Treasury Committee 

Oral evidence: Budget 2023, HC 1217

Wednesday 22 March 2023

Ordered by the House of Commons to be published on 22 March 2023.

Watch the meeting

Members present: Harriett Baldwin (Chair); Rushanara Ali; Mr John Baron; Anthony Browne; Douglas Chapman; Dame Angela Eagle; Emma Hardy; Danny Kruger; Dame Andrea Leadsom; Siobhain McDonagh; Anne Marie Morris.

Questions 82 - 176

Witnesses

I: Richard Hughes, Chair, Office for Budget Responsibility; Professor David Miles CBE, Member of Budget Responsibility Committee, Office for Budget Responsibility; Andy King, Member of Budget Responsibility Committee, Office for Budget Responsibility.

Examination of witnesses

Witnesses: Richard Hughes, Professor David Miles CBE, and Andy King.

Q82            Chair: Welcome to this afternoon’s session on the work of the Office for Budget Responsibility. Would you be kind enough to start by introducing yourselves?

Professor Miles: I am David Miles of the Budget Responsibility Committee at the OBR.

Richard Hughes: I am Richard Hughes, chair of the OBR.

Andy King: I am Andy King, also of the committee at the OBR.

Q83            Chair: Thank you for your report that was published alongside last week’s Budget. Today we will mainly be focusing questions around the Budget. You are named the Office for Budget Responsibility. In your view, Richard, was this a responsible Budget?

Richard Hughes: It was a responsible Budget in the sense that the Chancellor was still on track to meet the targets that he set for himself, which were to get debt falling as a share of GDP in five years’ time and to get borrowing below 3%. We could talk about the welfare cap. He was actually breaching his welfare cap based on this forecast, but that is a target that has slightly fallen into abeyance in fiscal discussions. In terms of the letter of the rules that he had, and the rules and regulations that we follow in producing forecasts, he was meeting those rules.

As we highlighted in the report and there was some discussion of among the commentariat, there are, however, a growing number of what you might call fiscal illusions—fiscal smoke and mirrors—meaning that there are a growing array of tools that Chancellors use to try to get around some of those rules. This Committee has certainly highlighted the issue around what assumptions we have to make about fuel duty beyond the current year and that the Government always insist that they are going to uprate it by RPI. The Government have frozen fuel duty every year since 2011.

Fiscal illusions of that nature make it more difficult to judge where fiscal policy might ultimately end up in five years’ time. There are a range of risks that hang over that forecast, which, because we can only score what Government say their policy is, do not get fully reflected in our forecasts.

Q84            Chair: You accept that it is incredibly uncertain in terms of what is going to happen in five years’ time. You are just drawing a 50/50 probability around that five-year forecast.

Richard Hughes: That is right. Based on what Government state their policy is at the moment, they had a 52% chance of meeting their fiscal rules, but that is a very narrow margin to have against your stated fiscal objectives. In fact, it is the lowest probability any Chancellor has had of meeting his fiscal rules since the OBR was set up. The Chancellor is meeting his target, but running it very close to the wire.

Q85            Chair: You mentioned the fuel duty fiction that we have highlighted on this Committee. You have now broken that out as a separate line in your reports. Are there any other examples of what you, or we, might describe as fictions in this forecast?

Richard Hughes: There are. There is a growing list of ways in which Chancellors can try to hide cost, such as the fuel duty increase. There are five categories that I would highlight. One is fantasy tax rises of the sort that the fuel duty indexation is.

Q86            Chair: Would you agree with my assessment that that is not going to happen in an election year?

Richard Hughes: It is highly unlikely to happen in any year in fact, based on the track record that Chancellors have had since 2011.

Q87            Chair: That is worth about £4 billion.

Richard Hughes: It is worth between £3 billion and £4 billion, yes.

Q88            Chair: Is that every year?

Richard Hughes: It is £4 billion by the time you get to the target year. That is £4 billion that would be taken away from the £6.5 billion worth of headroom that he would have.

Also, on the tax side, there are ambitions to cut taxes that are stated but not scored, because they are stated as ambitions rather than deliberate policy. The Chancellor, for example, has said that he would like to make what in our forecast is a temporary capital allowance within the corporation tax system permanent. Were he to do that, that would cost £10 billion by the end of the forecast period and therefore completely wipe out the—

Q89            Chair: Is it a case of the fiscal rules driving policy, in your opinion?

Richard Hughes: These fiscal rules are designed to drive policy, in the sense that Chancellors set themselves fiscal constraints that they try to achieve. It is oftentimes the case that Governments have more ambitions than they have resources. Therefore, they rely on these fiscal sleights of hand as ways of making what is a difficult equation add up.

Q90            Chair: You did not find that you ran your numbers and that forced the Chancellor to put that three-year limit, for example. We will be asking all the questions about that in the session.

Richard Hughes: Chancellors always have to prioritise within the resource constraints that they have. That is the nature of a rules-based fiscal framework, rather than our particular role within it. Even if the Treasury was producing forecasts, like it was back in the old days, Chancellors back then had to live within the fiscal rules they set themselves based on the Treasury forecast that they were given.

Q91            Chair: Do either Andy or David want to comment on whether this was a responsible Budget?

Professor Miles: It was a Budget where the Chancellor obviously has taken seriously the target to get, at least on the central forecast, debt as a percentage of GDP just about stopping rising five years down the road and at least give a very slightly better than 50% chance of doing that, on current policies anyway. Obviously there is all the time between now and then to adjust if things look like they are missing.

Q92            Chair: Andy, do you want to add anything to the comments on the fictions as well?

Andy King: The thing that I took away from this Budget was that the outlook improved marginally relative to November and two thirds of that was spent on Budget measures. The fiscal loosening—the giveaway, if you like—in the Budget is very large, historically. I was looking back at the March 2020 Budget, where it was a £20 billion or so loosening. In our EFO, we focused on the fact that that was the largest since the 1992 pre-election giveaway.

This is a big giveaway budget and yet, relative to March last year, the outlook is much worse, because of the energy price shock. That was absorbed, so when the energy price shock hit the public finances took the strain and we revised debt up from 80% in the medium term to 97%. Now, there has been a modest degree of improvement in the outlook, because the energy crisis is less severe.

Q93            Chair: That improvement and the energy price was worth about £30 billion, was it, in total?

Andy King: It was £25 billion-ish, I would say. Two thirds of that has been spent. This asymmetry in how Chancellors respond to surprises in the forecast has always been there. We have written about this before, that bad news is absorbed and good news is partly spent.

The thing that I would find worrying is that, in a very volatile environment, we will make larger forecast revisions from one Budget to the next. If that asymmetry is still the same, that the bad news goes into higher debt and the good news is spent, debt will ratchet up more quickly than it has in the past.

Q94            Chair: In economist-speak, that does not sound very responsible to me.

Andy King: It is a recipe for debt ratcheting higher, yes.

Q95            Chair: Apart from that, as you were highlighting, Richard, there is an aspiration, should things get better, to spend more on defence. I did not spot any change in terms of the date at which it scored that the aid budget will return to 0.7%, so I am assuming that that is still in the same place, in terms of the Treasury scorecard. Now, in addition to that, there is an aspiration to get defence spending up to 2.5%. There is an aspiration to keep these investment allowances going on a permanent basis. It is almost as though, if there were any upside, that is immediately going to be spent anyway.

Richard Hughes: That is right. In addition to the aspiration to get the ODA budget back up to 0.7% when resources allow, there is now this added aspiration to get defence spending up to 2.5% of GDP compared to where it is, which is roughly 2% of GDP. That is another £15 billion ask on the public finances if that were funded above what the spending envelopes look like.

Another thing to point out on the public spending side is that the Chancellor stuck to his nominal spending plans for both current spending and capital spending. That means that those overall envelopes are actually going to be slightly lower as a share of GDP by the time we get to the end of the forecast period, because the outlook for nominal GDP is slightly better in our forecast.

He has a tighter resource constraint, in terms of total spending as a share of GDP, but he is making commitments to increase components of total spending more quickly than GDP, because he wants to raise them as a ratio of GDP. Because there is no timescale attached to them, those numbers are risks to our forecast, rather than things that we would necessarily build in.

Q96            Chair: Did you agree with the Chancellor’s assessment—we are going to have more questions on inflation—that this was a Budget that helps with the Government’s objective of halving inflation this year? You forecast that it is going to get down to 2.9%, I believe.

Richard Hughes: We do. It is helped in the near term by the fact that the energy price guarantee is extended by three months, so the impact of retail energy prices on inflation is lessened over the period between April and June. What would otherwise have happened is that retail prices would have jumped from their current £2,500 to £3,000, which would have seen a further big increase in retail energy prices. Extending the price cap takes some of the pressure off retail energy prices in the near term.

By the time we get to the end of the year, we are expecting wholesale prices to drop below the price cap levels. That means that falling energy prices help to bring down the rate of inflation, as well as other big drivers of inflation that we have seen recently moderating toward global inflation rates.

Q97            Mr Baron: Can I pursue that theme? In the next five or 10 minutes we are going to focus on inflation. You mentioned the energy price guarantee. I would add that the fuel duty freeze and some other measures in total, some estimates suggest, reduce the inflation this year by three quarters of one percentage point, through their direct impact on taxes. I do not want to get into whether it is three-quarters of one percentage point, but it is of that sort of magnitude. With the war in Ukraine going on and so many other geopolitical uncertainties, how confident are you that you are going to hit your forecast 2.9%?

Professor Miles: I do not think that one can be very confident. It is a central forecast. As an indication of how quickly things are moving, in the last three weeks, since the beginning of March, the wholesale price of gas—the futures price as it will be in the winter of this year—is down something like 15%, having fallen very substantially relative to the last time we forecast in November. Oil prices are down quite a lot as well.

If we were doing the forecast right now, based on where the futures prices for gas are and where the oil price is, even though this morning’s inflation number was higher than we had thought, I suspect our central forecast might even be slightly lower than 2.9%. The fall has been so dramatic in oil and gas in particular and that has a big impact, of course, on the inflation rate. That is an indication of a substantial degree of uncertainty about where inflation will be even over a relatively short horizon, such as between now and Christmas.

Q98            Mr Baron: Can I push back a little bit on the forecast? One fully understands that the OBR has to make these sorts of forecasts. I think that the general consensus is that forecasts, not just by the OBR but by institutions generally, have often been very wide of the mark. We sympathise, for the very simple reason that you are having to take into account all sorts of factors, including human psyche when it comes to consumption.

We are in a particularly challenging period at the moment. We have geopolitical tensions, supply lines being shortened, rebalancing perhaps between capital and labour, after capital has been pre-eminent over the last decade or two, coupled with rising interest rates. The challenge of forecasting has got even greater, has it not?

Professor Miles: It is very substantial. There is no question. It has been a very volatile couple of years. In some ways, there is always something coming along that you did not see coming. There have been more things coming along over the last couple of years. Covid had enormous impacts, but more on real economy and GDP, perhaps, than inflation. Then there is what has happened to commodity prices after the invasion of Ukraine.

It is pretty difficult to forecast. It is part of the reason why, although we are obliged, in a sense, to produce a single number as a central forecast, as much emphasis should be placed on our regions of uncertainty and therefore probabilities that the Government might hit a target, rather than “yes, they hit it” or “no, they do not hit it”, particularly when you are looking five years down the road.

I very much agree with you. Making a single forecast and pretending that that is something very precise is not how we should present what we do, frankly. It is a central forecast. Things could be either side of it and they could be quite a long way either side of it, but it is one’s best guess as one can make right now as to what you might call the average outcome across a range of possibilities, which is wide.

Q99            Mr Baron: I must admit that, at least from my point of view, I think that you are at the optimistic end of the spectrum.

Professor Miles: Yes, that is true.

Q100       Mr Baron: I think that inflation is going to be much more volatile and higher than many people expect, and certainly forecasters. From your forecast, you must be pretty optimistic that the Prime Minister is going to meet his target of halving inflation by the end of this year, presumably.

Professor Miles: There is a pretty high chance of that. It could be blown off course for sure. As I say, coming back to energy prices, oil and gas, that was the single biggest factor for inflation getting up to 10%, which, frankly, nobody saw coming at the beginning of last year.

One can use the futures prices as the least bad guess as to what might happen, rather than an accurate forecast, simply the least bad assumption. As I say, since we made the forecast, oil and gas prices have gone south of that. They are quite substantially lower. If things were to play that way, there is a very strong chance that inflation would be half what it was at the beginning of the year. Of course, that would still be 5%, which, historically, in recent terms, is quite a high inflation rate.

Q101       Mr Baron: If I may interject, Professor Miles, according to your fan charts, the chances that inflation does not halve this year are so remote as to be, apparently, off the scale. It is a bold statement, given what is going on, is it not?

Professor Miles: Yes. If you said, “What are the chances that inflation is more than half its current level, i.e. more than 5%?”, I would not say that they are so negligible as to be in the realms of near impossibility. That would not be a sensible thing to say.

Q102       Mr Baron: This is a little hobbyhorse of mine. The renowned American economist Galbraith said, as you well know, that the usefulness of forecasts is to make astrologers look respectable. You have so many variables now.

One appreciates that this is a very difficult task, but to what extent do your models actually take into account, or can they take into account, things such as, for example, the nuances that have typically been associated with international relations hardening, the supply lines being shortened, or onshoring, which we are seeing? That has to be inflationary. There is an emerging middle class of consumers in millions coming through. Then you are trying to judge the human psyche when it comes to consumption in the established markets.

Those are just some of the variables you have to factor in. Is it not wise just to say, “There is all this going on”? Instead of producing a single forecast, which invariably is wrong, produce a bit of a band and say, “This comes with qualifications”.

Professor Miles: I completely agree with you. I do not disagree with anything you just said. Although we are obliged, in some sense, to come up with what I would call a point focus—a single trajectory for inflation, GDP, the stock of Government debt—and then assert that either you hit or miss the target, I would hope that people will pay every bit as much attention to our range of possible outcomes and probabilities, rather than the single path. I completely agree with you.

Richard Hughes: In addition to what we try to do in the EFO, which is to emphasise the uncertainty around particular drivers of the forecast and then, when we think they are especially important and there is particular uncertainty, we also do scenarios around that, including around energy prices, interest rates and, in this case, labour market participation, the other thing that we produce on an annual basis now is our fiscal risks report. There, we try to look into these other, deeper, longer-term drivers of uncertainty about the outlook.

Last summer, we looked into this question around international trade regimes, where they are headed and, if a global trade war were to break out and countries were to move towards something that looked more like autarchy, what that would do to UK trade and productivity, as well as that of the rest of the world. We try to also emphasise, in those bespoke bits of work, where we think there are particular risk factors that need to be better understood in policymaking.

Q103       Douglas Chapman: On growth, the Chancellor emphasised that the UK is not expected to enter a technical recession in your latest forecast, in contrast with what was said last November. In your view, what has changed the landscape around that?

Richard Hughes: It is really that what was a very tight squeeze on both households’ and businesses’ finances that we forecast back in November, from a combination of high energy prices, more generally high inflation and high interest rates, was somewhat alleviated when we did this forecast. It is still a very tight squeeze on living standards. It went down from about a 7% fall over two years to 6%.

It is still a historic squeeze on living standards of households, but, because all three of those things had come down since our November forecast, that meant that households had a bit more money to spend in real terms. There was less of a squeeze on business finances, so you saw less of a near-term contraction in consumption over the course of the first half of this year. You just saw, in one quarter, a contraction of around 0.5% and then a return to growth, whereas, in our previous forecasts, we were looking at a contraction in output of around 2%, more or less, over the whole first half of this year.

Q104       Douglas Chapman: What is the most significant part of that? Is it the fact that we have not entered a technical recession, or the fact that household incomes have fallen, or are expected to fall, more significantly going into the future?

Richard Hughes: One can get too preoccupied with whether there is or is not a technical recession. It depends on whether growth happens to be falling in two successive quarters. What drives a lot more of what is still quite a tough economic outlook is the fact that living standards are much lower over the medium term.

Q105       Douglas Chapman: Do either of the other two witnesses have any comments on that, in terms of falling living standards?

Professor Miles: We are slightly more optimistic about the fall in living standards than we were in November. It is partly on the back of energy prices again and inflation looking like it could be quite a bit lower in the near term. Interest rates are a little bit lower than they were. Projections of where the Bank of England’s bank rate will be and gilt yields are a little bit lower than they were at the back end of last year in November as well.

I would describe the situation as one where now, for this year we are in at the minute, the chances are, we think, that output may pretty much flatline for the year as a whole, rather than fall materially, which is what we thought back in November. As Richard said, whether we avoid the technical two quarters where GDP falls is probably not the most material question. There has been a change in the near-term outlook for the good.

Q106       Douglas Chapman: We had Torsten Bell in yesterday. He was talking about a toxic combination of low growth and high inequality, and how this is what failure looks like. Maybe we could call that “epic failure”. You can look at industrial policy, growth, productivity and all the other significant moving parts in the economy at the moment, such as Brexit, high inflation, lack of comment on exports, for example, and trade in the Budget statement, and the cost of living crisis.

With all these moving parts, what is the purpose of the Budget? Is it a holding Budget to see us through maybe into the autumn, and then we are in that pre-election period? One of the other criticisms yesterday was about how things are constantly changing and there is not enough time to allow either policy or decisions to actually bed down. Everything is always in a state of flux. What is your take on all that? Does this Budget set the tone for a period of stability? Is this the way forward or will there be much more significant changes to be made by the autumn?

Richard Hughes: You will have to ask the Chancellor what the intentions are behind his Budget. In terms of describing its economic and fiscal effects, it provides some alleviation of those near-term financial pressures on households. In particular, the extension of the energy price guarantee at £2,500 alleviates what would have been a big rise in household energy costs and plays a role in making that fall in output in the near term shallower and shorter.

In the medium term, the challenges that have plagued the UK economy for many years remain. Those are low investment, low productivity and then, more recently, since the pandemic, a loss of labour supply. The Budget makes a meaningful contribution to tackling some of those challenges.

In particular, on the labour participation side, we think that the measures announced in the Budget make a significant impact on the number of people who will be in work in five years’ time, around 110,000. That plays against around 500,000 people we think we have lost from the workforce since the pandemic. It by no means reverses that effect, but it makes a meaningful difference to making up for some of the shortfall that we have faced.

Q107       Douglas Chapman: David, do you have any comment on our current plight or current situation with regards to growth in the economy?

Professor Miles: Some of it is a continuation of what is a depressingly long-term issue for the UK. We are a relatively low‑investment economy. That has been true probably for the best part of 25 or 30 years, relative to other countries around us. We just invest quite a low proportion of GDP. That is largely a private sector phenomenon, in a sense. Economists have a long list of potential reasons for that, but, whatever has driven it, it has been there for quite a long time.

Added to that, you have the more recent double hit from Covid, the huge hole that created in UK GDP and the hole it created in the fiscal situation as the Government tried to support people through that. Just as you are kind of recovering from that, thankfully, you get the hit from the Russian invasion and its knock-on effects.

There are reasons why the fiscal situation has changed so quickly. These huge shocks have come relatively close together and forced changes in the strategy to try to deal with a really dramatic escalation in the size of the UK stock of debt.

Q108       Douglas Chapman: Andy, is there anything from your perspective?

Andy King: It is quite a big Budget. The labour supply measures come in at maybe £7 billion a year by the end. The full expensing measure is near enough £10 billion a year for the three years while it is in. These are big policy measures. They are not big relative to a furlough scheme or an energy price guarantee, but relative to addressing supply-side issues, and what I think of as historically normal Budget measures, it is a big Budget.

Q109       Douglas Chapman: In terms of investment and so on, the forecast is that the temporary 100% capital allowance for investment will bring forward investment from future years, but leave cumulative business investment unchanged. Is your view that the policy will have any real, lasting, serious impact on the economy or productivity? Those are the two big issues in terms of previous Governments and now this one.

Richard Hughes: On the investment side, it is a temporary measure. This comes back to the fact that it was announced as a temporary measure with an expiration date of March 2026. We score it as a temporary measure in terms of its economic effects. It raises the volume of business investment by about 3% a year in the years when it is in effect.

Because it is temporary, it expires in the end and, after that, you feel the full effect of the higher rate of corporation tax, we assume that it just brings forward investment into the period where you can get the tax advantage. Then it falls back below the level that it would otherwise have been, because you have some of those projects happening sooner rather than later. That is the reason why, by the time you get to 2027, cumulative investment over the period 2022 to 2027 is unchanged.

Q110       Douglas Chapman: If that was extended on a permanent basis, what effect do you think that would have?

Richard Hughes: If it were on a permanent basis, we think that it would make a permanent difference to the level of investment. It would increase permanently the post-tax return on investment that businesses would expect, and they would therefore target a higher capital stock as a result. It would have a lasting effect on the capital stock and the level of output were it to be sustained, but that was not the case.

Q111       Douglas Chapman: I do not know whether you have any figures on the regional impacts of the capital allowances and whether you would see any difference. We always look at London and the south-east as being a bit of a driver for the economy, but how do you think that policy might impact on the north of England, Northern Ireland, Wales, Scotland and so on?

Richard Hughes: I would not dare to speculate. We do not typically do regional impacts for these kinds of measures, because they are very difficult to model. Clearly, these kinds of tax advantages are the biggest advantage to companies that have very large plant and equipment investments. Those are oftentimes companies in the telecommunications or manufacturing sector. Those are not necessarily all in London.

Q112       Douglas Chapman: David, could you see it making any difference in terms of regional growth?

Professor Miles: As Richard said, the allowances are more generous for plant and machinery type investment and somewhat less for other kinds of investment. I think I am right in saying that they are probably less generous for commercial buildings and offices. To the extent that there is a more equal distribution of plant and machinery investment across the country than the service sector, which is relatively heavy in London, the impact of the measure is probably beneficial across the country, rather than being concentrated in the south-east.

Q113       Danny Kruger: Sorry for being late. Forgive me for missing what I have missed. Has anybody asked you about not getting sight of the DWP figures? That has not come up. Apparently, according to the outlook, you were not able to model the full implications of the childcare measures “due to restrictions on the sharing of Budget-sensitive information between Departments”, so DWP not giving you data. Is that the case and is that normal? How do you feel about that?

Andy King: It is not a case of anyone not giving us data. The free childcare hours measure is a Department for Education measure, so the Treasury and DfE worked together on that. Obviously it has implications for recipients of universal credit, which is a DWP policy measure. What we term the interactions between the policies could not be modelled because the Treasury was not working with DWP on the DfE measure.

That is normal. In the past we have had issues, particularly early in the roll-out of universal credit, where tax credits that were being administered by HMRC would have implications for universal credit being administered by DWP.

Q114       Danny Kruger: It was not that you were not getting sight of data. It was that the data was not being shared at all internally in Government, so by DWP and Treasury themselves.

Andy King: DWP officials were not privy to a measure that was led by DfE, which meant that we modelled some of the interactions.

Q115       Danny Kruger: What is your view on that?

Andy King: The Treasury’s management of Budget secrecy is definitely a matter for the Treasury. We work within the rules that it sets.

Q116       Danny Kruger: Okay, but it makes it difficult to do the sums, which I am going to come on to in a second. Thank you for explaining that. Coming on to economic inactivity and the long-term sick, the outlook also notes that much of the increase in long-term sick came from those who were already inactive before pandemic changing their reason for being inactive during it. That suggests that they did not contribute to the increase in inactivity post-pandemic, because they were inactive before it. They just changed the reason for it. Why do we think that people have changed their reason for inactivity? What were they citing before and what are they citing now?

Andy King: This was definitely the puzzle we spent most of our time wrestling with in putting together this forecast. If you look at the headline labour force statistics, it is very clear that the increase in inactivity is dominated by the increase in long-term sickness. By that, we mean people who, when asked by the ONS, “Why are you not in work or looking for work?”, say, “My primary reason is long-term sickness”. As of the latest data, that is 400,000 out of 500,000.

Other analysis has shown that early retirement is a reason for flowing out of employment, but you cannot see that in the data on the number of people who are inactive. Other analysis also says that the rise in long-term sickness is people either changing what they have said or remaining out of work for longer. Three years ago, perhaps they were already out of work for three years. Now they have been out of work for six years and they say that long-term sickness is their reason.

The reason why we puzzled over it was that two different ways of looking at the data from the same survey give different answers. We kept thinking that we would be able to wrestle this into a position where there was a consistent answer and it is not the case. Clearly, there has been a health crisis in the pandemic and there are considerable problems in the NHS. It is not surprising that, due to either the duration for which people are inactive because of sickness having gone up, or people becoming sick who were not before, that should be a source of rising inactivity.

The thing that is hugely uncertain is just how important it is. You can retire, feel sick and change your mind as to how you—

Q117       Danny Kruger: To understand that, you are suggesting that the same people were inactive before, and we would have expected many of them to cease being inactive in the normal course of things, but they have remained inactive, maybe citing a different reason. Does that account for the increase in inactivity levels? You are talking about the same people being inactive before and after, which suggests that there should be no particular increase, but there is an increase.

Andy King: In the normal course of events, some people stop being inactive and that seems to be lower than normal. They are remaining inactive for longer. Also, more people are flowing into inactivity than normal. These trends are particularly visible for those over the age of 50. I think the answer is that there seems to be a bit of everything going on. An uncertain but large share of it is related to health, but there are several other things going on.

For the younger working age or middle working age cohort, sickness has been on the rise, but it has been disguised overall because the number of people at home caring for young children is falling. That is because the birth rate is falling. There are fewer children to care for. Those things have been largely offsetting.

There are other parts of the labour market surveys that show that there are far more people in work who say they are disabled and far more people out of work who say they are disabled. The proportion of the population who report to the ONS that they are disabled has been rising. It has been rising for a long time and it has been rising more quickly over the past three years.

Q118       Danny Kruger: That is helpful. It is still very mystifying, but that is a very helpful explanation, so thank you. On childcare, this very significant package is obviously intended to increase the numbers of people going back into work sooner. I am sorry if you have covered this already, but what is your sense of the effectiveness of this measure, bearing in mind that only 40% of parents eligible for the three and four-year-old offer of free childcare take it up? Do you agree that it is likely to be a smaller proportion of parents with even younger children who would take it up? Do you regard that as good value for money and an efficacious policy in order to increase labour force participation?

Andy King: As I understand it, there are very different take-up rates for the different childcare offers. There is the 15 hours of free childcare that is available to everyone once their child is three, where the take-up rate I think is over 90%. There is then the additional 30 hours for working parents of three-year-olds at the moment, where I think the take-up rate is about 80%. Then there is tax-free childcare, where the take-up rate is 30% to 40%.

One thing you can take from that is that something that is more generous and simpler has a much higher take-up rate. This extends that more generous and simpler offer to those with children aged nine months to two years. The numbers assume that the take-up rate for those with younger children will be lower than for those with three-year-olds, but much higher than the tax-free childcare take-up rate.

              Sitting suspended for a Division in the House.

              On resuming—

Q119       Danny Kruger: On productivity forecasts, I think that you are slightly more bullish than the Bank. Is that fair to say? Can you account for why you think the growth will be slightly better than they think?

Richard Hughes: Yes, our growth forecast is, as was noted by Mr Baron, above the consensus and then significantly above the Bank, which is quite a bit below the consensus. It is a number of factors, some of which are the vintage of the forecasts that we produced. As we have discussed earlier, everybody is forecasting in a very volatile environment and some of the key forecast determinants are changing a lot just in the space of a month.

The Bank did its forecast in February. We did our forecast in March. Just between those two points in time, you saw gas prices come down. The Bank had them on average this year at £1.89. We had them at £1.50. That means that you have less of a squeeze on households’ and businesses’ finances in the near term, as well as less of a hit to productivity in the longer run, because gas prices fell not just this year but across the futures curve. That means that you have less of a weight from high energy prices on productivity and output in the longer run.

We had a slightly lower interest rate compared to the Bank. It had a bank rate of 4.4% at its peak. We had it at 4.3%. Some of those market drivers of both of our forecasts were different.

It also made a significant difference that we assumed that we see a fall in the participation rate over the period when the economy is contracting. Then it starts to recover towards the end of the forecast period and we get labour participation back to around 63%. The Bank assumes that it continues to fall from its current level down to 62.5%, so that is a more pessimistic outlook for the labour force.

Q120       Danny Kruger: What about on productivity itself?

Richard Hughes: In the long run we have a higher steady state assumption about the level of productivity than the Bank does. On average, we have steady state GDP growth of around 1.75%. They have, at the end of their forecast, around 1%, so there is a distinct gap.

Q121       Danny Kruger: What is the rationale?

Richard Hughes: It is mainly taking a different view on what you think is going to be the long-run productivity growth rate in the wake of the financial crisis. We assume that productivity recovers from its very low level post-financial crisis, but not back to its pre-financial crisis level. In effect, they assume that productivity never recovers and that whatever happened during the financial crisis that reduced both UK and worldwide productivity carries on.

Q122       Danny Kruger: You were explaining to Douglas your view on the business investment rate. It is a pretty depressing prospect if we are never going to recover our productivity, so I am glad you guys have a slightly sunnier outlook than they do.

Richard Hughes: There is some hope in our forecast.

Q123       Danny Kruger: Compared to other countries on productivity, how do you see us internationally, both now and over the medium to long-term?

Richard Hughes: All countries have seen a slowdown in growth in general. Since the financial crisis, more of that overall growth and output has come from the fact that we have been, up until recently, quite successful in getting people into the labour force, such as young parents, and getting older workers to work longer. That means we have been quite successful in getting more people into the labour market and getting more output just from higher employment. We have been less successful in getting output per hour to recover.

Q124       Danny Kruger: I see, okay. On that last point, output per hour is related to the migration question. I do not know whether that has been raised before. There are 250,000 net migrants per year in your predictions. Can we analyse the impact on productivity of increasing labour force participation through migration?

Richard Hughes: Our assumption is that they have the same employment rates and productivity as the resident population, so you do not get a productivity boost from high migration. You get an output boost, because you have more people coming into the country and the same proportion of that population working as the resident population.

Q125       Danny Kruger: Many of them are working in quite low‑productivity jobs, so presumably the net effect is actually to lower productivity per head.

Richard Hughes: The truth is that we do not know yet, because the regime has changed so much. The nature of the people who have come since 2020, when the migration regime changed, has been different in two respects. One is that we have seen very high levels of migration in the last year, but a lot of those flows were refugees. We do not know how long they will stay and how likely they are to enter the labour force.

Secondly, you have a very different kind of migration regime now applying to all people who come into the UK, because we no longer differentiate between EU and non-EU citizens. You have a migration regime that has a skills-based component to it, but is also granting visas to people for family reunification, for dependents and for students. We do not know to what extent those people are going to enter the labour force and into what kind of jobs. For now, the jury is out on what kinds of jobs they will be doing and what kinds of sectors they are going to be in.

Danny Kruger: You are assuming net effect. Fine, okay.

Q126       Dame Angela Eagle: I want to ask about living standards because you are forecasting the largest two-year fall in living standards since records began in the 1950s. Your forecast for this budget was slightly less bad, at minus 6% rather than minus 7%. Do you want to tell us what assumptions you made about the effect of that squeeze on consumption, because we are a very consumer-based economy?

Professor Miles: This is different from many other forecasters, but we assume that the household savings rate is going to be pretty low for the next few years. You can measure the savings rate excluding the part of savings that most people do not have much discretion about, because they are in company pension schemes and do not really see the money. They cannot not pay in without losing all the benefits of being in the pension scheme.

If you take that bit out and say, “How much are people saving out of the income that they have discretion over?”, we think that that savings rate drops down to pretty close to zero for the next few years as people try to see their way through this big squeeze on disposable income that is already underway. On our forecast anyway, that is partly temporary, because you then get a recovery a bit. It is partly on the back of gas prices being a lot lower down the road than they have been. That forecast gives a stronger profile of consumption than some other forecasters. The Bank of England would probably be an example of that.

Q127       Dame Angela Eagle: Do you mean in the near term or the medium term?

Professor Miles: I mean particularly in the near term, the next two or three years. It might sound as if a zero savings rate is an extraordinary and implausible assumption. It turns out actually that there are quite a few periods over the last 20 or 30 years where household savings rates for a few years have bounced around pretty close to zero.

We think that, given the squeeze on people’s incomes, they will dip into savings to the extent that they can. Many people will borrow if they can. Not everybody can. That holds up consumption a bit better than most other forecasts. It is one reason why, for the next couple of years, we have a markedly more optimistic forecast for total output than the Bank of England.

Q128       Dame Angela Eagle: There are internal differences depending on what income level you are at with this squeeze, is there not? We know that food and energy inflation are higher than the average and take up more as a percentage if you are on a low income than they do if you are on more medium-sized or higher incomes. You are also more likely to have some savings to draw on if you are on medium or higher incomes. Have you looked at what effect this is likely to have at lower levels? I know you are looking at macro, but have you modelled what is likely to happen at lower levels for lower-paid people?

Professor Miles: I suspect that you are right. It is much more difficult to, if you like, preserve your level of consumption when you do not have many savings to draw down and maybe it is difficult to borrow because you are at your limits of what you can borrow.

Q129       Dame Angela Eagle: Or you borrow from very dubious sources and have problem debts.

Professor Miles: Yes, at very high interest rates. There is no doubt that it is much more difficult, on very low incomes, to smooth the path of consumption through a sharp but to some extent temporary reduction in your income than it is for people who have accumulated some savings and maybe have the scope to top up a mortgage or just borrow unsecured from their bank. For sure, there are distributional impacts there.

Our focus tends to be much more in aggregate and macroeconomic. That is the judgment we have made, that the savings rate is a low one.

Q130       Dame Angela Eagle: We have a huge stealth tax coming in on income with the freezing of the thresholds over the next few years. I think that it is close to £30 billion of increases, with 6 million people dragged into higher levels of income tax equivalent to 4p in the pound on the level of income tax if it had been a non-stealth tax. To what extent do you think that that kind of higher effective tax rate for 6 million income tax payers is going to affect consumption and living standards?

Professor Miles: It is one factor behind the squeeze on real household disposable incomes. There are multiple sources, in a sense. It is partly because inflation has been high. Because inflation has been high and wage settlements have not kept up with it but are nonetheless higher than they were, that is what takes people into the higher tax bands.

Q131       Dame Angela Eagle: To be fair, if you had frozen income tax thresholds and inflation is 10.1% at least for this year and not zero by the end of the year, fiscal drag, even if they do not have much of a pay increase, will mean that people are dragged into higher rates. We have a cost of living crisis, falling real incomes and quite a substantial but stealthy rise in tax rates for people.

Professor Miles: You are right: it is a rise in tax rates. It generates more revenue for the Government. It is one of the many painful means of trying to close the gap between tax revenues and spending. I suppose that, at one level, you could say that the only source of tax revenue, in a sense, is the people of the country.

There are many ways you can get the money. You could try to do it through VAT. You could do it through corporation tax, but, ultimately, of course corporations are owned by households. At one level, it has to come from somewhere and this is just one of the more important ways of trying to close the gap and stop the stock of debt carrying on going up.

Richard Hughes: In the EFO we provide a breakdown of how household disposable income evolves over the five-year forecast period. You can see from that that, in the final three years of the forecast, net taxes and benefits are acting as a downward drag on the recovery in household incomes. As they recover, they are paying higher rates of tax as they drift up through tax system. By the fifth year of the forecast, it is acting as a drag of about 0.5% or 0.6% on offsetting what is otherwise a recovery in household incomes, because you have falling inflation and nominal wages start to recover more quickly than inflation.

Q132       Dame Angela Eagle: Do you think that there should there be more transparency about these tax levels? Do you think that the Office for Budget Responsibility ought to have a role in setting that out more effectively? I know your report is thick enough as it is, but perhaps there could be more transparency.

Richard Hughes: We try to be as transparent as we can about this. Andy has got open in front of him a two-page box that we provided on how many more basic and higher-rate taxpayers are being created by the freeze in thresholds and how much more they are paying in tax.

We have tried to spell this out, not so much to be unpleasant to the Government, but just to show this is a really big source of where the Government is getting extra revenue over the next five years and why the tax burden is going up. It is accounting for anywhere between one percentage point and two percentage points of that 5% rise in the tax burden over the period between the pandemic and the end of our forecast.

Q133       Dame Angela Eagle: How do the falls in living standards in the UK compare to other countries in the G7 experiencing high inflation?

Richard Hughes: To be honest, I am not sure I could give you a comprehensive answer. Because we are so dependent on gas as a source of both electricity and heat, it has a much bigger impact on households, because there is a double-whammy. You are using it for heat and for power. In that sense, we have felt the cost push part of it much more than other European countries. For that reason, we probably do face one of the bigger cost of living squeezes.

One thing we do point out in the report, however, is that the Government are also providing a relatively generous support package compared to other countries. That is partly offsetting the fact that they just have more of a problem to deal with, but we do have one of the bigger energy price support packages provided here compared with the rest of Europe.

Q134       Dame Angela Eagle: Were you surprised that, as you were trying to do your forecast, talks were ongoing on public sector pay but you were not given any indication about what might be happening or any money that was set aside to cover the costs of some of those issues?

Richard Hughes: Those things are matters for the Government.

Q135       Dame Angela Eagle: Literally the day after the Budget an announcement was made about an offer. We still have to see whether it will be accepted, but it seems almost like they were doing it behind your back and not giving you an indication of what might be going on. In earlier times, the OBR was given indications like that of what was on the Government’s agenda and what was likely to happen. Were you totally blindsided by that?

Richard Hughes: We were not told about the pay deal in advance. I would not want to ascribe motives for that. Had we known it, we would have reflected on it in putting together our inflation forecast. We did highlight in the EFO what we thought the risks to the fiscal outlook were from different possible outcomes of those wage negotiations and, in the end, it fell within what we thought was the risk band, which, admittedly, was quite broad. It was anywhere from £2 billion to around £11 billion worth of extra cost that could have arisen depending on where those pay deals ended up. We also just highlighted that it is not yet clear to us where the money is going to come from to pay for those pay settlements.

Q136       Dame Angela Eagle: I do not think it is clear to the Government yet. They are not actually saying. Just finally, if that sort of quite big thing is going on and is announced the day after the Budget, if there is a whole series of things going on that have quite a big effect but you are not included in, what does that do to the coherence and accuracy of the forecast that you can make?

Richard Hughes: It is good practice to have a comprehensive Budget that reflects everything you know about both the economic outlook and the decisions made up until then. We have been in a mode where we have been—

Dame Angela Eagle: At least you were asked.

Richard Hughes: We have been playing catch-up sometimes with what Governments do announce, but I agree that the general principle of knowing what all of the Government’s policies are at the time when you try to make an economic and fiscal forecast is definitely an advantage to its accuracy level.

Q137       Anne Marie Morris: Let me come to business investment and research and development. This is a growth budget, so these things really matter. Richard, in your post-Budget speaking notes, you said that cumulative investment of £340 billion is 20% lower than the 2016 forecast. What are the implications of that lower figure?

Richard Hughes: The implications are that you just have less capital per worker now than what we had assumed back when business investment basically stropped growing, which was in 2016. By having less capital per worker, you get less productivity out of those workers because they are working with less than what would have made them more productive. A lot has happened since 2016 and it is a puzzle that the UK’s investment has basically flatlined since then. In other G7 countries, it continued to grow.

A lot of factors go into explaining why that happened. Brexit is almost certainly one of them. The pandemic is another, as well as the energy price shock and then the rise in interest rates. All of this has added to the uncertainty around the investment environment that firms are coping with. Alongside that, you also have both a higher rate of corporation tax and general uncertainty around the corporate tax regime, both of which have been created over that period.

There are a lot of factors that can explain why we have had such a disappointing investment experience. Our forecast assumes that the measures taken in the Budget make some temporary difference to that, but not a permanent one because they are not permanent measures.

Q138       Anne Marie Morris: Were you surprised that there was no R&D target? Over the years, there have been research and development targets and, over the years, they have been coming down. Should we read anything into that?

Richard Hughes: I am not surprised given what I have said about just how unpredictable Government policy has been more generally in the space of tax incentives for business investment. There were some measures on R&D support in the Budget. Andy, do you want to say more about that?

Andy King: I am not sure if the lack of mention of an R&D target was because it has not changed rather than that it no longer exists. My understanding is that the £20 billion R&D Government spending target from the autumn still exists. I am less clear on the 2.4% of GDP whole‑economy one, because the statistics have been revised in such an enormous way that that target is met but partly because the statistics have been brought into line with what can be seen in the tax credits data.

As we talked about in the autumn, part of what has been going on with the tax credits is misuse of them as well as use of them by R&D-intensive businesses.

Q139       Anne Marie Morris: Given the importance of research and development and business investment for any growth agenda, did the Government miss a trick? Were there things that you had thought, or maybe even discussed, that could have been done to drive forward this growth agenda? One thing that seems to me to be an area that the Government started looking at was the life sciences industry.

Though it is clearly not a fiscal measure, even the changes they were suggesting in terms of how MHRA might operate going forward are an additional step. When you looked through this and produced your report, did you think about the Government’s overall growth strategy, their industrial plans, the life science strategy and now the latest high tech? Did you look at it and say, “If that is the overall policy objective, do we have the right fiscal measures to drive that”?

Andy King: No. We have not looked at the sector-based plans in that way. The final question of whether the Budget includes the right answers would not really be one for the OBR. The things that we looked at in very great detail were the labour supply measures and the full expensing measure.

On the R&D side, we looked at the fiscal rather than the economic consequences of the latest tweak to the scheme. My reflection on the R&D tax credits over the past few years has been that you can see the policy rationale and the challenges that come with it in the way this policy has been changing. R&D tax credits is one of the growth policies that has the best evidence basis. Therefore, make it more generous. Make the scheme more generous and people will abuse it as well as use it, so make it less generous.

Then, those who were using it legitimately complained, legitimately, so there is a new way of trying to target its generosity. It is a nice case study in how, in growth policy, you know your objective and you have your tools, but there is always unintended side effects that you are aware of that become greater than you expected.

Q140       Anne Marie Morris: When we look at these new investment zones, given all that you have said about some of the challenges of making these things work, are you aware of any more details than anybody else at the moment? I suspect, if you are, maybe you are unable to share it but, at the moment, it is fairly opaque to see exactly how this is going to work, how it is going to deliver the kickstart to growth and encourage the investment that clearly the Chancellor is after. Do you think that they are going to work? Has enough been put on the table to explain how they are going to work, to give you any confidence that they will contribute to the growth agenda?

Andy King: Happily, I am not aware of anything that you are not aware of, so I do not have to watch what I say. The simple fact of the investment zones, as described from an OBR perspective, is that it is £1 billion over five years. It is just too small. It will not have a macroeconomic effect. These zones might have extremely important effects where they happen, but macroeconomically £1 billion over five years is sub rounding error.

The model as described certainly has a lot of similarities to the freeports, and the freeports are something that we have factored into the forecast. When we did, we looked at both the economic and the fiscal implications and we decided that, while we were scoring the fiscal implications, the tax reliefs, for the purpose of the economic forecast, we would assume that the activity in freeports was displaced from other parts of the country.

That may not be how it works out in practice. That does seem to be how the enterprise zones from a decade ago worked out and that is part of the reason why we took the judgment we did. The Treasury was very aware of that evidence when it was designing the freeports and is trying to make sure that they are additional rather than displacement. I am sure the same will be true of the investment zones; it will try to ensure that it does not rob Peter to pay Paul.

We will look at the fiscal implications once the details are available—some of it is spending; some of it is tax reliefs—but, as I say, at £1 billion over five years it would be too small to have a macroeconomic effect.

Q141       Anne Marie Morris: You probably cannot comment on quantum, in terms of the steps that have been taken in this Budget to try to drive growth through investment. I am curious as to whether or not, going forward, that is the sort of question that the OBR might look at. From the answers you are giving me, there seems to be a separation between the economic outlook and forecast and looking at fiscal measures purely within a box that says, “Fiscal measures”, rather than looking at the two together. Am I misrepresenting or misunderstanding?

Andy King: We look at the two together when they are large enough to have an implication. The full expensing measure, for example, has had a material impact on the investment forecast. It is near enough £10 billion a year, not £1 billion over five years. It is orders of magnitude that often are key.

Q142       Anthony Browne: I am going to follow up with some questions on the capital allowance and also R&D tax relief. Douglas asked earlier about the fact that capital allowance is temporary for three years and you said, if I understood you rightly, that growth would be greater if it was permanent than if it was temporary. The CBI estimated that, if the growth was permanent, it would be equivalent to a 2% jump in GDP. What is your estimate?

Richard Hughes: We have to be careful about scoring alternative policies. We do not put a firm figure on it. We think that, if it were a permanent measure, it would have a more lasting effect on the level of GDP, possibly on the order of a few percentage points. You can see from the fact that just a temporary measure raises investment by 3% in the three years in which it sits that it, in effect, makes a difference.

Because some of that is bringing forward investment to take temporary advantage of it, you might expect that to be more than the steady-state effect, but it could certainly make percentage point differences to the level of investment over the forecast period. I would struggle to get to something that would have percentage point impacts on the level of GDP, just given the fact that investment is not that large a share of GDP in general.

Q143       Anthony Browne: It sounds, from what you are saying, that it is quite an effective policy. Were you expecting it to be?

Richard Hughes: We would not have put it in our forecast if we did not think it was effective. Something that we have learned as a result of the Government’s various tinkering with the corporate tax regime over the recent past is that we saw a more generous version of this policy recently, with the super-deduction.

By offering a 30% tax subsidy for investment, we thought that was going to generate a 10% increase in investment volumes during the period it was in operation. We were wrong on the order of 50% in that it only had a 5% impact on investment. We were recovering from a pandemic and in the middle of an energy crisis, so there may have been, to some extent, mitigating factors, but we are still recovering from a pandemic and in an energy crisis.

Q144       Anthony Browne: A lot of investment pipelines are more than two years. Companies take time to decide to invest. They are not always in the position to take advantage of short-term relief.

Richard Hughes: Yes, that is right. Giving three years gives companies a bit more time to take advantage of the tax allowance. That is one of the reasons why you have a smaller effect from this measure on the order of just over 3% for the three years in which it is in effect. The lessons are being learned given that a 130% super-deduction only resulted in 5%. A 100% super-deduction is going to get you something less than that.

Professor Miles: One of the great attractions of 100% first-year allowances or full expensing is that it neutralises the impact of the corporate tax burden in the sense that it leaves the incentive to invest for a company essentially where it would be if there were no tax system. Most people would agree that neutrality of the tax system, as regards the incentive to invest, is a good thing. I suspect that the Government see it that way as well. As we said at the outset, the reason why it is three years and not permanent is that it is not cheap. It is expensive. It costs you £9 billion, but there is a prize at the end of it, if that is where you get to.

Q145       Anthony Browne: There is a debate about the fact that the Government have increased the corporation tax rate up to 25% for companies with profits of over £250,000, which raises money and is offset by this tax cut. The Government have to raise money from different sources. The question that should be asked, which never is asked politically, is whether, if it is going to raise £5 billion from companies, it is better to have a higher corporation tax rate but target the reliefs as investment, as it is doing, or whether it is better have a lower corporation tax rate that spreads the favours across all sorts of activities.

George Osborne was just trying to increase the return of capital in general by having a lower corporation tax rate but not much relief for investment. Now, we have gone full circle and we have a higher corporation tax rate, though still the lowest in the G7, but far more targeted relief.

Richard Hughes: It is definitely not one for us to decide what is a better policy for the Government.

Q146       Anthony Browne: But you need to model the growth impact of it.

Richard Hughes: We do. In our baseline forecast is an assumption that, in the absence of anything else being done and just having the increase from 19% to 25% in the CT rate, that would have reduced the level of investment by 2% by the time you get to the end of the forecast period. The super-deduction is helping to temporarily offset some of that but, because it is temporary, you do not get the full offsetting benefit of the capital allowance.

Q147       Anthony Browne: I know you said you did not model certain scenarios but, if it was permanent, you would expect it to more than make up for the 2% deduction.

Richard Hughes: You would expect it to have an offsetting effect, for the reasons that David gave. It makes companies indifferent from the point of view of the tax regime about investing.

Q148       Anthony Browne: I was a big, open advocate of full expensing and I pushed it on the Government, so I was delighted they did it. One of the reasons is that I could not see any rational reason to give full expensing for corporate entertaining, for example, or other things that have no long-term benefit but can be deducted against that year’s profit, whereas investment, which we want to encourage, you can.

I know accountants will come in and say, “You buy a piece of equipment and you use it over 10 years. You ought to divide the cost over 10 years”, but that is an accounting thing. That is not about real economics and real output. Until now, we have put a greater tax burden on businesses for productive investment than we have for corporate entertainment. Is there any rationale for doing that? Most regimes in the world do that sort of thing and it just seems nuts to me.

Richard Hughes: The Government’s rationales for doing things are matters for them.

Anthony Browne: This comes back to David’s point about neutrality.

Professor Miles: There is a strong argument, if you can do it, to get to neutrality of the tax system. After all, it is not as if we are China, where such a high percentage of GDP in the past has been allocated to investment that you might almost think that there was over-investment. Nobody thinks that is the UK problem. Something that reduces what you might call the tax disincentive to invest seems a pretty good idea, if you can afford it.

Q149       Anthony Browne: You just said there are strong arguments for tax neutrality. What would be those arguments, in summary?

Professor Miles: It is almost inevitable that most taxes cause a distortion to people’s behaviour one way or the other, usually stopping them doing something that they otherwise would do, either supplying labour or investing. If you can devise a tax system that gets rid of the distortions but does what you want it to do, which is raise money to pay for the things that Government think they must do, that would, in some sense, be an ideal tax system.

There is a good argument, if you can afford it, that full expensing achieves some of that and makes the tax system neutral and reduces distortions that otherwise act against investment.

Q150       Anthony Browne: It reduces the tax bias for staff parties. I know a couple of others have talked about it, but I will ask about the R&D tax relief. Just to declare a constituency interest—it is enormous in South Cambridgeshire—a lot of my firms were very upset by the reduced rates. The firms in my constituency are genuine research firms that have spent huge amounts of money on research and make losses for decades before they can turn any profit. Do you think the targeting that they have done here will be effective at reducing fraud? Again, you might say that is not your area, but you do have to calculate what the overall cost of it is going to be.

Andy King: The combination of what they did in the autumn and the degree of unwinding of that and targeting that they did this time will reduce fraud, or the tax gap or the credit gap, however it is determined. That is reflected in the forecast. Part of the money that was raised by the measure in the autumn was an assumption that the degree of misuse of the scheme would be reduced whereas this targeting, as with any scheme with rules, gives someone an opportunity to break those rules. It is not that there will be no misuse of the new expansion, but we do not assume that it will have the same degree of misuse as the most generous scheme pre-autumn did.

Q151       Anthony Browne: For those companies, the new scheme is as generous as the previous one, so it should have the same impact on the amount of R&D done. I do not know if you model that. I assume you do.

Andy King: I do not think we have modelled that, but that does sound right.

Q152       Dame Andrea Leadsom: I would like to cover some of the impact of Government policy decisions, specifically the childcare policy and the energy policy. To start with, I would like to know to what extent you do modelling and analysis of behaviour changes when you do your estimates of what a particular policy will do to the workforce.

Richard Hughes: We do model behavioural changes for all of the policy measures that we score in the public finances. We model both behavioural changes of demand, where they support household incomes and we think they will make a difference to how much people will go out and spend in the economy, as well as behavioural changes to how much they supply in terms of labour.

With the childcare measure in particular, it has two main behavioural effects that make a difference to our economic forecast. One is that you get 60,000 more parents of young children into the workforce as a result of those measures. There would be a further boost to output from the fact that parents of young children, who are currently paying for childcare, will be getting some of that paid for by the taxpayer and will be able to work longer hours because they can afford to purchase even more childcare.

Q153       Dame Andrea Leadsom: It is very clear that you have done that modelling, but the question is, behaviourally, whether you survey parents on what they will do if they are able to work more hours because someone else is paying for childcare. What is their likely behavioural response to that?

Richard Hughes: We would love to have the time and resources to survey people as a way of informing our estimates. The reality is, given the time we have to digest these things and try to reflect them in our forecast—it is really just a matter of weeks, if not sometimes days—we have to go with what evidence there is out there of the effectiveness of similar types of interventions, either in the UK or in other countries.

The reason why we arrived at the 60,000 increase in employment amongst that group of younger parents was by looking at what happens to their immediate neighbours, parents of children aged three to four, and what effect the policy of free childcare for three to four year olds had on their employment rate versus that group of parents just below it at the nine months to two years. We assumed that, by getting a similar level of support, there was some convergence in their employment rates towards what you saw for three to four year olds but not all the way, because, if you have younger children, you are less likely to enter the workforce.

Q154       Dame Andrea Leadsom: Yes, exactly and, if you are extrapolating from parents of three year olds, that is very different to parents of less than one years old in terms of their desire to go to work. I would be interested to know to what extent the Treasury haggles with you over its forecast of the employment impact over what you actually model and predict. Did you have a big disagreement with the Treasury on this particular figure?

Richard Hughes: We always have an exchange of views with the Treasury over what I would term indirect effects of policy—not the direct effect on the public finances, but the second-round effect of the policy on the economy, which then feeds back into our fiscal forecast.

Q155       Dame Andrea Leadsom: What did the Treasury think that this childcare policy would do to the workforce?

Richard Hughes: Unfortunately, I cannot get into confidential discussions we have in putting together Budgets for reasons you would understand.

Q156       Dame Andrea Leadsom: Was it significantly different to your forecast?

Richard Hughes: Again, I cannot get into the details. We rely very heavily on what published sources say about the effectiveness of these policies.

Q157       Dame Andrea Leadsom: But we do not know, do we? The childcare policy is a very specific point. There are not loads of business studies. Did you do some international comparators, for example? I believe you personally advised the French Government. How does it compare with French policy and impact on workforce?

Richard Hughes: We did look at models in other countries. In particular, there are similar, more generous provisions in other European countries, especially in Scandinavia, and they do lead to higher employment rates amongst parents of young children in those countries. You always have to slight adjust for the fact that no two countries are the same.

There are lots of cultural factors that make a difference to expectations of young parents going back to the workforce and very different obligations placed on employers to take young parents back into employment, based on what the regulatory obligations are. You cannot just assume that we are suddenly going to become Scandinavia overnight in terms of our employment rates, but we do put a lot of weight on what we see based on empirical studies of similar interventions in the UK, as well as the effect of these kind of interventions in other countries.

Q158       Dame Andrea Leadsom: In terms of the supply side of childcare places, I appreciate it is not for you to determine the policy, but did you do some assessment of whether this policy can in fact work in practice due to supply-side constraints? Do you have a number for what the nursery settings say is the cost of provision versus what the Government are offering?

Richard Hughes: In the course of kicking the tyres and offering challenge to what would be a realistic implementation period for this policy, we did ask questions around how much would be paid for childcare and how quickly the supply side of the economy could be ramped up. We took note of the fact that the Government are increasing the ratio of children to carers, which alleviates some of the supply-side constraint, though no doubt with consequences. They are also increasing the per-unit funding for carers by 30%, which would, all things being equal, improve the attractiveness of going into the care sector.

They are phasing it in over a period of time, but it is an ambitious timetable for delivering it. That is one of the reasons why we have particularly emphasised in this book the uncertainty around the economic impact. It could be greater than 60,000, but it could also be considerably less than 60,000, with supply constraints being one of the key reasons why it could underperform against that target.

Q159       Dame Andrea Leadsom: Bearing in mind what a very new and untested policy it is, you have not done a fan that says, “At maximum it could lead to this. At minimum, it could lead to that”.

Richard Hughes: We have. In the costing, we provided different scenarios for this and the other labour supply packages. We do think there is considerable uncertainty about what the overall impact is going to be on the labour participation rate coming out of this.

Q160       Dame Andrea Leadsom: The Resolution Foundation analysis suggests that the poorest fifth of households will be £420 a year better off under the current tax and spend policies, middle-income households will be £750 a year worse off and higher-income households will be £2,000 a year worse off. Is there any crossover with this particular childcare policy? Are we in a position where you can, by virtue of being in the poorer fifth, increase your income under Government policies at the moment? Are we in an uncomfortable position where we are encouraging people not to work, giving with one hand and taking away with the other?

Richard Hughes: There is a combination of two things going on in this Budget that make a difference to the work incentives for people, especially those on higher incomes. One is the fact you have frozen thresholds for the basic rate of income tax as well as higher rates of income tax and NICs. Lots of income tax now comes from people at the top end of the income distribution. They are facing a much bigger tax take as their earnings go up. In effective tax rate terms, they are losing out more than people at the bottom end of the income distribution.

On the childcare measure in particular, because there is a £100,000 cap on the household salary of the people who can take advantage of it, there is a cliff edge. When you get to £100,000, on top of all the fiscal drag you get from the fact that more and more of your income is being taken up in tax, you also face a sudden withdrawal of your entitlement to free childcare once you get to that £100,000 level.

Q161       Dame Andrea Leadsom: In terms of user testing this range of policies, in effect, we are saying, “We are being much more generous to you at the lower end and much more harsh to you at the top end”, with cliff edges all the way through. You have not modelled what that does to the workforce. I am just interested in the fact that you are saying that this childcare policy could improve workforce participation, but we have lost 400,000 people. What are their motivations? Have you done any work on that?

Richard Hughes: We have. There is quite an in-depth exploration of this, where we are trying to understand the 500,000 people we have lost from the workforce and why that has happened. That is broken down both by age cohort as well as the reason they give for being out of the labour force.

Within each of those cohorts you have seen a rise in inactivity recently, but some of that falls away for a range of reasons. Partly, we expect some improvement in the NHS backlog. To the extent that access to NHS treatment is keeping them out of the workforce, that will help them back into the workforce. The childcare measures also make a bit of a difference, as well as a general recovery in real incomes, which helps to sustain and improve the returns to work.

In that sense, we do try to explore, in as much detail as the data will allow, what has been driving the loss of labour supply we have faced since the pandemic and what might drive its recovery over the next five years.

Q162       Dame Andrea Leadsom: I have one final question on the energy policies. Much has been made of these helping the cost of living over the next three months, at which point energy prices should come down naturally. As a long-term strategy, appreciating that this is for the Government to decide, has the energy price cap been shown not to work on the grounds that now everybody is subject to subsidised energy so nobody is exposed to the energy price cap? It has also meant a number of suppliers going bust.

Have you done any modelling on the advantages, for example, of requiring fixed-term energy prices to be offered by energy suppliers or indeed a basic level of subsidised energy to all households? Do you not do any of that sort of policy analysis?

Richard Hughes: We certainly do not look at alternative energy strategies because that is not within our legal remit. It is fair to say that an energy price cap system is always going to be better at protecting incomes than it is going to be at improving marginal incentives.

It is important to note that household energy prices have gone up an awful lot, and they are having a noticeable difference on energy consumption. We have seen energy consumption drop by around 15% since energy prices went up. That is more or less consistent with what we would expect in terms of gearing ratio between a rise in energy prices and a change in energy consumption.

Households are still exposed to quite a big increase in the cost of energy, just not the very big increase they would have faced had we allowed wholesale prices to feed through entirely into retail prices. They remain higher over the medium term. They are about twice as high as they were pre-pandemic.

The incentives to economise on energy and to find alternative sources of energy that are cheaper are still there by the time you get to the end of our forecast, and the EPG is not in place. It is the case that, at least over the last 18 months, the energy price guarantee had dulled what would have been some very strong incentives to economise on energy, if your bill had gone up not just two or three times, but five or seven times.

Q163       Chair: Did the Treasury share with you what rate they are planning to pay nurseries for the childcare at each age bracket?

Richard Hughes: Yes, I believe they did.

Q164       Chair: Is that in the public domain? Did you put it in your report?

Richard Hughes: We certainly reported on the fact that it would be going up by 30%.

Andy King: The precise rates are not in the public domain. As Richard said, when we were looking at the deliverability of the policy, we looked at the assumptions they were making in the allocation they would put into the DfE DEL.

Chair: The rates themselves are to be confirmed.

Andy King: Yes.

Q165       Emma Hardy: We have had really interesting evidence this afternoon. That policy uncertainty and the impact of that was repeated yesterday. Paul Johnson highlighted this regarding the pensions announcement. He said, “The lack of any coherent strategy here remains deeply disappointing. Do not forget these changes are largely a rowing back on changes made just a few years ago by this Government”. Who knew George Osborne was a socialist?

I want to focus a little bit more on the changes to pension allowances. What would have been the cost of the lifetime and annual pension allowances, if they have been targeted only at doctors?

Richard Hughes: I am not sure we know the answer to that question because it does fall into the territory of what-ifs about policy rather than what the Government introduced.

Professor Miles: You could say the following. It looked to us that, if you looked at who has amounts in their pension at the moment that, over the course of the next five years, could get them to the old £1 million lifetime allowance, it was a pretty large number. It was potentially 500,000 or 600,000. That looks at how much people have in their pension pots at the moment and makes a broad-brush assumption about the rate of return on their assets over the next five years, which would take them up quite materially.

It looked to us like there was a large number of people who could have been getting to the old £1 million lifetime allowance. That was a number that was very much larger than just consultants in the NHS, who were facing it right now.

Q166       Emma Hardy: The evidence that we had yesterday—I believe it was Torsten, but it could have been Paul Johnson—said they thought around a quarter of the people to benefit from this change to pensions were doctors or senior highly medical staff. They thought about 20% of the people who would benefit worked in the financial sector. Would you make a similar judgment?

Professor Miles: I am not sure. The numbers I have seen are estimates of numbers of people who have a stock of assets at the moment in their pension in different ranges. Those were £600,000 to £700,000, £700,000 to £750,000 and numbers like that. I have not seen an identification of where those people are. It is pretty clear they are relatively highly paid people, but my instinct—this is not firm knowledge—is that it is wider than just doctors and people who work in the City of London. It will be wider than that.

Q167       Emma Hardy: Torsten said there were a similar number of doctors as bankers working in the financial sector.

Andy King: Torsten is working off the same data set we did. We just have not gone into the individual sectors. We do know that, as he said and as his institution’s report on the day after the Budget said, it is not far off 50:50 private sector and public sector.

The reason we need to know that is because the implications of the measure are very different for those who work in the private sector compared to those who work in the public sector. At least the implications for the public finances are different because, if those who are in the public sector choose either not to opt out of their pension scheme or to opt back into an unfunded public sector scheme, their pension contributions go to pay for today’s pensioners in those schemes. That saves money on the public sector side.

On the private sector side, people being able to save more into their £1 million-plus pots, subject to the annual allowance restrictions, is a cost because that is a tax-relieved contribution.

Q168       Emma Hardy: We know that judges have their own exemption and their own lifetime allowances. Have you done any modelling on what it would look like if this did only apply to doctors and medical staff? What would the cost be, bearing in mind the point you just made about private sector people costing the taxpayer and public sector people potentially saving us money?

Andy King: No. As Richard said, we are proscribed from costing alternatives.

Q169       Emma Hardy: The Times also reported on the inheritance tax impact of the possible removal. It said: “The changes also raised concerns that the Government had created a new inheritance tax loophole because any unused elements of pension pots are not subject to inheritance tax”. Have you done any analysis on or looked into the potential ramifications in terms of the loss in inheritance tax of this limitless pension plan?

Andy King: The impact of the measure itself will not have large inheritance tax implications within the next five years. The numbers you have seen in the Budget do not assume a loss of inheritance tax. The inheritance tax loophole was opened up with the pension flexibility measures in 2014, when the 55% charge on inherited pension pots was removed and, very importantly, when the requirement to annuitise when you are 75 was taken away.

The requirement to annuitise meant there was nothing left in defined contribution pots for those over the age of 75. Now you can leave as much as you are able to leave in there, if you want to protect your assets from inheritance tax. As the newspapers have been pointing out, this is an established way of avoiding inheritance tax. The impact of the measure itself will be to allow a little more of that, but the amount you can capitalise on it over and above what you could before is constrained by the annual allowance.

If you are very wealthy, the annual allowance is just £10,000 a year. If you have a very high income, the annual allowance falls away to £10,000 a year. That is why we have not assumed an inheritance tax effect within the five years of our forecast, but it is something you would expect to build up over the longer term.

Q170       Emma Hardy: You have said you might not expect to see that over the next five years, but you are expecting to see it later. Do you have any plans to look at the impact of this change on inheritance tax?

Andy King: Yes, absolutely. It is something we will have to look at. More generally, because of the time it takes between even the 2014 reforms and the growth in defined contribution pots that can then be bequeathed, the lead times on this are very long. The IFS has done a nice piece of analysis on how this is likely to be growing. Yes, it is an issue we will need to come back to.

Q171       Emma Hardy: Potentially, from these changes to the pension allowance, you are going to have people working in the private sector gaining at the benefit of the taxpayer through the pension pot and gaining at the benefit of the taxpayer through the ability to avoid inheritance tax.

Andy King: If they are able to live through their retirement without using their pension pot, yes, they can pass it on inheritance-tax-free.

Q172       Emma Hardy: In your economic and fiscal outlook report, you said that these changes to pensions will increase employment by 15,000. As I am sure you have seen, the IFS thinks that is a very optimistic figure. There were various calculations as to whether this is going to cost taxpayers £100,000 per extra person in the workforce or £80,000 per extra person in the workforce. Could you talk through how you got to the figure of 15,000? What is your calculation of how much we are paying per person because of these changes?

Andy King: Again, that draws on the same survey you were talking to Torsten about yesterday, the wealth and assets survey. In that survey, you can see that people do try to avoid going over the £1 million lifetime allowance. The distribution of pension pots by size is not smooth. A lot of them are in the £950,000 to £1 million bucket.

The underpinning micro data of that survey can also show you that the employment rates of people who have pension pots of that size are lower than the employment rates of people either side of them. That tells you that one of the ways people make sure they do not go over the LTA is they stop working.

It is from that piece of data that we get the 15,000 figure. It is worth saying that it is hugely uncertain as to why people have pension pots of that size. It might be a coincidence, but it does look like there is something going on because it is different to people either side. It is a top-down estimate. Just in case your next question is, “How many are doctors?”, we do not know. In general, for both the tax costing and the employment estimate, the data here are not great. The uncertainty around this is large.

Q173       Emma Hardy: The figure for how many people are going to be back in the labour force because of these changes to pensions is completely uncertain, and therefore it is uncertain as to whether it is costing the taxpayer £100,000 per extra person or £80,000 per extra person. We just do not know. Is that right?

Andy King: There is uncertainty around the impact of the measure on tax. The number of lifetime allowance charges has been rising quite quickly over time. We have to make a projection for how much it would have risen over the next five years, absent the measure, and the measure then takes that away. That is uncertain.

It is uncertain how much people will save into their pensions as a result of this. The “hundreds of millions” cost is uncertain, and then the 15,000 is particularly uncertain. That is taken from a survey. We are then dividing one by the other.

Q174       Emma Hardy: We have potentially spent £1.1 billion on this with no certainty that it will have any impact on the labour market, which is interesting.

Andy King: It is our central estimate. You can see in the data that the employment rate is lower for people—

Q175       Emma Hardy: Yes, I understand that. Say we have the 15,000 people going back into employment. Let us pretend that will happen. Do you see that they will start paying income tax on this? If that happens, if you have the 15,000 and they are paying income tax on their income, could that counteract the cost of the pension change?

Andy King: It is factored into our forecast now. It is a modest offset because it is only 15,000 people. We assume these will be high-income people, but, even so, it is modest.

Q176       Emma Hardy: Even if we get the 15,000, which the IFS thinks is very generous, that is not going to equal the amount of money we have spent on changing the pension system.

Andy King: The entire Budget, the labour supply package and everything that goes before it, adds almost £4 billion to revenue in the final year, of which the childcare measure is by far the most important.

Chair: Thank you to the Office for Budget Responsibility for coming in and giving us all this evidence. I think I speak on behalf of the whole Committee when I say we very much welcome the fact you did publish your report alongside the Budget. Thank you very much for being here.