Treasury Committee 

Oral evidence: Budget 2024, HC 320

Tuesday 5 November 2024

Ordered by the House of Commons to be published on 5 November 2024.

Watch the meeting

Members present: Dame Meg Hillier (Chair); Dame Harriet Baldwin; Rachel Blake; Chris Coghlan; Bobby Dean; John Glen; Dame Siobhan McDonagh; Lucy Rigby; Dr Jeevun Sandher; Yuan Yang.

Questions 1 - 102

Witnesses

I: Richard Hughes, Chair, Office for Budget Responsibility; Tom Josephs, Member, Budget Responsibility Committee; and Professor David Miles CBE, Member, Budget Responsibility Committee.

Examination of witnesses

Witnesses: Richard Hughes, Tom Josephs and Professor Miles.

Chair: Welcome to the Treasury Select Committee on Tuesday 5 November. Today we are really pleased to welcome the Office for Budget Responsibility to give us evidence on the Budget. Obviously, they are a key part of the Budget process.

I am pleased to welcome Richard Hughes, who is chair of the Office for Budget Responsibility. He needs no introduction. He is joined of course by Tom Josephs, who is a member of the Budget Responsibility Committee, and by Professor David Miles, who is also a member of that committee.

We are here today to dig into the Blue Book and find out what the OBR’s take is on the Budget ahead of meeting the Chancellor of the Exchequer tomorrow. Of course, this afternoon we have further witnesses as well. I am delighted to welcome you. I will pass to John Glen MP to kick off.

Q1                John Glen: Thank you, Chair. It is a great privilege to have you here. Obviously, the OBR is a significant arbiter of truth, or is deemed to be, when we get to fiscal events. I want to ask about GDP and how you calculate what the expectation is going forward. There is a lot of controversy around that.

If we look at the last four years since the pandemic, we have an annualised rate of about 0.6%. Recently, in the first half of this year, we have seen a 2.0% annualised rate. I want to clarify this: given how the OBR is markedly more optimistic, typically, than the Bank of England and some other forecasters, how do you assess the prospects of the Government coming into this fiscal event? Obviously, the first half of the year is rather different and appears to show an upward trajectory.

Richard Hughes: Let me start on that. I am sure that Professor Miles will want to come in. From relatively disappointing growth last year, close to zero, we have slightly revised up our forecast for growth this year at around 1.1%. We think that the combination of the momentum coming into this year plus the boost given to GDP by Government policies will boost that growth rate up to 2% going into next year. That is mostly a temporary boost to output from the demand stimulus coming out of the fact that the Government are increasing spending by more than taxation in this Budget. That raises GDP by around half a per cent. at its peak, but that demand effect dissipates over the remainder of the forecast and growth dips down to around 1.5% by the time you get to the end of our forecast period. That is a bit below our long-run assumption for the potential growth rate of the UK economy, which is around one and two thirds, but part of that below-trend growth is needed to take the demand stimulus out of the economy, which we assume happens over a period of years after this year.

Q2                John Glen: Can I probe a little bit further on that? Your assessment over the forecast period is that growth will be 0.7% lower than you did at the March event. One of the criticisms, to be fair to the Government, is that they would say that some of the supply side reforms that they envisage happening would have a positive effect over that forecast period. Can you explain to the Committee why that has not been factored in? Is it through historical optimism of Treasury forecasts, or is there another reason? Obviously, this Government have made a virtue of some of those reforms and headlined on them from day one. Is that a reasonable assumption on your part?

Professor Miles: The main pro-growth measure that will come through a little bit over the forecast horizon, but stronger outside the five-year period because it inevitably takes time, is the fairly substantial increase in Government public investment, increasing the public capital stock, which takes time to come through. There is a time lag between starting projects, spending some money on them and them actually coming on stream. Obviously, that is long with some things, such as building a new motorway or road, or a power station, and less with other things. On average there is a bit of a lag. That comes through a bit by the end of the forecast horizon, but more strongly after that assuming that the higher level of public sector investment is sustained beyond that.

There is a bit of an offset to that in terms of the productive potential. The real driver of growth over the long term in the UK is what happens to our productive potential. There is a bit of an offset from slightly lower labour supply as a result of the national insurance measure. That is a smaller offset than the positive effect you get from higher public sector investment.

The net effect of those things is that over the forecast horizon overall Budget measures do not move the dial very much on growth. Before the Budget measures we thought it was going to be about 1%, 1.5% or 1.6% over the forecast horizon. We think it is about the same after it, but beyond that you get the much more positive effects from the higher investment.

You are right, by the way, that we are more optimistic than the Bank of England has been on the growth potential in the UK economy, and a bit more optimistic than probably most other forecasters. That is because we have taken a view that, if you look back over the last 10 or 12 years or so, it has been an abysmal period for productivity growth in the UK. There are some reasons for that which are beyond what is happening in the UK. There was covid, the Russian invasion of Ukraine and the knock-on effects that that has had. We are not so pessimistic as to believe that the 10-year backward-looking average is what you might now expect going forward, so we have taken a view that the next 10 years—from now on forward, if you will—is about halfway between the dismal last decade and the much more positive 40 years previous to that. That is why we are a bit more optimistic than most.

Q3                John Glen: Can I turn to household spending and saving and the impact that has in the near term? Obviously, with what happened after covid, savings patterns changed. Could you say something about what you think is likely to happen with savings levels? There is an indication that they might still go up, as people feel insecure. What impact would that have on growth and economic activity?

Professor Miles: For reasons that are pretty easy to understand, the household saving rate became very high during covid. To a large extent that was because people’s ability to go out and spend money was much reduced, so no great surprise there.

What has been surprising is that it has not fallen back to anywhere near the very low levels it was in the years leading up to covid. We had thought that might happen, but it turns out that it has not happened. To some extent, but only a minor part of it, interest rates have subsequently moved up since the covid restrictions became much less severe. Interest rates, on balance, moved up a bit more than people had thought. That may be a bit of a factor. I suspect a stronger one is just heightened uncertainty about what the future might bring. Covid was a huge shock, and then you had the massive increase in energy prices after the Russian invasion.

Our best guess—hopefully, an educated guess, but not much more than that—is that the savings rate drops a little bit from its level, but it does not get back as low as it was pre-covid. Because consumer spending is the biggest chunk of overall spending on GDP and the economy, even relatively small changes in the savings rate can have a pretty big effect on demand and the economy.

Q4                John Glen: So a slightly lower interest rate will mean that people will save less and spend more, and that will be good for the economy. That is the essence of what you expect.

Professor Miles: On balance that is probably right. Part of it just naturally runs through the mechanism of mortgage rates being a bit lower and people having more disposable income, and that being more than an offset for people who have savings finding they have a bit less money because interest rates are lower.

Q5                Rachel Blake: Professor Miles, I was struck by what you said about Government investment in response to John Glen’s question around growth. I am really interested to know how you factored in the proposed planning reforms, and whether or not there is any dependence on the deliverability and the market’s response to those reforms to deliver on some of that growth.

Professor Miles: There is no direct estimate of the impacts in our central forecast, largely because we are still waiting for more specific detail on exactly what they imply and how that might play out. We have not factored in anything explicit about planning reforms boosting investment, particularly in housing, over the next five years. Things may become much more specific and clearer on the policies over the next six to 12 months. When that is right, we will factor something in. There is a bit of an asymmetry, in a sense. You would have to be very pessimistic to think that, whatever the plans are, they do nothing. The chances are that there will be some upside on investment, particularly residential structures, but we have not factored that in yet.

Q6                Rachel Blake: Is that because it is very difficult to forecast and understand because of regional impacts? Could it be a bit of that, or is it because of the lack of detail?

Professor Miles: It is a bit because of lack of detail. It is also because, as you rightly say, it is hard to know quite how effective measures will be. There has been a history in the UK—I am sure people here are fully aware of this—of Governments saying, “Well, we’re going to tweak the planning system and build more houses.” It is pretty difficult to move the dial.

Chair: Groundhog Day.

Richard Hughes: The details at the moment are sketchy. There are ongoing consultations. It is worth saying that what details we have are mostly about residential planning. If we are talking about business investment, a lot of what matters to businesses is the commercial planning regime and less the residential.

Q7                Chris Coghlan: Thank you for coming in today. I am very interested in the fiscal stimulus that you have in these forecasts. You have a 1% fiscal loosening, yet you have GDP only increasing by, as you said, 0.6% at its peak and a zero net effect over the five years. Why is that, exactly?

It implies that there is no real fiscal stimulus. Is it due to the quality of the multipliers that were used, or is it due to what it has been spent on? Is it going more on salaries, less on infrastructure and very little on R&D? If you could talk a bit more about multipliers that would be helpful.

Professor Miles: The big picture answer is that the UK, at the moment, looks like an economy with not a whole lot of spare capacity in the economy. The unemployment rate is pretty low. There may be some loosening in the labour market, but it is still the case that vacancies are historically quite high. A lot of surveys suggest that companies don’t have a lot of slack.

If you add some demand to the economy, which this Budget clearly does, you can get a short-run impact that is meaningful and is what drives the growth rate up to 2%. But, if you are running up against capacity limits, that is going to put a natural ceiling on how much you can boost GDP until the point at which Budget measures actually start increasing the productive potential of the economy. That happens significantly outside the five-year window rather than inside it. That is why it has not moved the dial a whole lot on growth over the forecasts around.

Q8                Chris Coghlan: Thank you. What I don’t fully understand, therefore, is that you have inflation going up by quite a lot, yet you say that there is a lot of crowding out. Also, taxes are going up significantly for the NI rise. The tax rises are generally more recessionary in terms of impact than spending increases. Is there not a bit of a contradiction there in terms of inflation going up so much?

Richard Hughes: There is a net fiscal loosening. Spending is going up by twice as much as tax. Net borrowing is up by about 1% of GDP. That pushes up inflation a bit. It also pushes up our expectations for the path of interest rates over the forecast period. We have added about a quarter of a percentage point to interest rates, both bank rate and gilt rates, over the forecast period. That is part of what then takes some of the heat out of demand over the next five years and allows inflation to come back to target. Part of that crowding out is happening because it is increasing the cost of finance to businesses and households, and that is part of what helps to bring demand back into line with our view of potential.

As David pointed out, at the moment we assume that the economy is quite close to potential. If you push the economy above that, you have excess demand and that creates an issue for the Bank of England in terms of having to manage that excess demand. We think, all things being equal, that means it is going to take longer for interest rates to come back down than they would prior to this Budget.

Chair: We will come back to some of the crowding out issues in a moment. I now ask Dame Harriet Baldwin to come in.

Q9                Dame Harriett Baldwin: Thank you, Chair. This is a question for Richard Hughes. You start your report by saying that the economic and fiscal backdrop since March is broadly unchanged. The Budget itself creates an enormous £350 billion increase in public spending. You are the Office for Budget Responsibility. Is that responsible?

Richard Hughes: It is a loosening of fiscal policy. I guess there are three ways to look at the risks around this particular set of policy decisions. You can look at what is happening on spending; you can look at what is happening on tax; and you can look at what is happening to borrowing and debt overall.

On the tax side, in our view about half of the tax rises are relatively certain and reliable. Putting up national insurance is a very reliable tax. It is a tax on payrolls and if you raise it you will bring in the revenues. Tom Josephs will talk more about that. The other half of the tax yield is based on raising taxes on a relatively small number of individuals, for which the revenues are quite uncertain because it depends on how they respond. On the tax side there are some risks around the yield that you might get from the receipts.

On the spending side there is a big increase in public spending: 2% of GDP, about £70 billion. It is very front-loaded in its profile. There are lots of extra resources being provided to Government Departments, this year and next, but then the profile of that spending slows quite dramatically from over 4% this year down to 3% next year and then down to 1.3%. I think the deliverability of that profile poses challenges.

Q10            Dame Harriett Baldwin: I want to ask a bit more about some of those aspects later on. I want to ask about the impact on interest rates. You said in your report that you have raised permanently the interest rate by a quarter as a result of the measures taken in the Budget. How sensitive is the UK economy now to additional shocks in terms of interest rates?

Richard Hughes: Clearly much more sensitive now that we have 100%—

Q11            Dame Harriett Baldwin: Can you put a number on it? With a 1% move in interest rates that is not anticipated in your projections, how sensitive would that make the UK economy?

Richard Hughes: Around a one percentage point increase in interest rates—colleagues may help me—

Tom Josephs: In terms of the impact on the fiscal position, we have various scenario analysis and sensitivity analysis in the EFO. Roughly, a one percentage point increase in interest rates adds about £16 billion or so to borrowing.

Q12            Dame Harriett Baldwin: The entire headroom, basically.

Tom Josephs: Looking at headroom against the current Budget, which is about £10 billion, we have some sensitivity analysis which says you just need a change in the effective interest rate of about 0.3% or 30 basis points.

Q13            Chair: Just to be clear, a 0.3% change would wipe out the headroom.

Tom Josephs: Yes.

Q14            Chris Coghlan: I thought it was 1.3% that would wipe out the headroom.

Tom Josephs: There are a number of different analyses in the book on the impact of interest rates on the fiscal position. We have a full scenario where we look at, as you say, a 1.3% increase in the interest rate and run that fully through the model. That results in the current balance, in five years, being in deficit by £11 billion, so you are actually missing the rule by £11 billion. The sensitivity analysis that I was talking about previously just looks at what you would need to get the current balance down to, essentially, zero—to take away all the current headroom. We have 0.3% for that.

Q15            Chris Coghlan: How worried are you about this? Obviously, gilt yields went up by 10 basis points on Friday. In the mini Budget, they went up 40 basis points. I think that is the highest, ex the mini budget, and it was the largest increase in gilt we have seen from any Budget for many years.

Relatedly, the other thing I am worried about is that I think I saw that there is £22 billion of extra borrowing just as a result of inflation-linked gilts in Government debt. Given that the extra spending is only £30 billion, that seems highly material to me in terms of the overall risk profile of the UK fiscal position.

Richard Hughes: We expected the Budget to be a surprise to the markets just in terms of the volume of gilt issuance. To a large extent, the gilt market response was just a response to higher volumes. If there are more gilts on the market, that drives down the price. To some extent, the front-loading of the expenditure was also a surprise to the markets. The volume that the market was being asked to take down this year and next was more than they expected. We had expected the gilt markets to be a bit surprised. That is why we added the extra quarter percentage point. Where gild yields have settled down, I would say they are broadly in line with that expectation or maybe a little bit above, but not significantly.

Q16            Yuan Yang: Thanks to the whole panel for your immense work on this outlook. Mr Hughes, I want to get into the question about spare capacity in the economy and your assumption that there is very little spare capacity left.

I wonder if the OBR has been overly pessimistic about the idea that the UK economy is operating at full potential. You previously wrote that there has been a scarring effect from the pandemic on potential output due to factors including a loss of skills and increases in labour market inactivity and, of course, the data shows that our workforce has shrunk since the pandemic more than any other rich economy’s workforce has shrunk since 2020.

My question is, if the origin of this economic scarring lies in a health crisis, to what extent do you think the Government can heal the scarring? If they can in fact heal the scarring, have you been a bit too pessimistic about the potential for more labour market activity?

Richard Hughes: My colleagues will definitely have thoughts to provide as well. I would say there is a distinction between untapped potential and spare capacity in the economy. When you look at most of the indicators of spare capacity in the UK—meaning is there ready capacity being under-utilised at this point in time which firms can draw on—unemployment is close to what most people think is its structural rate. It is a low 4%. The capacity position in businesses is pretty high. You have seen high numbers of vacancies relative to jobseekers. All those things point to the fact that, in terms of a labour force that is readily deployable to a set of jobs within the next few months, all those things look quite close to there being a relatively small output gap.

It is also true that the participation rate in the UK economy has fallen dramatically since the pandemic, but quite a lot of those people are out of work for health reasons. They are likely to require some kind of health interventions and employment support to get them back into the labour force. The previous Government had announced, and the current Government are considering, further measures to act on that group. One thing that we know about the group is that you require interventions and time to bring them into the labour force. When they come back into the labour force they do not always work full time, and they do not always stay in employment for long periods. It is not akin to traditional unemployment where somebody has lost their job, they are looking for a job and, when they find one, they will quickly be back working full time and at a full wage.

Yes, there is untapped potential in the labour force. There are people outside the workforce for health reasons. Whether that is something which, given that the Government are spending a lot of money now, will be a readily available labour supply that could respond to that and meet the needs of the Government which are, in the sectors of healthcare and education, highly trained professional jobs, was not clear to us and suggests that that is going to put some inflationary pressure on the economy.

Q17            Yuan Yang: Following on from Rachel Blake’s question about planning reform, is the reason you have not yet modelled the impact of that health and social care investment due to a lack of detail, or is it simply that we are in a quite unprecedented situation post the pandemic and, therefore, you do not really know based on previous evidence what the impact might be on the labour market inactivity?

Richard Hughes: It is worth saying a few things. One is that we do actually model the impact of public investment on potential output. For the first time we have actually incorporated estimates of the long-run return on that investment for the potential output of the UK. The issue is that the time lags are very long. It takes a long time to build a hospital or a new railway. Within a five-year forecast horizon, you see a relatively modest impact, but some impact—0.1%—on the level of potential output. That boosts the capital stock of the UK economy in the long run by a lot more, but it takes time.

There is also potential for some spending in general on healthcare, spent in the right places and in the right way to provide some of the support that people need to get back into the labour force, if that spending is targeted on the particular difficulties and health problems that that group of people has. We did some work in our fiscal risks report over the summer that looked at what the potential returns on those kinds of investments are. They are huge. If you can keep people healthier for longer and staying in the labour force, you are talking about tens of percentage points on the level of Government debt in higher tax revenues, lower spending on benefits and less pressure on the health service. Again, it takes a long time for those benefits to be realised because it can take several years to get people back into the labour force. It takes several years for the long-term benefits from that to come through taxation, and ultimately for the pressures they put on the health service not to materialise. You can see modest differences over a five-year forecast. We have done that in previous forecasts when the Government announced some welfare to work measures, but so far what Governments have done is relatively modest, even in the near term. The benefits take quite a long time to mature.

Q18            Yuan Yang: I have one final question on this. You talk about indicators of unemployment. How confident are you in the jobs market data, given that the ONS has paused publication of the labour force survey for about a year? We have had declining responses to the survey. People do not seem to want to fill it out. The Bank of England and the Low Pay Commission are now using alternative sources of data, but those alternative sources sometimes point in different directions. How confident are you about the picture that you have on the labour market?

Professor Miles: Not very, for the reasons you said. The response rate to the labour force surveys fell sharply. We thought that that was maybe largely to do with covid, but it has not really come back. The reliability of that data has fallen a lot.

The ONS are doing something about it, but it takes time. Right now, there is still a big question mark about that. We have some other indicators that are not a labour force survey. You can ask firms, “Are you finding it difficult to hire people?” I feel some confidence in the view that the labour market is relatively tight. Vacancies data is pretty reliable. That does not depend on the labour force survey. It is still at quite a high level, although the number of vacancies is falling. The judgment that there is not a whole lot of spare capacity in the UK labour market right now looks a reasonable one.

Q19            Yuan Yang: There is the idea that there is short-term tightness and medium-term uncertainty, depending on how many people can come back into work.

Professor Miles: Yes.

Q20            Yuan Yang: What is the timeframe for those two time runs?

Professor Miles: It goes back to your question about health. For example, on waiting lists, if waiting lists were to come down substantially over the next three or four years, you would expect that to have some impact. I think it might be limited though, even over a three, four or five-year time horizon, partly because I imagine that in the health service the priority would be given to people who are in real distress and in real pain, many of whom may be over 60 years of age. You do an enormous amount of good by getting those people off the waiting list and helping them, but you might not get much payback in terms of them rejoining the labour force. Somebody who needs a hip replacement and is 60 years of age is probably not going back into the labour force.

Q21            Yuan Yang: On confidence in the data, obviously there is a tremendous amount of work in the economic outlook. Is there an argument for there to be more caveating or confidence intervals of the projections you present, given the lack of confidence that we have just described in the data inputs?

Professor Miles: I love caveats, but it comes across as so defensive. You just keep saying, “This is a central estimate. It is guaranteed to be wrong. We’re not sure in which direction it is going to be wrong.” But all those things are true.

Richard Hughes: One of the reasons why it is so long is that it is so full of caveats and scenarios. We have swathes around our GDP forecasts and swathes around our inflation forecasts. Markets themselves give you different reads on interest rates almost every day. We also try to do scenarios partly to illustrate the uncertainty around our central forecasts, but also just to illustrate what matters and what difference it makes if we are getting it wrong in one direction or another.

We have done scenarios around what the potential output effects of big investment might be, which range quite widely, depending on whether you believe it crowds in or crowds out private investment. We have to have a central forecast because we have to tell the Government whether they are on track to meet their fiscal rules, but we also try to emphasise every time that there is a huge amount of uncertainty around those forecasts and that Governments need to manage the public finances.

Q22            Dr Sandher: Thank you all for coming this morning, panel. I really appreciate it, as well, indeed, as the work of the OBR. I want to pick up on some of the stuff around health. Is it fair to say that in your judgment potential output is limited because, in part, of the state of the NHS, with the highest waiting lists in history? A simple yes or no is fine.

Richard Hughes: People being out of work for health reasons is accounting for hundreds of thousands of people lost from the labour force since pre-pandemic. The issue around the waiting list is that most people on the waiting list are not those people. They are people who are older, have left the labour force or were not working, or who are still working and are just waiting for healthcare. Addressing the waiting list may have some impact on that group, but, as David was saying, the majority of the people on the waiting list are older people who are not in the workforce anyway or people who are already working.

Q23            Dr Sandher: More broadly on the state of public health, we are the only OECD nation to see sickness rise after the pandemic, so it is fair to say that something in our public health is going wrong. In your judgment, is that limiting potential output, especially with the situation where we are today?

Richard Hughes: Certainly. It is a mixture. We have seen some improvements in physical health but some deteriorations in others. The fastest growing health problem is mental health. It is the fastest growing reason people cite, and now the most common reason people cite for being out of the labour force for health reasons.

Q24            Dr Sandher: So public health in general leading to a reduction in how well we are moving forward. I want to think back to some of your previous forecasts. This is not just about public health cuts but other cuts that lead to a deterioration in health. How have cuts in the public sector in general, but in public health in particular, with cuts by a third since 2015, figured in or factored into your previous forecasts for potential output?

Richard Hughes: It is worth saying a few things. One is that we have only recently started doing a bottom-up assessment of the potential output of the UK economy and making it explicitly responsive to individual Government policy measures. We started doing that about two years ago. We have been slowly building up our ability to do that, primarily thanks to what the ONS have been able to provide us about the drivers of potential output, about the labour supply, about the capital stock and about productivity.

Work that we have done has given us a better understanding of the links between Government policy and those components, but it is by no means easy to assess in a straightforward way what happens in the health service, what happens to the health of the nation and then what happens to the labour supply. That is a very long chain of causality, each step of which is not well understood in this country.

Q25            Dr Sandher: I appreciate that it is difficult. The thing I am concerned about is what has happened previously with cuts, your out-turn data and then you not shifting the forecast. I am looking here at chart 4.5 of your old potential output data. I do not expect you to go into every single chart of every single publication you have had, but what I see is potential output estimates varying over the past decade. What I have also seen is a lot of public sector cuts now damaging public health and now, in your estimate, damaging potential output. What I am concerned about with this Budget is that increase in health expenditure is not, in your estimate, leading to increased potential output. It has also been varied on public sector cuts over the past decade. Do you see my concern?

Richard Hughes: My predecessors and I have revised down our views of potential output pretty steadily since the aftermath of the financial crisis. Every country in the world has suffered a big hit to potential output, including those like the US which continue to spend lots and lots of money on healthcare. I do not think the idea that there is a direct one-for-one link between how much you spend on healthcare and the potential output of the country is demonstrated by the data.

Lots of different factors have fed into the UK’s poor potential output performance over the last decade and a half. Part of it has been the sectoral composition of our economy. Part of it has been something the world has faced, which has been a slowdown in technological innovation and its impact on the growth potential of all our economies.

Whether you can directly link that, as an economist doing a forecast, to specific decisions made by specific Governments to spend money in particular areas is difficult. In this forecast, what have we seen? A big increase in Government spending this year and next on healthcare, mostly to get through backlogs in the health service and other kinds of services. We know very little about what the Government’s plans are for healthcare spending after that, so we have nothing on which to base any kind of assessment of the impact of any of the Government’s spending plans beyond next year on what it does to the economy. All we have is one number for current spending and one number for capital spending.

Q26            Dr Sandher: If I may, Mr Hughes, I do not think it is just about public health cuts. I think it is about more general public sector output, or rather the impact of public sector cuts since 2010. I do not think the American healthcare expenditure statistics are particularly instructive, given their healthcare system compared to our own.

I want to pick up something that Professor Miles said. You talked about the assumptions you are using about public investment multipliers over the next five years. In fact, you said it was inevitable. I am interested that you are using an assumption rather than out-turn data. I am particularly interested that the United States has grown faster than its potential output forecast since 2021. It is about 2% larger. Unemployment is at 4% and inflation is at 2.4%. It is growing quite rapidly from an increase in public investment. It appears that it is having an effect within five years. Where did the real-world out-turn data of the United States factor into your forecasts and how you construct them?

Professor Miles: The forecasts of the impact of public sector capital spending draw upon a quite big, empirical literature across lots of different countries as to what is the rate of return on public sector capital spending on things like infrastructure. We used estimates based on a range of those studies from a lot of countries. Disproportionately, they are US studies because that is the nature of the academic world. People do research on the US more than any other country. They fed into our assessment about what higher public sector capital spending is going to do to protect the potential of the UK.

The reason it can look a bit disappointing as a forecast horizon is partly, but not the main reason, that the big increase in Government spending is a little bit more on current spending in the near term than it is on capital spending. The bigger reason is that there is just a time lag.

Q27            Dr Sandher: Professor Miles, with respect, that was not the question I asked. The question that I asked was this. The United States has invested a lot of money since the pandemic. It has grown faster than potential output. I appreciate the empirical exercises, but I would say two things about that. One is that empirical exercises over decades past may not be very structured in the post-covid data.

My specific question is around the out-turn data. In the United States there has been a huge increase in public investment, leading to a huge increase in growth, faster than the potential output forecast in 2021. Did that figure in the way you were forecasting potential output in the UK?

Professor Miles: There is a bunch of reasons why the US might be different from the UK. Higher public sector output would be one of them, but I think there is a bunch of other factors going on there.

Our assessment of what public sector capital spending does to the productive potential of the UK, because it draws on all these different studies, is going to be about the average of all the countries that were looked at in the studies, which were disproportionately the US.

Richard Hughes: It is worth having a look at the paper we published over the summer, which I think is probably the most exhaustive piece of work on this question out there in the world. One of the people we talked to in putting it together was the Congressional Budget Office in the US. We basically put to them exactly this question. “How would you assess the impact of the Inflation Reduction Act and the CHIPS Act in the US on the potential output of the US economy?” They have come up with almost exactly the same numbers as we have—in fact, slightly lower in terms of what they think the impact of those measures is going to be on the US economy. We have very explicitly talked to our American colleagues about this and come to something of a meeting of minds. If anything, we think that the Government’s measures here are going to have a slightly bigger effect than they thought in the US.

Q28            Lucy Rigby: I am conscious that you have extended your forecast out to a 10-year and a 50-year period. I am also conscious, Professor Miles, that you mentioned the timeline, which I want to dig into in a second. I am conscious as well of the note in your report about the new draft charter for budget responsibility. Do you think the fact of looking at a longer-term forecast and a longer-term horizon incentivises longer-term investment strategies?

Richard Hughes: We hope so. It has been an abiding philosophy of ours that you have to look over a number of different time horizons to answer different questions. Definitely, when you are getting into questions of how the Government can move the dial on a whole set of structural challenges that the UK economy faces, be it long-term sickness or under-investment either in the public sector or in the private sector, how can you demonstrate the return on those kinds of policy interventions when you have huge time lags to help people, and huge time lags between spending money, getting shovels in the ground, getting a railway built and getting trains running on it? You just have to look beyond the five-year horizon. The longest we do is a 50-year forecast.

You will see on this Committee next summer—hopefully, we will come and talk to you about it—our next fiscal risks and sustainability report which does 50-year projections for the public finances. There, you really see the difference that different kinds of policy choices can make, for better or for worse on fiscal sustainability. In our economic and fiscal outlooks, where we think there are policy measures where the medium-term effect of policy changes is materially different from the near-term effect, we have also tried to quantify and show that.

As David was saying, we did that on the public investment measures and you can see, over time, the effect of those things building up all the way to 1.4% of extra GDP in 50 years’ time, and then building up from the 0.14% that you get at the end of the five-year forecast horizon. Those are the time horizons you are talking about with public investments. It takes a long time to get a return on those things.

There are also things on the downside. There are parts of the public finances where you look beyond the medium term, and you start to worry. One thing is the trajectory of health spending, which just goes up and up and up. It is growing faster than the economy consistently over time. The other thing is trajectories for revenues. Fuel duty is the most evident one that stands out when you look 50 years ahead. Fuel duty revenues in this country are headed to zero. That is around 1% of GDP-worth of tax revenues. If people didn’t like the tax rises that they have seen recently, you are about to see that amount of tax revenue disappear from fuel duty over the next—

Q29            Lucy Rigby: On those time lags, you are obviously assuming a decent amount of time. How confident are you about the evidence for those time lags?

Richard Hughes: We try to draw it from the best empirical literature that you can find. Obviously, to assess impact on 50 years you have to wait 50 years. A lot of the studies are looking at the impact of, as David was saying, federal government investment in the US in the 1950s and ’60s on the federal highways system. One of the things which we have worried about is the fact that building a highway system from scratch gives you a big investment return, whereas fixing the one you already have probably delivers something slightly less.

You have to aim off from the fact that when you are looking at mature advanced economies with established infrastructure networks, and you are just patching them up, fixing them and building some extra capacity, you are not going to get anything like the big return you get from building a port for the first time, building an airport for the first time or putting in a highway system for the first time. We try to make some adjustments for those things and come up with a central estimate of what the likely economic return of those interventions is going to be.

Q30            Lucy Rigby: One more question if I may, Chair, on dynamic scoring. How do you choose which policies are within scope from a scoring point of view?

Richard Hughes: We set out a set of criteria about two years ago, in summer 2022, to answer that precise question. Where we see policies which we think are going to have a material evidence-based additional—there is one other word which I have forgotten, but it is in the paper—impact on the supply side of the economy, we would take it into account. Obviously, every policy might have some small effect. The most important ones are “material” and “additional”. Is it a big effect and is it something different that you would not otherwise get from just Government business as usual? Are Government doing something that will make a difference from just standard tax and spending?

Q31            Lucy Rigby: Do you think Government might be incentivised to go for policies that you are more likely to score?

Richard Hughes: We will see. So far, in the last few Budgets, you have seen a handful of policies that meet those kinds of criteria and where we have applied supply side effects. To be honest, the impacts are relatively modest because the policies have been relatively modest. We are also looking over a relatively short time horizon, so you do not see a big difference from any kind of policy intervention over five years. There are the sorts of things they have done on welfare to work and even on public investment. Public investment has been raised by about £20 billion. That is a significant amount of money, but all it really does is hold the level of public investment flat as a share of GDP compared to where it is now, rather than falling down to 1.7. It makes a bit of a difference, but by international standards it is still a relatively modest amount.

Q32            Dr Sandher: I want to talk a little bit about the way you have been forecasting things for the past 14 years and what it might mean for today. You were saying that productivity between 2010 and 2012 would hit 2.5%. In 2015 you said it was about 2%, and now you are forecasting productivity at 1.5%. In that time productivity has not really exceeded 1%. Is it fair to say that your forecasts were missing something?

Richard Hughes: You can’t really expect me to say they were wrong. Early on, when the OBR was first established, like a lot of economists we thought that the financial crisis in 2008 was going to be tough but that, basically, all our economies were going to bounce back to something that looked similar to pre-financial crisis normality, and productivity growth would just return to its previous trends. It did not. Then you had five to 10 years of economists living in hope that at some point, once people got their balance sheets sorted out and once the structural changes in our economies happened that needed to happen, they would return to those levels of productivity.

More recently we, and other forecasters, have just been downgrading our view of the long-run output for productivity and potential. As David was saying, we have ended up somewhere between pre-financial crisis highs and post-financial crisis dismal performance. It is a number we keep under review every time we put a forecast together.

Chair: Of course, we will have the Office for Budget Responsibility in front of us many times over the next year to discuss how they work. If we can focus on the Budget, particularly with the Chancellor coming in front of us, that will be helpful.

Q33            Dr Sandher: The thing here is what this means for stuff going forward. Basically, your investment multipliers at the moment are at about one. They decay to zero by the end of the forecast period. The IMF has it at about 1.4. Other studies have it much higher. Are you worried that your multiplier estimate is wrong today, and has been wrong in the past—that the mistake you made in 2022 is where you are today?

Richard Hughes: I am pretty satisfied that the estimates we have for the long-run return from public investment on potential output is central and in line with the evidence. You need to be a little bit careful when you look at IMF and World Bank studies because they tend to look at a broad range of advanced emerging markets in developing countries when they estimate their returns on public investment.

It is a world away investing in infrastructure in a country like the UK, which has six airports around London, a motorway system, a mature transport network, and you are trying to improve the operation of that network, and an emerging market or developing country where you are putting those things in place for the first time. There is no doubt that in those kinds of countries investments in infrastructure deliver a huge economic return because they connect the country to a global economy that it was not previously connected to.

For the UK, that is not the situation we are in. We are trying to make an existing network, which has already connected us to the outside world and to ourselves, function a bit more efficiently. That is a different proposition from the kinds of multipliers that you get from the papers that the IMF produces.

Q34            Dr Sandher: I have one more question. I will put forward a story to you. If you had been underestimating the public spending changes since 2010, that would have led to lower than predicted productivity and the higher borrowing that we have seen. Actually, there is a good question, in terms of what is happening in the forecast: the underestimate of public spending changes—the impact on growth—is something you might be doing today, over the next five years, with this Budget as well.

Richard Hughes: What public spending changes are you referring to? Do you mean health spending?

Q35            Dr Sandher: All the public spending that impacts health is broad. It is not just about health. It is about all the rest of your current spending, so you are right about the bottom-up thing. It is really hard to estimate each individual bit of spending, but the overall impact of those public spending changes has clearly had an impact on our health today. Similarly, there is an increase in public spending changes now, and you are underestimating it. Are you worried about that happening now in the way it could have been happening since 2010?

Richard Hughes: I worry about all sorts of things. If you just look at health spending, we have gone from being the lowest health spender in the OECD to the sixth highest—out of 19 countries—so health spending in this country has been rising faster than it has in most other countries as a share of GDP. At least in the health sector I don’t think there is a lot of evidence for the fact that spending on health has been behind our international partners or somehow a drag on growth. It is also difficult to draw a one-for-one connection between spending on particular public services and the potential output of the economy.

Q36            John Glen: I would like to turn to the dynamics with the Treasury. I must declare an interest. Until a year ago I was Chief Secretary and before that I had some other involvement in the Treasury.

Clearly, as I said at the start in my first set of questions, you are set up to give a dispassionate assessment of what is true, and you provide, at times, challenge to what Ministers of all parties want to do, or assert will be the outcome of their decisions. Could you describe the typical rhythm of your interactions with Treasury officials, between fiscal events?

Richard Hughes: Tom, would you have a go at that?

Tom Josephs: Essentially, the forecast is produced on a kind of iterative basis. Right at the start of the process we produce our first economy forecast.

Q37            John Glen: When the date of the Budget is declared.

Tom Josephs: Yes. The date of the Budget is declared. Typically we are given 10 weeks’ notice of that. At that point we produce our first economy forecast. That economy forecast is sent to both the Treasury and the Departments that we work with to produce the fiscal forecast: in particular, HMRC, which produces much of the tax forecast, and DWP, which does a lot of the welfare forecast, but other Departments as well. They use that economy forecast. They input that into their models. They produce their fiscal forecasts on a very bottom-up basis, with forecasts for each tax stream and each spending stream. We have a process where we, in the OBR, essentially scrutinise all those forecasts, and have discussions with the Departments and officials. We have the right to make changes to those forecasts, and typically do, and take key judgments that will drive the final forecast. That is the fiscal forecast part of it, and that iterates on, until we produce the final forecast on Budget day.

Then there is the policy side of it, where the Treasury will typically, after they have seen our initial forecasts, start to consider the policies they are going to announce at the Budget. We have a similar process whereby HMRC, DWP and the Treasury produce an initial estimate of the costs of the individual policies. They come to us; again, we scrutinise them. We very often ask them to make changes until we are satisfied that the policy costings are central. Then we incorporate them into our forecast and produce what we call the post-measures forecast, which essentially incorporates the impacts of Government policy.

Q38            John Glen: That is completely aligned to my understanding and experience. I want to move you on to talk about the situation between fiscal events, before that moment is triggered. My experience as Chief Secretary was that we were always carrying a set of notional pressures across a range of Departments and they informed the dialogue between the Chief Secretary and a departmental spending Minister and their respective officials, but there was no OBR involvement in that day-to-day process of government. That is correct, isn’t it?

Richard Hughes: That is right.

Q39            John Glen: Yes, so this assertion—

Richard Hughes: I would say to a limited extent; to some extent, but we will come on to the—

Q40            John Glen: I am just trying to establish—I have a lot of respect for the dynamic between the Treasury and the OBR: what I am trying to get at is how we got into a situation where an assertion is made on 29 July about a black hole, which I acknowledge is an ongoing tension that would crystallise at a fiscal event, through the process that Mr Josephs has just described. I want to determine what you think about that assertion, when there was no OBR involvement prior to the fiscal event date—Budget—being triggered.

Richard Hughes: We have built up a way of working with the Treasury. We are going to get into the weeds a bit, unfortunately, on how forecasts are put together. In particular, departmental expenditure limits—the 40% of public spending that is allocated to Departments—had worked well up until, I would say, this past year. Within periods covered by spending reviews, for which DELs were set by Departments, there was a system of expenditure control in place. When we had a high-trust relationship with the Treasury those things were being well managed, and managed within the total. That system very clearly broke down.

When the information that came to light was presented to Parliament in July we immediately wrote to the Committee to say we were going to look into it, because we were not aware of the pressures that had been highlighted. We did our own investigation, overseen by our own non-executive directors, and asked the Treasury the specific question: what were you aware about, at the time we were putting together the March Budget, which was earlier than the July statement, in terms of pressures on departmental spending? The short answer was that there was about £9.5 billion-worth of net pressure on Departments’ budgets, which they did not disclose to us as part of our usual Budget preparation process around DEL, which under the law and under the Act they should have done.

We have written to the Committee with the findings of that review and we have also, together with the Treasury, put in place a better process. It gives us greater confidence, and I hope it will give this Committee greater confidence, that in future that kind of failure will not happen again. It will involve greater scrutiny on our part of departmental expenditure limits and the preparation of Departments’ budgets, to make sure that those kinds of pressures get disclosed to us and that, if they are disclosed to us, we have a conversation about how they are going to be managed—how they are going to be offset and what does that mean for net overspending or underspending against departmental expenditure?

Q41            John Glen: The point I am making is that as a Minister one receives figures from Treasury officials and is aware of those tensions. The interaction between you, your officials, and Treasury officials is outwith the relationship between Ministers. This is, essentially, as you have described, a dysfunction in the smoothness of the dynamic between the Treasury and the OBR. What you are saying is that you think that will be fixed going forward.

Richard Hughes: The focus of this review and these recommendations is the institutional relationship between the OBR and the Treasury. What goes on inside the Treasury—you will have the Treasury in front of you, so you can ask them.

John Glen: Yes, we will.

Richard Hughes: The recommendations that we make here are about the exchange of information between the OBR and the Treasury, and the way I would characterise it is that we are moving from a system of trust to a system of trust but verify. They have a set of budgets but we want to know more about what the pressures on those budgets are, and more about how much of the reserve has been committed at the start of the fiscal year and how much of it is left to deal with genuine contingencies. We want to know what decisions made about pay imply for pressures on departmental budgets and growth, and those thereafter, to make sure that we are satisfied that the failure of oversight that clearly happened in March does not happen again.

Q42            John Glen: Can I ask you one other thing about the interaction with the Treasury? I recall, in previous fiscal events, there was an iterative process of discussion—for example, around the therapeutic effect, if you like, of the childcare policy. During that conversation, the impact on jobs and so on worked through. My assumption is that you are not doing this in an ivory tower. There is an iterative process, and the insistence of a politician, or a democratically elected Minister, on asserting things, interacts with your process. What I am trying to get at is that I think you were unfairly vilified by previous Chancellors and Prime Ministers in my party. That is highly regrettable, in my personal view, but in order for you to have credibility, going forward, it would be good to establish that you are subject to oversight and input from politicians who can make assertions on policy, and you are not beyond challenge on that.

Richard Hughes: Of course. We come before this Committee to answer to your oversight and we have to reflect the cost of Government policy as we understand it, and as explained to us in our forecasts, but we rely on the Treasury to be forthcoming about their best estimates of the cost of Government policies and the risks around those. In this case that does not appear to have happened.

Q43            John Glen: But don’t you think it is highly regrettable that over the last few months you have been sucked into this political debate about a black hole? Do you think that can be avoided in future?

Richard Hughes: I think what happened was regrettable, because it meant that there was a serious overspend against our forecast. We needed to make serious adjustments to that and the Government have had to make serious adjustments to policy. I think the situation that happened was regrettable. We do not have the luxury of standing on the sidelines in these things. We have to do a forecast for departmental expenditure, and if there are errors, and if there is undisclosed information, we have to correct for that and explain ourselves, which is why we did this review. It is why it was overseen by our non-executive directors, and why we submitted it to the Committee as soon as it was done.

Q44            John Glen: It is just that the problem we have, and that we are left with—I will finish on this question—is that the assertion is made by the Government that there was a sort of wilful restriction on what was shared with you. My impression, working through, I think, seven fiscal events, was that there was a formal iterative process, as Mr Josephs described, where Ministers relied on their officials to share whatever you requested. Therefore, I find it very hard to understand how that happened, given the integrity of Treasury officials.

Richard Hughes: We rely on the Treasury. That iterative discussion has to start on the basis of disclosure of information that the Treasury knows at the time, about what is happening within departmental budgets, and the pressures on those budgets. That information was not shared with us at the time of the March Budget, and it was information that was available to the Treasury at the time. Why that was the case—

Chair: We have the permanent secretary in front of us tomorrow.

Q45            Dame Siobhain McDonagh: As a question from a lay person, following John’s, it seems amazing to me that something obvious, like the compensation due to sub-postmasters, or for victims of contaminated blood—

John Glen: If I may, as the Minister who did that, we concluded it the day before the election was called. It was impossible—

Q46            Dame Siobhain McDonagh: Yes, but it is how that could not be included.

The other thing that I find quite interesting, given our discussions with the former Chancellor about childcare, is how it can be that the current Government had to put in an extra £1.6 billion to meet the upcoming changes to the childcare policies brought in by the former Government. Surely if you come up with a policy you have to cost it and put it—

Chair: Let’s see if Mr Hughes can answer that.

Richard Hughes: Will you say something on compensation, Tom?

Tom Josephs: The compensation schemes for infected blood and the Post Office were highlighted in our report in March as risks to the forecast, but we were not able to score them at that point because the final details of the compensation schemes had not been announced. To be able to put things into our forecast with precision—

Q47            Dame Siobhain McDonagh: That might have been because they did not want to put in how much it was going to cost.

Chair: Mr Josephs cannot speculate on what goes on inside the Treasury.

Tom Josephs: For us to be able to put policies in our forecast we have to be able to cost them with reasonable certainty, and there was not sufficient detail before the election—in March, I should say—to allow us to do that. We have now put the cost in the forecast. Because the final details of those schemes have now been announced, we are able to have discussions with the bodies that are running the schemes and agree on what a central estimate of the costs will be. There is still quite a lot of uncertainty around that, in terms of things like the degree to which there will be take-up of the schemes, and the average payments, and the timescale over which the schemes will run, but we felt that we had enough certainty to put numbers in the forecast.

Q48            Dame Siobhain McDonagh: And childcare?

Tom Josephs: The childcare measure was one we included in the forecast last autumn, initially. There have been some changes to our estimates of the costs over time. We have, in particular on that one, been looking at whether delivery is on track, and we have an assessment in this latest report on that, where we essentially conclude that the first phase of delivery of that programme looks on track, but there is still quite a lot of risk around the subsequent phases, so we will continue to monitor that.

Q49            Chair: Mr Hughes, you said something along the lines of—I paraphrase—the departmental spending controls of HMT had broken down. Obviously, there was no spending review for—there were bad roll-overs, which are always a challenge. Was that, do you think, one of the reasons why there was a problem with the information you were being given, or am I asking you to speculate?

Richard Hughes: I think it has been a general problem of trying to put together a forecast for departmental spending, which, as the spending review horizon shrinks more and more of our forecasts, is just not supported by a detailed set of plans. It is important to point out that the failing that happened here was for this financial year, which is still covered by the previous spending review. One thing that contributed to it, certainly, was the fact that those spending plans were put together at a time when everyone was expecting relatively modest rates of inflation. We then had the Ukraine war, a big rise in energy costs, and a big rise in inflation, and those budgets were not generally speaking adjusted for that higher inflation. That put huge volume pressures on those budgets.

Q50            Chair: And the pay and pension changes.

Richard Hughes: Yes, pay and pension changes, for which some budgets were adjusted and others were not. So part of that net pressure that built up was pay and prices pressure on various Departments.

Q51            Chair: I ask the question because I previously chaired the Public Accounts Committee, and we could see these pressures every time we looked at a Department. We were doing two different Departments a week, pretty much; so if it could be seen in the accounts, or in the pressures on a particular area of spending, was the Treasury not seeing it? Were you not seeing it? Where was the gap? Where was the problem? Where was the challenge?

Richard Hughes: The gap was partly not coming forward with us taking us through what the net pressures on Departments were. Part of it is, “Look, we’ve got 50 people in our organisation. We’ve got to cover £1 trillion-worth of public spending and £3 trillion-worth of debt. You’ve got to deploy your resources where you think the risks lie”. Heretofore the risks on the public finances did not really lie within DEL, because the Treasury managed DEL like nobody’s business, down to a few billion a year overspending, here or there. It is unusual to see that level of net pressure building up, but taking into account much higher inflation, unchanged budgets, some of the other volume pressures that were hitting some key services, that is where these things materialised.

Chair: I think we have plenty of questions for the Treasury when they are in front of us. It is going to be a lively discussion, I think. Bobby Dean MP, over to you.

Q52            Bobby Dean: I want to move on to your modelling of the Government’s changes to national insurance contributions. We spoke about the labour market uncertainties a bit earlier, and it relates to that. You have static yield changing really significantly over the course of the forecast period. How confident are you in that modelling—particularly with a large amount of the effect being down to lower wages in the labour market?

Professor Miles: What we have done, there, is rely on a pretty well-established way of thinking about how a tax change is allocated—a tax change that, in legal terms, falls just on companies as the employer; but the economic question is where the real incidence of the pain is, if you will, from higher taxes. That analysis depends on how sensitive the demand for labour is to changes in the cost to the employer, and how sensitive the supply of labour is to any erosion in real after-tax wages that people receive.

That has been in place—that kind of analysis and that structure of thinking it through—for several decades now. We apply that. It throws out an estimate that, in the long run anyway, the majority of the impact shows up in lower real wages—wages lower than they otherwise would have been. It generates a number: about 75%—three quarters of it—ends up, not in the short run but in the longer term, falling on workers, with real wages lower than otherwise they would have been. About a quarter of it is lower profits. So nobody escapes completely, but more of it falls on workers, as lower real wages, rather than as lower profits.

In the short run it is a bit different. It is plausible to envisage that this does not play out with companies, on the day the employer NICs rate goes up, saying to the workforce “You’re going to take a pay cut now.” It will not work out that way. Over the next few years, instead of maybe a 3.5% pay increase, it becomes 3% or 2.75%. A couple of years of that gets much of the burden ultimately shifted back to the labour force. That is how we estimated it.

I do not think there is much disagreement among most economists who study labour markets that that is the way to think about it. At the edges, of course, there is a bit of uncertainty with how sensitive the demand for labour is to changes in real wages, and all that. Some people will put the share that hits real wages at a bit above 75%. Some people put it a bit beneath it. We think ours is a central estimate.

Q53            Bobby Dean:  Yes, I appreciate that those are the established ways of thinking about it. We have also talked about some unprecedented challenges that the economy is facing. We talked about the level of economic inactivity being really high, and we have spoken about some of the things that might be driving that—particularly in relation to health. We talked about the uncertainty of the data we are getting back about the labour market, as well. I put the challenge again about how you tested those assumptions. How certain are you about the elasticity of labour demand?

Professor Miles: There is a quite big, very boring, academic literature on these elasticities. I would not wish it on anybody. We read lots of it. I think I am confident that the numbers we used are a central estimate, based on a lot of studies. You can certainly find some studies that would have said 75% pushed on to labour is too high a number, and it might be 60% or 65%. There are some other studies that say it should more or less all go on to labour ultimately, and that they take 100% of the hit. So, is there uncertainty about it? Inevitably yes. I am fairly confident that our estimate is at least central, based on hundreds of boring studies.

Q54            Yuan Yang: Professor Miles, when you say your estimate is central, do you mean that you have picked the middle of the range? I see that you have described a range of 0.15 to 0.75 in the elasticity of demand for labour. Is that just choosing the middle point? It seems like a reasonable middle point, because there is a spectrum of five times, in that.

Professor Miles: Sure—no, sorry; for the overall impact—which we think is 75/25—the range of uncertainty is a lot less. I would say that the low end is 60% and the high end is definitely 100%. A lot of people think that ultimately it all flows through to lower real wages; so that spread is 60%, say, at the low end and 100% at the high end.

Q55            Bobby Dean: Can I move on also to who this is likely to impact the most? We have a quote here from Alex Baldock, the chief executive of Currys, who said this “disproportionately hits high-employing sectors”. I am thinking of pubs, shops, restaurants and care homes—places that employ a relatively high number of relatively low-paid people. Is that assessment correct? Will those be the people the most likely to be hurt by this?

Professor Miles: Yes, on the face of it that is very plausible, because there is a kind of lump sum element, because of the £9,000-odd limit before the employer pays national insurance. That comes down to £5,000. That affects almost everybody who is working—almost. The marginal change in the rate—13.8% to 15%: the more people are paid the more expensive it gets for the employer to pay that, but the lump sum element would suggest that it would have a bigger impact on the proportional cost to an employer of employing someone on low wages than on that of employing someone on higher wages.

I think, however, there is a bit of an offset to that, which is the national living wage. As you will know, that is about to go up by 6.7%. That puts a limit to how much employers can offer people lower wages to offset the higher cost to them of paying employer national insurance. So the national living wage, in a sense, puts a ceiling on how much can be passed on to lower-paid workers.

The overall question, then, whether this is going to disproportionately hit lower-paid workers, is not entirely obvious. I tend to think that the way in which most employers are most likely to respond to this is, in the short run, to just take it as a hit; then, as I said a moment ago, when it comes to the pay settlement next year, the year after, and the year after that, maybe it becomes 3% rather than 3.5%. If that is what happens—and it is more hunch than solid forecast—it tends to suggest that it would be shared across the board. So I think the answer to the question is that it is not entirely obvious. I can see some arguments why it disproportionately hits employers who employ people on lower wages; but I suspect that the national living wage effect offsets some of that, and it is not so clear. It is very disproportionate on lower-paid workers.

Q56            Bobby Dean: Obviously, some of these industries are the ones struggling the most to recruit at the moment. We do not have enough care workers. If you go into any pub or restaurant they struggle to get staff; they are always advertising. What do you think the net effect will be on those businesses that are already struggling to recruit and that now face these two cost pressures—the national minimum wage and national insurance contributions? Do you think it could result in headcount losses, or even closures?

Professor Miles: Headcount losses, relative to a world in which there had not been a change in national insurance, yes—and our forecast puts in a 50,000-person lower level of employment than would otherwise have been the case. That 50,000 is a material number. It is not trivial. As a proportion of a workforce of 32 million or 33 million it is a relatively small proportion, but it is a meaningful number. It is not 500 people; it is 50,000.

Q57            Bobby Dean: My final question is whether or not you did any sector-by-sector analysis of the impact of this, and if that had subsequent impacts on your forecasting.

Professor Miles: As you will appreciate, our focus is very much on the aggregate economy—the aggregate fiscal position. We tend not to have the resources to do a lot of detailed sectoral analysis, but I think it is almost inevitable that the sectoral distribution will not be entirely even.

Q58            Dame Harriett Baldwin: Richard Hughes, you are the Office for Budget Responsibility. Is the new fiscal rule more or less responsible than the previous one?

Richard Hughes: Let me say a few things. At least at the moment, it is over the same time horizon, so the Government have five years to reach their target to balance the current budget and get public sector net financial liabilities—known in the trade as “persnuffle”—falling. The Government’s objective is to bring that forward a few years until it becomes the third year of the forecast, and then becomes rolling, so in that sense both targets are more likely to be binding on more meaningful parts of our forecast than some previous fiscal targets have been.

One of the most important elements there is the fact that, if you get a better alignment between the deadline of the target and the deadline for spending reviews, that gives us and you more confidence that when the Government say, “This is my objective for the current balance and for PSNFL,” it is supported by a detailed plan for public spending. We have all known that one way in which Governments have met the letter of their fiscal targets has been to have a profile for public spending that looks very tight but is unsupported by a detailed plan; when the time comes to do the detailed plans, it tends to get revised up. In that sense, the time horizon gives us more confidence as forecasters that there is a plan to actually deliver those targets by the deadline. The issue is that one thing we have removed from the fiscal framework is a pure definition of Government debt. We are now netting off financial assets and financial liabilities against that.

Q59            Dame Harriett Baldwin: Can I ask about those? My understanding is that one of the financial assets that is now in the public sector net financial liabilities is the student loan book. Is that in there at nominal value or at market-to-market value?

Richard Hughes: Tom might want to say more, but it is all the loans that are now included on the assets side of net financial liabilities. We apply case-by-case treatment to them depending on the nature of the loans and our own assessment of their likely performance. Where we think there is a probability of non-repayment we will factor that into our valuation of those loans in the forecast. Because by design there is a strong likelihood of non-repayment to quite a lot of student loans, they have a very particular accounting treatment.

Q60            Dame Harriett Baldwin: Can you just help us with that? Yesterday, an increase was announced in the student loan required to go to university. How much would an extra £100 show up as in public sector net financial liabilities?

Tom Josephs: That announcement to increase student loans in line with RPI is what we were assuming in the forecast. It will not change our forecast. In terms of increases in student loans, as Richard says, in that case there is a well-established methodology that the Office for National Statistics uses to take account of the fact that a proportion of the loans will not be repaid, and that is what is included in our numbers. It is roughly a 50% to 75% assumption in the numbers. The assumption of how much will be repaid depends on the particular type of student loan, because there have been different versions of it.

Q61            Dame Harriett Baldwin: The point is that it is the market-to-market value in the fiscal rules. That was what I was trying to get an answer to.

The second question is about the pensions system. My understanding is that this new fiscal rule—public sector net financial liabilities—includes the net asset value of—Meg and I both should declare an interest; the Chair and I are both trustees of the parliamentary pension scheme. I believe that this fiscal rule includes the net asset value of funded pension schemes, but what about the unfunded public sector liability? Is that in this fiscal rule at all?

Tom Josephs: Unfunded pension liabilities are not in this measure; it is only funded pensions, as you say.

Q62            Dame Harriett Baldwin: How big is that?

Tom Josephs: For the unfunded pensions liability, we have a number somewhere. It is quite large. It is included in some other measures of the balance sheet.

Richard Hughes: It is tens of percentage points of GDP, certainly.

Q63            Dame Harriett Baldwin: It is not included in this fiscal rule. Okay. Is the debt interest accrued on the index-linked included in this fiscal rule? How are you accounting for that in your assessment?

Tom Josephs: Yes, that is included in the measures of borrowing and, therefore, feeds through also to debt. It was mentioned earlier that there has been a big increase in the cost of index-linked gilts this year compared to our previous forecast. That is because of higher RPI forecast. That hits borrowing immediately, although the actual cash costs of that are spread over the longer term.

Q64            Dame Harriett Baldwin: You are accruing for it rather than having it as a lump-sum maturity payment the way the bond itself works. Okay, that is helpful.

Finally, this predecessor Committee was interested in fuel duty fiction. My understanding is that the 5p has been extended for another year to March 2026, but then your numbers assume that that ends and that we restart indexing. Is that correct, Mr Hughes?

Richard Hughes: In response to an explicit recommendation of this Committee, we now produce our fiscal forecasts on two bases: one in line with Government-stated policy of the freeze for now but then starting indexation again in the remaining four years of the forecast, and one where it is just frozen for the four years. The one where it is frozen for the four years, which would be in line with the decision that every Chancellor has made since 2011, halves the Government’s headroom against the current balance. It takes about £4 billion or £5 billion off that just from freezing fuel duty alone.

Q65            Chair: I just want to follow up on one of Dame Harriet’s points about the student loan policy changes. Have you normally included an assumption of RPI inflation in your forecasts, or is it just for this Budget?

Tom Josephs: For the specific impacts on student—

Q66            Chair: On student loans.

Tom Josephs: The whole stock of student loans is in our numbers. We use whatever the policy setting was for each portion of the stock of student loans.

Q67            Chair: This was specifically because of this Budget. You were advised during your modelling that this was an announcement that was going to come.

Tom Josephs: Similar to fuel duty, there are some baseline assumptions in our forecast, and the baseline assumptions for student loans are that they will increase with RPI.

Q68            Chair: To be clear, you have included the assumption that it would go up in previous forecasts even though it has not.

Tom Josephs: Yes, and then when it has not gone up we have adjusted the forecast.

Chair: Okay, so you did not do anything different this time than you had done before, just to be clear. Thank you.

Q69            Bobby Dean: Public sector net financial liabilities is an established measure, but I am not sure how well established it is as a fiscal rule. Do you have other country comparisons? Do others use it? How do we compare to them?

Tom Josephs: I am not aware that other countries use that specific measure. It is well established in the UK; it has been around since 2016. It is the case that it has not been a part of the fiscal framework before, which means that it has had less scrutiny as a measure both by us and by the Office for National Statistics, which produces it. We have now agreed a work plan with the ONS, which we set out in the book, to ensure that we develop the methodologies that we use to forecast it, and the ONS further developed the methodologies it used to produce the outturn in response to it becoming part of the fiscal framework.

Q70            Bobby Dean: There is the idea of measuring the Government finances where it is novel, and there are other measures as well; public sector net worth is another one that I know you track. Are there other countries that are adopting a slightly more expansive version of fiscal rules, and are we able to learn lessons from them about what we should be monitoring and what this Committee should be scrutinising in the coming years?

Tom Josephs: Other countries have used wider measures of the balance sheet previously. New Zealand is one example. It quite often uses different measures. It uses a wider measure. It uses something that is close to public sector net worth as part of its fiscal framework. It is something that international organisations such as the IMF have previously recommended doing. Essentially, because it is a wider measure of the balance sheet, it includes more liabilities and assets than the previous measure of public sector net debt. That has the advantage that Governments are more likely to pay attention to those other assets and liabilities and try to ensure that they are managing them effectively.

It also introduces some risk to the forecast because it has these new elements that we need to forecast. As I said before, some of these elements are ones that we have put a bit less focus on than other areas of our forecast in the past. It also creates some policy incentives that potentially create some risk that we will certainly be watching out for. Essentially, because assets such as loans are in this measure, it potentially creates an incentive for Governments to deliver policy through loans and equity injections rather than direct investment. The Government have set out as part of the Budget a set of controls to try to ensure that that is only done where it is good value for money, but we will also certainly be paying close attention to that and making sure that we try to assess the value of the assets accurately and robustly, and take account of any risk of default and write-downs in our forecast.

Q71            Bobby Dean: Finally, you have identified some additional risks and potential policy perverse incentives. How would you respond to the criticism that it is essentially just a bigger number, it is an accounting trick, and that is all that has changed?

Tom Josephs: From our perspective, we are focused on the implications for the forecast and implications in terms of risk to the forecast. There are ways in which it potentially reduces risk because it incentivises Governments to pay closer attention to a wider range of liabilities and assets. There are also potentially ways in which it increases risk through the policy incentive I described before. There were similar incentives in the old measure as well. All these measures create different incentives. Public sector net debt, because it had no assets of that type in it, created an incentive, for example, to sell financial assets even if that was not good value for money. One example of that, going back to student loans, was selling the student loan book in order to reduce debt despite the fact that it was not good value for money.

Q72            Yuan Yang: Mr Josephs, you talked about fiscal allusions in the outlook and you named the sale of the student loan book for below its market value as an example. Is the Government’s financial transactions control framework, which aims to stop this kind of behaviour in future, a framework that the OBR will be scrutinising and producing reports on as well in future?

Tom Josephs: Yes, certainly. They have announced a number of different strands to that control framework, which includes trying to ensure that that sort of activity only happens through particular institutions that have expertise. It also includes looking at the valuation of those assets and getting independent assessment of that via the National Audit Office and having more transparency through producing reports on those assets. Certainly, we will be working very closely with the people who produce those reports and with the NAO, if it has this role, to ensure that the valuations that we include in our forecasts we think are robust and accurately reflect the risk.

We have already started to do that. The National Wealth Fund is an institution where this is relevant. The Government gave more money to the National Wealth Fund at the Budget, which it used to provide loans to particular projects. We have incorporated an assumption on the risk that some of those loans will default over time into the forecast.

Chair: Thank you very much. Back to Bobby Dean MP.

Q73            Bobby Dean: Moving on to investment spending, there was not a lot of data about where the additional capital spend is going. Given how much of it is front-loaded as well, that is leaving with us lots of questions. In your engagements with the Treasury, did you get better insight about where this near-term capital spending might be going? Did that inform your forecasting?

Richard Hughes: A lot of it is going on a combination of investments in the infrastructure of core public services, such as health and education, and significant investments in energy infrastructure, such as carbon capture and storage projects and other kinds of energy investments. But, as you say, this is for the second half of this year and next year. We do not know what the pipeline looks like for the next five years or indeed after that. We do not have a lot of visibility about what the Government are spending their capital on. That is one of the reasons why, when we put together our investment framework in looking at what effect it might have on GDP, we have just applied an average multiplier to the whole lump sum of public investment.

Our colleagues at the CBO and others have tried to do something more sophisticated and look at the composition of public investment in the different kinds of projects and apply different kinds of returns and different kinds of investments, whether it is economic infrastructure or other things. Both it and we have found that to be very difficult to do, mostly because of a lack of visibility about what the Government’s investment plans actually are. Then you also have the question that you can plan for one thing but what you spend your money on is another, as the Chair will know from her experiences on the PAC.

Q74            Bobby Dean: Just thinking about the economy as a whole and the readiness for this huge injection in the next couple of years of capital spending whether or not we have the labour force, the resources and the shovel-ready projects ready to go, did you factor that into your forecasting as well? Do you have a confidence level about the number of infrastructure projects that are ready to go?

Richard Hughes: Part of the assumption that we had around crowding out was around this very fact that, if you see a big ramping up of public spending, that will put pressure on the labour force and on access to materials to do construction projects. That was one of the things that informed the overall macro judgment we made about the impact of the set of fiscal decisions made in this Budget. As we discussed at the start of this session, are the resources readily available to respond to demands being put on them in terms of skilled personnel to do the building and access to materials to build the things? Part of the reason why we have inflation going up and we have interest rates going up a bit is because we think the short answer to that is no.

Q75            Bobby Dean: I have just one final follow-up question. Is there a fear then that perhaps this could drive up the cost of some of these projects if that is what will happen in the short run? Instead of spreading that capital spend out over the forecast period, by front-loading it we might end up with more expensive infrastructure delivery.

Richard Hughes: Quite possibly, yes. We have higher inflation in our forecast as a result of the fact that there is a big fiscal loosening in this Budget. About two thirds of it is going on current spending, but about one third of it is going on capital, which makes it more capital-heavy than the overall composition of public spending. It is a significant injection.

Q76            Lucy Rigby: Just taking a step back and just to round off this bit, can you explain at a high level how this current Government’s approach to investment spending differs from what has gone before?

Richard Hughes: That might be more of a question for the Government, I suppose. As I said at the beginning, we have a year and a half’s worth of a plan here, so that does not look that different from what we have had up until recently from the previous Government, which is quite a short time horizon. The Government have plans for doing a full multiyear spending review next year. They have stated their ambition to provide a 10-year pipeline of investments, which the previous Government had also done on some occasions. You have to give previous Governments some credit for the fact that they also had a pandemic and an energy crisis to deal with, so those plans did not survive contact with what turned out to be reality. The Government have an ambition to provide more detail about their investment plans and their composition, which we will have a further look at, but for the moment we have assumed a general multiplier on those sorts of things.

As Tom said, there is an open question for us about what choice of vehicle they use to do the investment. One of the things that concerns us and we will be keeping an eye on is whether the new fiscal framework creates an incentive to channel investments into the form of loans and equity injections rather than direct investment even if that is a less-value-for-money and more risky way of going about doing the investment. The Chancellor has announced a set of guardrails that she wants to put in place to make sure that those investments are well managed. We will come to our own view about what we think the ultimate value of those investments is likely to be, what the risks are and whether those guardrails are working. That is an area of heightened risk around the new framework that we will need to make sure we are doing our part to assess.

Q77            Chris Coghlan: Can I just pick up on a point that both Bobby Dean and Dr Sandher made? I was really curious in your answer about the difference between the Inflation Reduction Act in the US and fiscal loosening in the US and what is happening in this Budget, because, as Dr Sandher said, that saw a pay-off in a relatively short period of time flowing through to GDP, as you saw in the US after the financial crash. We are not seeing that in these forecasts. I was very interested that you have looked in detail at the difference between the US and here.

My question is: is what is driving that in your forecasts mainly the lack of visibility around what that public investment is and what you said, or is it on what the quality of the public sector investment is? What I mean by that is that we all know that the NHS is in a desperate state and we need to get these waiting lists down, so there is a public policy imperative to do that, but from an economic growth point of view, as you rightly said, a lot of these people who are on these waiting lists would not be in work anyway, so it would not have that much impact. Economists such as Paolo Surico have said that the best way that the Government can improve productivity with public sector investment is through multi-mission, targeted, very specific targeted R&D, and that crowds in private sector investment. There is hardly any of that, as far as I am aware, in this Budget. There is a lot of current spending. Is that what is driving the difference versus the US, or is it just the lack of visibility?

Richard Hughes: Let me say a few things. One is that we have growth going from 1.1% this year to 2% next year. The UK economy has not often posted 2% in the recent past. So we do think that there is an economic impact of the fiscal decisions made in this forecast. About half of that better growth performance next year is coming from the fact that there is a net fiscal injection coming from the Government going into the economy.

The biggest demand multipliers we have come from public investment the same way it does in the US. It is important not to overstate what the Government are doing on public investment in this country. They are holding it flat as a share of GDP compared to this year. As a share of the economy, the Government are doing no more investment in five years’ time than they are right now. What they are not doing is cutting it down to 1.7%, which was the previous Government’s plan. This is not a transformation of the level of investment going on in the economy. It is just not being cut back.

Q78            Chris Coghlan: It is one of the largest fiscal loosenings in recent history.

Richard Hughes: It is, but two thirds of that is current spending.

Q79            Chris Coghlan: That is not really driving it.

Professor Miles: One way of thinking through the return on public sector investment is to calculate the average real return on the money spent over the life of an investment project, and that number turns out to be quite high. It is about 9%. If you take the investment and you calculate how much is the extra GDP you get from now into the very long term and express it as a rate of return on the money you spend up front, it is 9%, and that is 9% real after inflation. That is not very different from an estimate of the real rate of return on investment in the private sector.

I do not think it is that we have taken an ultra-pessimistic view on what you get back from public investment; it is more that the time lags are likely to be significant. You might not see much of a boost to GDP potentially in the UK over the next three or four years. It is a bit difficult to know quite what the time lags are because we do not have much visibility on what the type of investment is. You could think of some investments where you spend the money on Monday morning and they have their return on productive potential by Tuesday morning, such as if you fill a load of potholes. On the other hand, if you build a new motorway it could take 10 years to finish it.

Q80            Chris Coghlan: Just to follow up on that, there are choices on where the Government can spend this huge fiscal loosening that has happened. They have chosen to spend two thirds of it on current spending. Gilt yields have gone up by 10 basis points. That would indicate to me that we are kind of close to where we can max out the credit card here—i.e. there is potentially a significant opportunity cost to this Budget. The opportunity for the Government is therefore reduced in the future to make the kind of more growth-oriented, productivity-enhancing investments because we cannot borrow any more. Is that fair or not?

Richard Hughes: Yes, you have fewer choices when you have 100% of GDP-worth of debt compared to 20% or 30%, which is what we had at the start of the century. The interest costs on that debt go straight into the current balance. Even if the net financial liabilities rule is not binding on you and giving you some space, that extra interest cost is current spending, and the Government only have £10 billion to spare on that. If you are borrowing more, adding to your debt stock, and you are paying interest on that, you can pretty quickly eat into that headroom with extra borrowing, yes.

Chris Coghlan: One more?

Chair: A short and sharp question, Mr Coghlan.

Chris Coghlan: Is it a quarter of Government debt that is inflation-linked? Is that normal relative to other countries? That really worries me. Why was that decision made? I guess that is a question for the Treasury.

Chair: Save it for tomorrow.

Q81            Chris Coghlan: Yes, I will save it for tomorrow. How concerned are you by it? It seems massively material to me. Should we be getting out of it, or is it just too expensive to refinance it?

Chair: You are all looking at each other. No one wants to take that.

Professor Miles: I think we all have different views on this.

Chair: Mr Josephs, we will start with you.

Tom Josephs: A couple of things. It is the case that the UK has a higher proportion of index-linked gilts than pretty much any other country—most countries, certainly. They have been in existence for a long time—many decades. It is the case that for much of that period index-linked gilts were relatively good value for money for the Exchequer because investors were willing to pay a premium for that investor protection. We have quite a lot of demand for that sort of instrument, essentially from the defined benefit pension schemes. Of course, when you are hit by a big inflation shock, it has a big cost. It is also the case that the Government decided a few years ago to try to reduce their exposure, and that has been happening for about the past five years. The amount of index link as a proportion of the stock has been falling a bit.

Q82            Rachel Blake: We have talked a bit about public spending. Now I want to delve more into the departmental budgets. We have talked about some particular categories of public spending, and I want to focus on the front-loading, which you alluded to a few questions ago. What scope do you believe there is for Government to reduce spending in the latter years of the spending review? I would be particularly interested to know how you might be anticipating that and how you might be forecasting that.

Richard Hughes: It is the case that in this Budget the Government have added significant resources to the overall departmental expenditure envelope, and most of the extra money announced was to go into DEL. The issue is that they have added a lot in the first two years and not very much in the latter two years such that growth in current departmental spending known as resource DEL is 4.8% real this year, 3.1% next year, and then it goes down to 1.3% over the remainder of the Parliament, which is actually not much above the real growth rate in those resources that you saw in the previous Government’s plans. Obviously, it is growing off a higher base, but none the less that overall envelope has grown more slowly than our estimate of the economy, which is somewhere between 1.5% and 1.66%. That envelope is growing by 1.3%.

You have a health service that historically has grown faster than GDP—on average a number above 3—and in this forecast you have it growing above 4% in the first year, falling to 3% in the second year. That is already growing twice as fast as the overall envelope on public spending. You then have commitments in areas such as defence where the Government are saying, “At least we want to meet our NATO 2% target, but actually we have ambitions to go to 2.5%.” That is another thing that will have to grow faster than GDP. Then you have overseas aid, for the moment growing in line with GDP, but the Government say they want to get it back up to 0.7%.

So more and more of the stuff within the envelope is supposed to be growing faster than the envelope. What does that leave for the rest? If you look over the Parliament, the rest of departmental spending grows a little bit in real terms over the Parliament, but if you take the period of the next spending review, which is the period from 2026-27 onwards, remaining Government Departments are actually seeing a real cut in their budgets of around 1% before you then try to pay for defence going to 2.5% or overseas aid going up to 0.7%.

Q83            Rachel Blake: I am concerned about how realistic, towards the end of the spending review period, those figures might be and your assessment of how realistic they might be, and how you have come to that assessment.

Richard Hughes: It depends on the choices that Governments are prepared to make going into the next spending review. There is no doubt that it sets up quite a challenging envelope for that spending review and one where Governments will have to prioritise between competing pressures on resources. It is a particular challenge when Governments are not so much committing to delivering a particular service but they are just committing to delivering a level of spending. If you commit to increasing spending as a share of GDP and your overall envelope is going down, that has a very obvious and clear price tag. It limits your scope to prioritise within those things. On top of that, you have a set of pure volume pressures on services that have to be accommodated.

We show in our longer-term projections, looking out 50 years, that there is no funding solution to dealing with those pressures on public services. If you just meet the cost of demographic change and assume the same unit cost in growth and healthcare spending, public spending just rises and rises up to 60% of GDP and debt goes to 200% or 300% of GDP. If you have a bunch of services where the volume of activity and the cost of activity are always growing faster than the economy, your public sector just grows and grows and your tax receipts do not unless you do something quite different from what you have today.

Professor Miles: The rate of increase of real spending on Department services slows down very markedly. I suppose the question is: supposing it did not, what would then happen? What would happen is that Government spending as a percentage of GDP would almost certainly be rising. We are at the optimistic end of the spectrum on the growth of the productive potential of the economy. You have Government spending rising and rising relative to GDP, and that means that either the tax take has to keep going up or you borrow yet more.

Q84            Rachel Blake: You have quite effectively highlighted the importance of reform, which we will be coming on to with the Chancellor. Could you just sketch out volume pressures and explain some of the detail of what you mean by volume pressures?

Richard Hughes: Sure. In the health service, you just have an ageing society and you have people living longer, which is obviously good news, but it means that they are around longer to be clients of the health service. One of the more worrying trends that we have seen in recent years has been people are living longer but not necessarily spending more of their years in good health, which means that they are more likely to need the support of the health service for a longer proportion of their lives. As the weight of your population moves into older cohorts, that creates challenges and pressures for the health service.

You also have the fact that the better and better we get at curing things the more the next set of things are more difficult and more expensive, and so unit costs in healthcare tend to rise faster than unit costs in other services because you are always innovating and you are always trying to cure the next thing that is wrong with us. Unit cost pressures in the health service are also very high.

On the other side of the ledger, on the tax side, the flip side of an ageing society is a shrinking workforce, so that means you have fewer taxpayers supporting more and more people who have left the workforce because they have retired but they need support from the healthcare system and from adult social care.

Chair: Before I pass to Mr Glen, I will just observe that something like 45% of DEL spending is now on health—day-to-day spending from Government Departments. That highlights some of the challenges ahead.

Q85            John Glen: I just want to ask one question about this productivity issue and productivity savings. Most Government Departments assert, I think, 2% per Department and stress the rigidity of that. What is your experience of the delivery of that and any optimism bias in that assertion? It seems intuitively that, with AI and different ways of delivering services, there should be scope for a significant transformation of services. Can you say something about how you make an assessment of that and how it affects your forecasting?

Richard Hughes: It will be one thing in our enhanced oversight of departmental expenditure that we will be asking more searching questions about. You are right that a 2% efficiency assumption or productivity dividend is a pretty standard thing that has been in place in previous spending reviews. It is not particularly exceptional, I would say, compared to previous rounds.

One of the issues and questions that we often ask is: to what extent are these savings cashable? Are these things that free up resources within a given Department in order to meet new pressures elsewhere? You can make more productive use of people’s time, but if the same people are still there working nine to five that is not saving. They are providing a better service to people, and that is a good thing, but that is not necessarily alleviating financial pressures on the rest of the service. One important question is: are these cashable savings or are these just productivity improvements in the delivery of a service for a given person?

The more worrying thing when you look at the data is that productivity in some services has not been improving; it has actually been falling. In the health service, that is probably the No. 1 concern.

Chair: Again, challenges for tomorrow. We are now moving into our quick-fire round, and we are being led off by Mr Glen.

Q86            John Glen: I just want to ask about the tax side of things. There has been a lot of controversy about the agricultural property relief, and that will be ongoing. Some of that is outside your realm. Were you asked to do any different scenarios around the threshold changes? What did they give in terms of projections of different savings?

Tom Josephs: We cannot talk about any policies that we might have been asked to look at. We only talk about policies that the Government have actually announced.

Q87            John Glen: Am I allowed to ask you, “If you were asked”? If I asked you to apply a higher threshold, what effect would that have on revenues? Obviously, it is something that many stakeholders in the industry are looking at in the context of all the other pressures they face. What material impact does that have? If you are not allowed to answer it, I am sorry for asking.

Tom Josephs: We are only allowed to cost policies that have been announced by the Government, so that restricts what we can say about other policy options. If you were to raise the thresholds, you would get less revenue, but we have not looked at that.

Q88            Chair: Will you be doing any modelling on these long-term taxes—the things that do not kick in? National insurance straightaway kicks in. Once it kicks in, it is revenue coming in. These longer-term changes are a much slower process, and presumably you are modelling all that.

Tom Josephs: Yes, that is something we have talked about in the report, partly because the Government have in the charter asked us to look more at the long-term impact of policy. We talk in there about, in particular, longer-term impacts from the capital tax changes and the fact that some of the behaviours that those changes will provoke are ones that are not likely to be seen over the five-year forecast but will appear over the longer term.

On inheritance tax, because of the changes, the fact that more people are likely to look to give gifts earlier in life ahead of the seven-year cut-off before death is a behavioural change that is likely to happen but probably will not show up very much in our five-year forecast. There are other changes in behaviour. For example, we know that people have used the agricultural property relief as a means of tax planning and, essentially, have bought agricultural land on that basis. The change is likely to reduce the incentive to do that. The impact of that on the forecast is probably going to be quite long term and not—

Q89            John Glen: Have you done any distribution analysis of where that money is from—how many people? Is it 2,000 estates that will yield the £520 million over the forecast period?

Tom Josephs: For the costing of the measure that was announced, the HMRC estimates are that there are about 2,000 estates that currently use this relief. Of that, about a quarter—I think it is about 400—have assets over the £1 million threshold and therefore would be ones that are caught by that.

Q90            John Glen: Do you know anything about the baseline? It is asserted that 73% will not be in scope of this. If the baseline is inflated by, essentially, a house with three acres that is not really a farm, can you say anything about that assessment?

Tom Josephs: You mean the increase over the forecast period in the number of estates that might be—

Q91            John Glen: I mean the 73% could be seen as misleading because it includes small holdings that are not, for meaningful purposes, actual farms.

Tom Josephs: For our purposes, the data that is relevant for the costing are estates that use this relief. That is what the £2,000—

Chair: It might be interesting when we have you in front us again to look at some of your modelling particularly on behavioural stuff, because that is really quite interesting in the context of this Budget but obviously future Budgets as well.

Q92            Dame Siobhain McDonagh: The OBR re-costed the March 2024 non-dom reforms and found that they raised twice as much as originally estimated—£10 billion over 2025-26 to 2029-30. How did that happen?

Tom Josephs: The re-costing was on the basis of a couple of things. One is that we had new HMRC estimates of, essentially, the number of non-doms in the country based on another year’s worth of data. That showed that there were more people who would be caught by the reforms than we previously thought.

The other factor that changed it was just the fact that a lot of the revenue is driven by global equity prices, global asset prices, and there was a pretty big increase in world equity markets between March and the latest forecast. That, again, inflated the tax base quite significantly.

It was a big change. We highlighted in March that it was a very uncertain costing, mainly because we were uncertain about the behavioural response that it would provoke. But, even the tax base on a measure like that, which is very international, is quite uncertain as well.

Q93            Dame Siobhain McDonagh: What really interests me is that, whenever you go to tax wealth, there is always great consternation and very loud noise and concerns that none of these measures will make any money and they are merely politically spiteful. Given that the measures in the Budget include taxing those people with the broadest shoulders—non-doms, capital gains tax and inheritance tax—what can be done to improve the evidence base on this group so that we can have more confidence when designing policies about how much they will raise? Is there a way of collecting more data or about making better use of the data the HMRC holds? It is a big change, is it not—£10 billion?

Tom Josephs: A million. What is worth saying on that particular change is that most of the revenue that we have scored in the forecast comes from what are called the transitional protections, which is, essentially, three years’ worth of lower tax rates that are provided to people who are caught by the new regime. We assume that that population will make use of that offer and bring quite a lot of assets into the UK and pay what is a reduced rate of capital gains—12% to 15%. The main yield is a short-term three-year yield in that window. The steady-state impact of the reform is much lower. I think it is £3 billion or £4 billion year per year on an ongoing basis through the fact that the new regime for people who are not eligible will mean that they will pay more UK tax.

Q94            Dame Siobhain McDonagh: Given the estimates of how much the non-dom changes would originally have made, are you happy with the evidence that you get from the Treasury on policy measures and how could they be improved?

Tom Josephs: Generally, the information that we get from HMRC is very thorough and detailed. It is always the case that we can look at ways of improving it. We produce an annual report that looks at the accuracy of our forecasts—both the economy forecast and the tax and spending forecast—and sets out a number of different ways in which we think we can improve the forecast. We had a whole set of recommendations in that report this year, as we do every year, on how we can improve the tax forecast. We are certainly very keen to do that. Some of that was around trying to find ways to get better information sets on different tax bases.

On the non-doms one, it is more challenging because you are trying to get information on the global assets of this taxpayer population, and there are limited sources of data on that, which is why it is particularly uncertain. It is also the case that changes in the economy can have a big impact on the value of the tax base, which is what we saw between March and our latest forecast. That will likely change again, so these estimates will continue to change over time.

Q95            Yuan Yang: Mr Josephs, following on from that question, you forecast very large behavioural changes, and in particular very large emigration changes in response to taxes on assets such as in the private equity industry. There is research from the Centre for the Analysis of Taxation that suggests that those emigration effects are more than a third lower than what you might model based on UK data. How confident are you in your estimates of behavioural changes to taxes on assets? In particular, are those estimates from any UK-based evidence of previous migration impacts?

Tom Josephs: We certainly acknowledge, as we did in the book, that it is an uncertain assumption. We try to make use of the literature on the impact of tax changes on migration in particular on that subject. There are a limited number of studies looking specifically at the UK. More look at other countries such as the US. We make use of that information. We also took into account the impact of the last time the non-dom regime was reformed and what impact that seemed to have on migration.

Our estimate in March on the initial reforms was that it would lead to roughly 10% to 20% of the population leaving the UK. We increased that a bit this time just because some of the newer changes increased tax liabilities for that population—in particular the changes to inheritance tax. So we increased those estimates by up to 12% to 25% leaving the country.

Q96            Chair: Thank you very much. I just want to go back to a point in answer to Mr Glen, Mr Hughes. You said that the Treasury did not give you all the information that it should have done under the Act. Can you clarify if, in your view, the Treasury broke the law when preparing the spending forecast it passed to you in preparation for the March Budget?

Richard Hughes: It did not provide all the information that we require to do our forecast. There is always information that is relevant to the work that we do that we would like to have. In this case, this was a material amount of information that would have led to a materially different forecast had we had it. Every public servant in this country does their utmost to try to obey the law and respect both its spirit and its letter. I have no doubt that in the preparation of this forecast the Treasury has been very good and very forthcoming about implementing all the recommendations that we have come up with. I think there was a systemic failure in putting together the last forecast and potentially a misunderstanding of expectations on both sides about what needed to be provided.

Q97            Chair: It was a systemic failure. It was a material matter. I would back up Mr Glen that Treasury officials are usually of very high calibre, very good, honest public servants, but they did not provide you with the information they should have done. What went wrong? Did they break the law?

Richard Hughes: It is a question for the Treasury to ask why information was available within the Treasury and not provided to us. That may have been a misunderstanding of how the law ought to be interpreted. There is no doubt in our minds that had that information been provided we would have had a materially different judgment.

Q98            Chair: But a misunderstanding? It is not like the OBR is new. This relationship between the OBR and the Treasury is a well-worn one, as, helpfully, Mr Glen, got Mr Josephs to lay out. What do you think went wrong?

Richard Hughes: We had a way of working that had worked well up until this particular forecast. It was one that kept the error against our departmental expenditure limits forecast within a few billion from year to year, which is very small. Clearly, pressures had built up, which, based on previous practice, the Treasury would not have disclosed to us but was material to our forecast this time around, and had we known it we would have come to a different judgment about the level of public spending.

The law puts a lot of expectations on people to provide lots and lots of information. You always have to make a judgment at different points in time about what is provided. There is no doubt that had we had this information we would have come to a different judgment.

Q99            Chair: Given that it was material, are you not just utterly surprised that it was not passed on to you?

Richard Hughes: Yes. We want to make sure that something like this does not happen again, which is why we—

Q100       Chair: Have you taken legal advice about whether the Act was broken?

Richard Hughes: What is important to us is that this information gets provided in future and that we have a better system going forward.

Q101       Chair: You have not taken legal advice, but you have given the Treasury a rap over the knuckles, as you have in writing.

Richard Hughes: We have taken a good and long hard look at the legal obligations on different parties. We have spelled it out in the front of this report. We are happy now that we have come to a better understanding with the Treasury about what information we need to do our jobs.

Q102       John Glen: What concerns me is that, given that the rhythm of activity was routine and you had no reason to believe that there would be a change in the way that Treasury officials would interact with you, at the time of that fiscal event in March/April the OBR never said anything about its concerns over a material change in the dynamic leading up to that event. What is concerning is that there is a change of Government, there is clearly a political advantage from asserting that there is a black hole, but it was not substantiated, so you were completely in the dark that there was a change in the way that they were interacting with you in that previous fiscal event. Is that correct?

Richard Hughes: We do not know what we do not know. The Treasury has a large number of public servants managing departmental budgets. We have a handful of people who have to focus their scrutiny and challenge on where we think the biggest risks lie. At the time of the March Budget, we had assumed that that system was going to continue to work well. It clearly was not. There was material information available inside the Treasury that should have been passed on. Had it been passed on to us, we would have come to a different view about the level of public spending. Now, I am not saying that we would have said public spending was going to be £22 billion higher—that is not the case—but it would have been materially different had we had that information and we would have come up with a different view. At the very least, the Treasury was aware of £9.5 billion-worth of spending pressure on departmental budgets, which was relevant to a judgment we were making about the level of spending against the departmental expenditure limit.

John Glen: I was there until 12 November.

Chair: 2023.

John Glen: In 2023. I cannot account for the interval between that and the fiscal event. However, having worked with those departmental spending teams week in, week out, I cannot see how their demeanour and approach to doing their job would have changed in those four months. That is why it is quite confusing that we have got to this situation.

Chair: That is a big concern, which we will continue to look at. Thank you very much indeed for coming. In summary, we have heard that the headroom is incredibly fragile; that the interest rate increase of just 0.3% means it is basically gone; and that health investment is likely to take a number of years to impact on labour supply, which is obviously a concern and something we may take up with our sister Committee, the Health and Social Care Select Committee. We have also heard today that there has been abysmal productivity growth over the last decade, and we do not know whether the package of measures in the Budget yet will move that dial. It is something that all of us whatever our party would hope it would. We have heard this concerning issue that the Treasury may have even broken the law in the run-up to the spring Budget in not disclosing all public spending information to the OBR. It is certainly an area for us to probe further.

I thank our witnesses, Richard Hughes, Tom Josephs and Professor David Miles from the Office for Budget Responsibility very much indeed for their time.