a wide number of them. Some are fiscal, in that it has sought to increase revenue from taxation in order to increase public spending and therefore meet its fiscal rules.
At the time of the budget, there was a lot of commentary not just about that but about whether reforms to the tax system could help to unlock some of the issues in the UK economy. I am not asking you to comment on whether that is the right or the wrong thing to do, but is there a commitment in the UK Government to do that?
12:30
That is really a question for the UK Government, so you would need to ask it. Our role is to assess the cost and impact of the policies that the UK Government chooses to announce—why it chooses to announce those is a matter for it. However, it is certainly the case that it has introduced a large number of changes to taxation. Some have in mind a fiscal objective in order to pay for increases in public spending and others have in mind more specific policy objectives, too. One example in the recent budget is the introduction of taxation on electric vehicles, which the Government would say has a fiscal objective as well as a number of other policy objectives.
Just to be clear, the OBR is not being asked by the UK Government to do any analysis of possible changes to the structure of taxation. Is that correct?
We assess the impact of the tax policy changes that the Government chooses to announce.
The current ones.
Yes. We do not do any other work for the Government on taxation policy.
Thank you.
I have a couple more questions on issues that we have not touched on. One is about the increase in tax on property income and savings income by 2 percentage points at the basic, higher and additional rates from April next year. The budget says that the UK Government intends to
“engage with the devolved governments of Scotland and Wales to provide them with the ability to set property income rates in line with their current income tax powers in their fiscal frameworks.”
In its reaction blog on the UK budget, the Scottish Parliament information centre said:
“Once the Scottish Parliament has the powers to set income tax rates to property, it will presumably face a choice between at least matching the rates for England, or accepting a block grant adjustment which will reduce funding for the Scottish Budget.”
What are the implications of that policy for savers, those letting out properties and tenants?
I will focus on the property side, because that has the most direct implications for the Scottish Government, being part of the devolved set of taxes, but the implications are similar on the savings side. I talked earlier about the behavioural effects of tax policies. At UK level, when we looked at the policy in this case, our considerations included impacts on the property market. In our forecast, the yield from the increase in taxation was slightly offset by a negative impact of the tax on house prices, which more than offset a slight upward effect on rents, in terms of the relative tax.
The implication is that the policy will reduce the number of flats available for rent. Is that correct?
That is true, particularly over the long term. In recent years, our economic and fiscal outlooks have included a specific section on the long-term implications of policy. In that context, we highlighted that this policy is set in the context of various changes to the tax treatment of landlords and property income over the past decade, which have reduced returns to private landlords, and that you might expect that to reduce the supply of rental properties and therefore increase rents over the long run. We flagged that as a risk from the policy, in the context of a number of policy changes in the landlord and rental property space.
If the Scottish Government decides not to copy the UK Government, what will be the implications of a block grant adjustment?
I am afraid that I do not have the specific figures to hand, but I think that, in essence, it is a straight choice between that and a proportionate reduction in the block grant adjustment relative to the yield at the UK level, which we estimated at around £0.5 billion. Others will know better than me how those things translate. I am sorry that I do not have figure to hand, but the revenue at the UK level from the property aspect, which is the most relevant part in the Scottish budget context, is £0.5 billion, and that translates through in the usual way.
At the Scotland level, it is a direct choice between at least matching the UK Government rates of tax on property income when the powers have been put in place to do so, which I understand is something that the Governments are working on together, and, as I think other witnesses to this committee have mentioned, considering the implications of those changes for the Scottish rental market in the context of other changes to the treatment of Scottish landlords over the past decade, particularly the relatively high rates of property transaction tax.
The impact of that could be tens of millions of pounds.
That sounds about right to me, taking account of the usual proportions of around 10 per cent.
In terms of capital, you say in paragraph 2.49 of your report that a
“relatively high cost of capital and a weak rate of return together generate a modest decline in investment as a share of GDP over the forecast”.
You go on to say:
“the cost of capital has risen over recent years ... and the real return on capital is at a historically low level. Investment intentions and business confidence also remain subdued.”
What do you perceive to be the impact on growth of that?
You are right—over the past few years, we have seen the real rate of return for businesses trend down and reach relatively low levels, although I should say that recent Office for National Statistics revisions have made the picture look a little bit less bad than it did maybe a year ago, so it looks like a less bad position for businesses.
It is a little bit less bad but still bad.
Yes, it is still bad but a little bit less bad than it was.
Over our forecast, we think that businesses will try to rebuild some of their rate of return and their profits, so the profit share of GDP should rise a little bit and the rate of return should go up a bit as well.
Another revision from the ONS was to business investment, which pushed up the level of that as a share of GDP compared with what we previously thought, so the picture for business investment looked a little bit better.
We think that the relatively weak rates of return, although those are increasing a little bit, and the high cost of capital—we have talked quite a lot about interest rates, which will feed through to businesses’ borrowing costs as well—will together weigh on business investment, so we have business investment as a share of GDP trending down a little bit over our forecast. It is broadly flat in a wider context but is going down a little bit. That will feed into the capital stock and therefore our capital deepening forecast. If business investment was going up as a share of GDP, that would build up the capital stock and contribute to productivity growth. As it is sort of flat and slightly falling as a share of GDP, that part of our productivity forecast is a little bit worse.
You are talking about a significant boost to capital in the current financial year, but that will reduce such that, by 2029-30, it will be lower than it was in 2023-24. My concern about that is that you will get inflationary impacts—you do not have a 15 or 16 per cent increase in capacity, but you have all this additional capital, so prices go up and then, suddenly, the share of capital declines, relatively speaking, and you are stuck with high prices. Is that a potential impact?
We still think that deepening capital will contribute to growth over the next few years—
Clearly, it will contribute—it would be a worry if it did not—but it is about the level of contribution and impact on growth.
It is very slightly lower than we had in our previous forecast, but they both still round to about 0.3 per cent a year over the forecast.
If you think about the business capital stock of the UK economy—I cannot remember it off the top of my head, but it is very large—the annual flows are quite small compared with the overall stock. You must have big changes in the flows of business investment to generate the big changes in the capital stock, so even the adjustment to business investment in our forecast does not have a hugely significant impact on capital deepening and productivity growth.
Okay. Lastly, near the bottom of page 29 of your report, well below chart A, it says:
“UK and global productivity growth between the early 1990s and mid-2000s was likely boosted by rapid increases in trade as a share of GDP. UK trade intensity has stagnated since 2008, and we expect it to fall in the coming years due to the recent resurgence in global protectionism on top of the enduring effects of Brexit. This is set to weigh on productivity growth”.
The report goes on to say, in the final paragraph of page 46:
“Weak growth over the medium term reflects a more restrictive global trade environment as well as the ongoing impact of Brexit, which we continue to expect to reduce the overall trade intensity of the UK economy by 15 per cent in the long term.”
What are the implications of that on the UK finances to the end of the forecast period?
I do not have a specific number for the exact impact of that on the UK Government finances, but I will talk a little bit about the different factors and trade and how that impacts productivity.
Sorry, but a 15 per cent reduction in the overall trade intensity of the UK economy is very significant.
Yes. That is largely from Brexit. That would translate into a 4 per cent reduction in the level of productivity of the UK economy. We would expect that to come in around 10 to 15 years after the UK left the European Union—by 2030 to 2035. That is still weighing on productivity growth in the UK economy and therefore real GDP growth and the public finances over our forecast period—and even slightly beyond it as well.
As I mentioned earlier, there is a small offset to that from the trade deals that the UK has signed to date—
Four per cent, you said—
Yes, a small offset—
Four per cent versus quarter of a per cent.
Yes. You also mentioned the impact of global protectionism.
Indeed.
We have seen US tariff rates rise significantly since the end of 2024. As at September, which is when the International Monetary Fund produced its world economic outlook, on which we condition our forecast, rates on the UK had increased by around 8 percentage points. That is a significant increase in tariffs but slightly lower than the increase in tariffs on some of the other trading partners of the US, so the UK was in a slightly better position relative to them, although we are in a worse position than we were at the end of 2024.
We think that that impact on productivity of that increase in US tariffs on the UK and the wider impact on slowing global trade from US protectionism is around -0.1 per cent, so, again, it is relatively small compared with Brexit, but it is still a drag on UK productivity growth over the next five years.
Thank you very much for your evidence this morning. It has been very helpful to the committee. Just before we wind up, Tom, are there any further comments that you want to make? Is there anything that we should have touched on but did not that you want to emphasise?
I do not think that I have anything else to add.
With that, I call an end to this meeting. Thank you very much, everyone, for your contributions.
Meeting closed at 12:41.