James Smith and Gemma Tetlow.

Q15 The Chair: Welcome to the Lord’s Economic Affairs Committee’s second evidence session on our inquiry into the United Kingdom’s fiscal framework. We are delighted to have with us two experts: James Smith, research director at the Resolution Foundation, and Gemma Tetlow, chief economist at the Institute for Government. We are very, very grateful for your time. Thank you for coming. We are broadcasting this session live on Parliament Live TV, and you will be given a full transcript shortly after the meeting to make sure that we did not get anything wrong and a chance for you to make corrections.

Can I start with a very general first principles question for you both? What is the point or value of having a fiscal framework? What is its purpose and what does it generate for the public interest? Has the post-1997 era in which fiscal rules have been dominating the fiscal landscape in different ways enjoyed greater fiscal stability as a result of fiscal rules?

James Smith: Thank you for inviting me; it is really great to do this session. Fiscal rules, if you think about them in the context in which I think about them most, as a key part of the overall macroeconomic policy framework, then they play a really central role. They are fixing a macroeconomic problem, or they are at least designed to fix a core problem with the macroeconomic policy framework, which is that Governments left to their own devices would have an incentive to cut taxes and increase spending before elections to appease voters, therefore ratcheting up debt and ending up with higher debt. This type of deficit bias problem gives rise to a very clear case for having fiscal rules. That is the way they are generally viewed in that context. But more than that, they play a role in setting out the fiscal strategy of a given Government. So by setting out fiscal rules, you are saying, “Here’s roughly what I’m going to do in terms of spending on investments, public services and other day to day spending. This is what broadly what I am going to do on taxes”. So it sets expectations for that policy. The third thing is basically an internal process to help enforce discipline in terms of the overall fiscal approach of the Government.

I would strongly push back on those who would say that we could do without fiscal rules: all three of those functions are critically important in terms of the overall setting of such a key part of policy. Would we have had a more stable fiscal policy without them? Obviously, we would never know; we would never observe that counterfactual. Obviously, this near tripling of government debt has been an incredibly volatile period for fiscal policy, but if you look at cross-country evidence then you see quite clearly strong empirical evidence for the idea that countries with fiscal rules, with independent fiscal watchdogs, have lower debt and lower costs of borrowing as part of their observed outcomes. So it is a really key part of the overall policy framework.

Gemma Tetlow: I would agree with everything James said, but would perhaps just add a couple of things. First, on the wider fiscal framework as opposed to the rules per se, the existence of having an independent fiscal council that produces independent forecasts has created much more transparency around the UK’s fiscal position and has countered the over-optimism that we used to have in official fiscal forecasts before 2010 when the OBR did not exist. So that is another benefit of the more recent fiscal framework.

I would agree with James; it is very difficult to know what the counterfactual is of what we would have seen on fiscal policy if we had not had fiscal rules in the last 20-odd years. But the IMF has some international evidence looking at trying to use cross-country over-time variation in the existence of fiscal rules and it actually finds a potentially interesting sort of magnet effect, which is that fiscal rules seem to stop countries from over-borrowing. But also you tend to see a bit of a tendency for Governments to run smaller surpluses in good times when they have fiscal rules. So perhaps the rules have led to this pushing borrowing towards zero but doing a bit less of the running surpluses in good times.

When thinking about some problems that we have seen in fiscal policy-making the last many years it is easy to be sceptical about fiscal rules and framework, but those actually reflect the strategies of successive Governments trying to deal with very difficult fiscal times and facing up politically to making tough choices on tax and spending when the economy has been growing very slowly, rather than being attributed to fiscal rules. The fiscal position has been incredibly challenging, rather than the fiscal rules themselves.

The Chair: You both mentioned at least three different functions. First, there is the political tying of hands to the mast to bring about more responsible government. Secondly, there is the public facing part—giving a sense of the strategic plans and priorities. Thirdly, it is signalling to markets, particularly bond markets but other markets too, about things. Which of those three is most important? The answer is probably all of them, but have the bond markets become sort of—

Lord Petitgas: Fiscal rule number two.

The Chair: Yes, bond markets have become players in the narrative, particularly in the last few years, for all sorts of reasons. Is there any evidence that fiscal rules have actually brought discipline that has reassured bond markets? Or have fiscal rules ended up bringing about effects that have not particularly been positive in the sense of Government’s relationship with bond markets?

Gemma Tetlow: Bond markets have been different during different periods of the fiscal rules’ existence, and, for quite a lot of the time, the bond markets do not seem to have been the constraining factor on Government. Actually, the fiscal rules have been more binding than the discipline from markets. But that is less true now and they both seem to be important constraints. I think you may be hearing from bond market players later so I am sure they can give you more insight on how they actually view this. It is difficult to know; speaking to bond market actors in recent times, one thing that people have said to us is that actually there have been so many changes in fiscal rules in recent years that the bond market players do not necessarily know exactly what the fiscal rules are now.

So it is judging—more than perhaps we did under the Gordon Brown era, where we had the same set of rules for a long time—the Government a bit more on fiscal policy in the round, and the sense of whether it is credible and sustainable or not, rather than necessarily the specific rules. But there is a potential danger there as well that—to the extent that bond markets do not have a huge amount of time to digest everything that Government are doing—there can be a bit of a fixation on the headroom numbers and the central forecasts. So that headline summary measure is “Are the Government meeting or not meeting their fiscal rules?”, rather than whether policy is more broadly sustainable.

James Smith: I completely agree with that. The thing I would add is that bond markets are the discipline of the extreme, I suppose. At the point at which your creditors stop lending to you, a country is in deep trouble because the way in which bond markets price government debt feeds back directly into the cost of borrowing, and that is a key input to the fiscal position that you are in; you can end up with some very fast-moving crises. That is the most extreme form of discipline, and we have seen that in the UK on occasion, particularly for emerging markets too. The overall fiscal framework—by which I mean the watchdog, the transparency, all the bits really, not just the fiscal rules—has changed the information sets that all actors are dealing with, particularly in financial markets, but also policymakers.

Neither Gemma nor I are saying bond markets are not sophisticated, but my impression is that they monitor all aspects of fiscal policy very closely, and the information that you get as part of the fiscal rules, as part of the transparency, is really important for that. I would not say fiscal rules have changed the role. It sounded a bit like what you are worried about is that, because we have fiscal rules and they are judged so frequently, we have more crises because bond markets are realising this. That is more about the fiscal position that we are in right now rather than the overall framework.

Lord Burns: Supposing we were to design a test beforehand to say whether it had been successful, what things might we include? Transparency and data, et cetera, would be a very positive one in terms of keeping people up to date with what is happening, but what about other measures such as volatility of budget deficits, what has happened to the overall level of debt or if the forecasts been any better than they previously were? Have the Government acted more quickly to correct things when they have gone offline? We are working pretty hard—once you get beyond the transparency and data availability—to make a strong case that those things have been better; would you agree? The circumstances have been pretty volatile, but in the past they were also quite volatile for various reasons. How would you design a test? What factors would you be looking at? Do you have any idea what the score sheet looks like?

Lord Burns: About the same.

Gemma Tetlow: Slightly better than the Treasury forecasts were before. Well, that was the case a few years ago. We have obviously had a series of years of over-optimism on productivity, but this is where it is really hard to know what the counterfactual would have been in a world without fiscal rules. Do you run smaller deficits overall and have debt rising less than some counterfactual world?

Lord Burns: The answer is no.

Gemma Tetlow: The fiscal rules have definitely not prevented the Government from behaving in a somewhat asymmetric way in response to shocks. With the possible exception of last year’s Budget and the Spring Statement, when forecasts have been better successive Governments have, on average, given away pretty much all the good news; when forecasts have been worse, they have only partially consolidated. That is partly facilitated by the fact that all the fiscal rules we have had have given Government some time to get back on track when you have short-term shocks. So they have often been targeting borrowing and debt figures three or five years ahead.

There is just a trade-off in fiscal rules between how constraining and how sensible they are as an economic management tool. Most of the time you would not want the Government to be unable to do extra borrowing in times when the economy is weak and it is needed. When Covid hit, you would not have wanted a set of fiscal rules that prevented the Government from doing extra borrowing to support the economy at that time, and similarly during the financial crisis. But it does then mean that Governments can exploit that asymmetry in their behaviour, and you get a bit of a ratcheting up. We might come on to talk about it in your later questions—how you might design a slightly different set of rules that would prevent that.

Lord Burns: Yes, we will do.

James Smith: You can look at the period since 2010 and say, “We’ve had a lot of fiscal rules, my God, they’re not helping because we’ve had a lot of increases in debt, volatile government bond yields; things have been terrible”. That is entirely missing the sort of causation trees for the correlation woods, if you see what I mean? I am not mixing my metaphors, but the key thing here is what role the fiscal rules have played. You had some hint during the mini-Budget episode—I would not argue this was the only thing going on during that period—where a lot of that transparency fell away; we were seeing decisions that were taken without the scrutiny of independent fiscal watchdogs; we were seeing them operating a little outside the fiscal rules, and there were really large increases. So to the very difficult counterfactual that Gemma alluded to, you get a little of a sense of how things go wrong, and it would be a huge mistake to blame the experience of the past 20 years or so entirely on fiscal rules.

Lord Burns: Things went wrong in bond markets long before there were fiscal rules as well, at various occasions.

James Smith: Absolutely.

Lord Burns: I was looking at the chart of the Budget and fiscal deficit movements in that wonderful document that the OBR produced with all the financial data going back; I struggle to see that the volatility of budget deficits has been any better.

Lord Petitgas: I just wanted to add one thing. Thinking about a counterfactual, if you remove for a minute the debt associated with Covid—that is an exceptional point, and I agree that if the fiscal rules were very tight it would prevent you from doing things and it would be wrong; let us just take it out as an aberration—then the question is, what would the fiscal rules over that period actually look like in terms of performance and the increase in the borrowing, et cetera? Covid has clearly distorted the balance sheet so I do not know what it would really look like; would it look as bad? Might fiscal rules actually be more effective than we think?

Secondly, what strikes me is the fiscal rules, particularly as we get into the Budget, are preventing politicians from basically doing what they love: lowering tax, increasing spending and borrowing for the future. It sort of creates a situation where you invoke as a virtue to balance the books, you never cut spending, but you increase taxation. So fiscal rules are effectively being the justification for increasing tax, and I think that is what we will see in the next round, then you borrow a little on top. The gilt markets will welcome more tax until such point where they decide that the trajectory is not sustainable, either on spending or on tax. I do not know exactly how fiscal rules operate at the margin when you get into the magnetic field, that is too close for comfort, and I think they will be tested.

Gemma Tetlow: On your second point, if we look back to 2010 they were used in a completely different way; from 2010 to 2015 we had huge reductions in spending and much less on the tax side. The reason we now have much more of a focus on tax than on spending is that Governments found it very hard to make those spending cuts stick, and certainly much harder to go even further on spending cuts without getting to a point where you are having a conversation with the public about what the state is not going to do anymore.

The reason we have a focus on tax now is not fiscal rules, it is because Governments—it was the same under the last Conservative Government as this Labour Government—have decided that actually the public is not up for scaling back the size of the state. So if you want to keep offering the services and the welfare benefits then you have to raise taxes.

James Smith: That was definitely true during the euro area crisis years. Fiscal rules in the EU during the euro area crisis were really big attempts to cut spending rather than raise taxes; it was very clear that was the sort of received wisdom about minimising the effect on growth. So I totally agree with Gemma; I do not think fiscal rules are telling you to raise taxes rather than cut spending.

The Chair: We need to make some progress. That is partly my fault for keeping this first question going so long.

Q16 Baroness Wolf of Dulwich: I would like to focus on the current set of rules and your assessment of these. Any set of fiscal rules will set up a number of incentives—some positive, some not so great. For example, we know that clearly the current fiscal framework means that within government, there is always this, “Can we score it? Can we score it fast? Can we score it at the level we want to score it?” Do you feel that this is actually something that is having an evident serious and undesirable effect on fiscal decisions at the moment?

Related to that is the size of the fiscal buffer and how far the way that the rules currently operate and have done recently incentivises Governments to leave themselves very little space and to just constantly go as close as they can. That is obviously related partly to the overall fiscal environment, but do these seem to you to be actually sort of serious questions? To some extent they are built into the whole general approach, but are they a major issue under our current set of rules?

James Smith: I guess if you look at the equivalent of monetary policy, more or less every country has a 2% inflation target if you look at the world over. It is very standard. There are differences in how exactly central banks are mandated, but pretty similar. This is not true for fiscal rules as there are some quite different fiscal rules: take the German debt break, the debt ceiling in the US, and our fiscal rules. So there is less consensus about what a good fiscal framework looks like.

If you take my starting point that fiscal rules play that deficit bias role but they also make clear what your fiscal strategy is, then the question is: are the current set of fiscal rules a good depiction of this Government’s fiscal strategy? You would have to ask the Government the answer to that. But by choosing a current balance as the key binding fiscal target, the current balance rule and a public sector net financial liability secondary stock target, what they have done is essentially create themselves more space to invest and less incentive, if you like—we will come on to this less incentive—to cut investment in times when you need to tighten fiscal policy. We heard Rachel Reeves talking about that this morning and the importance of that part of the fiscal framework.

So the current set of rules are in a pretty good place. The work we have done at the Resolution Foundation would point us to advocate for a public sector net worth target rather than a public sector net financial liabilities target. The difference there is you include physical assets within government that the Government create as part of your fiscal rule. That does more to incentivise good decision-making on investment, but these are particular types of policy that the Government can follow. What is currently incentivised is financial investment projects done through financial transactions. That is the thing that the Government basically has given itself a free pass on, so you can think about that part of it.

The three-year window that they will get to in terms of their fiscal rules is a good one. We would prefer at the margin to see it cyclically adjusted rather than just the level of the current balance but again, that is a small thing. The big thing I would emphasise here is that the current fiscal rules are not building fiscal space. They are maintaining at best and are consistent even with debt rising and meeting the fiscal rules, rather than bringing down debt and creating room to do fiscal loosening in bad times. You could make a strong argument that the Government need to be running surpluses, not huge ones, but that is beyond what they currently have in. So, the rules are in a decent place, but you could argue for some changes.

Gemma Tetlow: There are definitely features of this new set of fiscal rules that help overcome some problems of previous iterations. As James said, distinguishing between current budget balance and borrowing for investment reduces the incentive towards short-termism on Government and the incentive to cut capital spending when things are a bit tight. I am definitely supportive of targeting the third year of the forecast for borrowing and debt figures rather than the fifth year of the forecast that we had previously, particularly combining that with the Government now setting out firm three-year spending plans. That means it is much harder for the Government to pencil in essentially fictitious plans for the later years of the forecast. We previously had Governments pencilling in overall very tight spending plans and future increases in fuel duty that over many years add up to quite a few billion pounds, but everyone knew were never likely to actually be implemented. So going for the third year rather than the fifth year helps avoid some of that problem.

The other feature which has not come in yet is that from 2027, the Government are going to target a range of current Budget balance for the spring forecast. They will say the rule is being met if they are between a deficit of 0.5% of GDP and a surplus of 0.5% of GDP. That should help to overcome the desire for Governments to tinker twice a year with fiscal policy when they are just marginally missing rules when the forecast changes. It would be better if that was already in place because that is already proving to be an issue. The rules themselves do not incentivise Government to operate with minimal fiscal headroom at the moment. As I said before, that is more a feature of the very tight fiscal environment we are in, which means that it is politically hard to build up a few extra billion pounds of headroom.

But to your question, it is a problem for Government, and it is a problem for fiscal policy in this country because we have seen in the last year that you can have relatively normal size forecast changes and it buffets the Government into having to make very rapid fiscal policy decisions, some which have then fallen apart, and that does not support good policy-making.

Baroness Wolf of Dulwich: Is there anything we could do about that? We are likely to remain in that situation for some time to come at least.

Gemma Tetlow: With the rules as they stand at the moment, we can encourage the Government to build more headroom in. Perhaps the sales pitch to Government is that actually this has made them very reactive on fiscal policy and makes it hard to command the agenda and really think long term. There are things you could do if you changed some legislation around this. The OBR is currently simply required to judge, yes or no, do the Government have a more than 50% chance of meeting the rules based on their current central forecast? There are some other models. One that we have looked at is an approach used in the Netherlands where it appoints what is known as a study group on fiscal space; that essentially looks at the current fiscal environment, thinks about what the risks are over the next few years and then makes a recommendation to Government on how large a headroom they need to maintain to have a reasonable expectation that they will in fact have borrowing falling and debt falling. You could think of different ways of defining that sort of reasonable chance, but at the moment I guess we are going for a 50:50 chance. You could aim to set headroom with perhaps the OBR saying you need a 70% chance and the headroom that flows from that.

Baroness Wolf of Dulwich: Do you think how frequently we have changed the rules has done any serious harm? Do you think the Dutch system has broadly worked? Worked is a different question, but is it worth looking at seriously?

Gemma Tetlow: I do not know enough about Dutch fiscal policy-making, but it is worth looking at and it is one way of somewhat taking that question about how much headroom you retain out of the Government’s hands. There are difficult political dynamics within a governing party around headroom because I suppose as a Government you are always open to pressure from your backbenchers to give away the headroom if they see it sitting there. Maybe those pressures would be slightly eased if you had an independent judgment that says, “Actually, you need to be maintaining £20 Billion, not £10 Billion against your rules”.

James Smith: The rules have obviously changed a lot. We have had a lot of crises; we have had a lot of changes of Government. If you buy my fiscal strategy argument then it is not a huge surprise that when you get a change of Government you get a change of fiscal rules. We would have benefited from more consistent, constant fiscal rules, but I do not think it is wildly surprising that they have changed quite a bit over the past 15 years or so. What the OECD says is true: we have changed our fiscal rules more than other countries. We are on the naughty step internationally as far as that goes but again, to the conversation we were having earlier, you have to separate the framework and the rules from the shocks and the economic circumstances. Those are playing a really big role in that change. As I said earlier, I do not think it is the change in the rules per se, those have been a very important feature; I am arguing that our policy framework is not causing the difficulties that we are having.

Q17 Lord Agnew of Oulton: James, did I hear you say that you thought the Government should be aiming for a budget surplus?

James Smith: I said they should be running surpluses, yes. It depends exactly what flavour of surplus you are talking about, but their fiscal target is current balance; so bringing day-to-day spending and taxes into line. At best that is consistent with pretty flat debt. If you wanted to see debt falling as a share of the economy then you would need to run surpluses consistently. Bad times are going to turn up and, boy, have the past few years showed us that. If you want to build that space up then you have to ratchet the debt down in good times, and we are not currently doing that.

Lord Agnew of Oulton: How would you achieve that, given that nobody has managed it for the last 15 years?

James Smith: If you go back to the turn of the millennium, we were doing that pretty regularly. It is not completely out of the realms of possibility. When we have been in “normal times”, which does not seem to have happened very much recently, that is feasible. Achieving that is about choices on tax and spending. You could do all the spending and more that you want if you were raising taxes, and these are choices for elected politicians.

Lord Agnew of Oulton: Can you help me a little here? The country has become addicted to entitlements in the 25 years that you have just referred to; so if we are going to cut spending, what entitlements would you be prepared to cut?

James Smith: There are lots of different approaches here: you could cut spending, you could raise taxes. For me, improving the taxes we have would be a key priority in achieving—

Lord Agnew of Oulton: What do you mean by improving them?

James Smith: Improving them and obviously raising more money—so, having a more efficient tax system which did less to damage growth, but also slightly higher taxes would be the route that I would advocate. This is about the choices of elected politicians. You could think of ways to cut the benefits bill, ways to cut the public spending bill, but they all involve pretty tough choices. The key thing is that if you want to build some fiscal space you have to run a tight fiscal ship.

Lord Agnew of Oulton: Can you name an economy in the world that has grown through ever-increasing taxation? We are already at a 50, 60-year high and you are saying that if we just tax everything a bit more everything will be okay. You are being incredibly vague to me. Just tweak a little here, tweak a little there. But what?

James Smith: If you are asking for a full plan, that is a bigger conversation for another day. But there are lots of countries with higher taxes that have grown more rapidly than the UK: some Nordic countries, for example. There is no cross-sectional relationship between taxes and growth.

Lord Petitgas: There is no inheritance tax in Sweden. Zero.

The Chair: We might have to draw this conversation to an end, but it was a good exchange, thank you. Lord Verjee.

Q18 Lord Verjee: This is following on from Baroness Wolf’s questions. How should a sufficient fiscal buffer be formulated? With what flexibility, if any, should the rules afford Government to tackle economic downturns?

Gemma Tetlow: On sufficient fiscal buffer, I would point back to my previous answer to Baroness Wolf. In some worlds, my suggestion is observationally equivalent to what I think James is talking about: you aim for a surplus with a 50:50 chance of having a surplus. If you aim for balance with a more than 50% chance of having balance then, in expectation, you would be running surpluses in normal times. So mine and James’s recommendations are somewhat similar to one another.

On the flexibility to accommodate downturns, that is an important feature of fiscal rules. As I said before, you do not want a situation where a Government are forced into retrenching going into a downturn. Equally, you want to have a system that does not encourage Governments to behave pro-cyclically, spending all that money when things are going well. Many of our previous iterations of fiscal rules have had quite an explicit cyclical adjustment in them. For most of the period between 2010 to 2019, the Government was targeting a cyclically adjusted measure of the deficit; that is explicitly trying to adjust for the position of the economic cycle on borrowing. We do not have that in our current rules, but the fact that Government are targeting measures of borrowing three years out means that actually, for most types of fiscal shocks, having three years to get to that balance position is probably long enough that we will be through the fiscal shock by that point anyway. So the current set of rules give you enough flexibility to accommodate shocks in the short term while still getting back on track in the longer term. But it is an important part of the fiscal rules to have that flexibility, yes.

James Smith: Absolutely to Governments fighting recessions, bad shocks, all that sort of thing—we should certainly build that into our framework. That was absolutely crucial, particularly when interest rates at the Bank of England were locked up against the lower bound, very close to zero, for a long period. It is slightly less pressing in the current environment, but still we should be very clear that fiscal policy has a big role to play when you have a big economic shock.

During the pandemic, particularly when, to a large extent, the shocks affected the supply side of the economy and were very highly distributionally skewed, fiscal policy became essential. So facilitating that should be a key part of the fiscal framework. If you look at what people like me call the escape clause element of the fiscal framework at the moment, it basically involves the Chancellor saying the UK has been hit by a big shock, writing to the OBR, the OBR replying and then potentially saying yes or no, but still the Chancellor would suspend the fiscal rules. So it is a little bit of a convoluted way of operating an escape clause and does little to talk about the circumstances in which you come back onto sensible fiscal rules. It could be improved, but it is a really important part of the framework.

On the size of headroom, let me be even more bold in terms of what I am saying on this. It is clear that £10 billion is too low given the size of the shocks that we have been facing, not just over the past few years but in terms of looking at a longer sweep of history. That very thin buffer leads you to pro cyclicality in assessing a fiscal policy. So there is an extremely strong case for increasing that headroom. If you look at some evidence that looks at the types of shocks the economy has faced, then it would say that if you had £10 billion headroom against a fiscal rule, it would be more or less a coin toss whether you hit that fiscal rule over the duration of the rule. You can up that number to more like three quarters if you double and go even further. If you hold those bigger buffers, it massively increases your chances of being able to operate with a given fiscal framework. But there is nothing innate within a set of fiscal rules about low headroom. I really emphasise that there are two decisions being made here: you can have a great set of fiscal rules but if you set your buffers too thin, then that creates that volatility.

Lord Petitgas: Is there a mathematical formula for this? Taxes are worth about £1 trillion, so £10 billion is 1%. Is that right? So you think it should be 5%? No.

Gemma Tetlow: So the average amount by which the five-year-out forecast moves is about £15 billion to £20 billion.

Lord Petitgas: On the trillion?

Gemma Tetlow: On the borrowing numbers, so that is £100 billion or something at the moment.

Lord Petitgas: The borrowed money?

Gemma Tetlow: Yes. Which is what—

Lord Petitgas: So we borrow £200 billion a year?

Gemma Tetlow: Well the borrowing number, which is what the Government are targeting, is the difference between a very big number on tax and a very big number on spending, so those £1 trillion tax and spending numbers only have to move a relatively small amount for the gap between them to move quite a bit. On average, you are revising the OBR forecast for borrowing by £15 billion to £20 billion every six months, so a £10 billion buffer does not give you a high chance of staying within that.

Lord Liddle: A quarter of a century ago, Jeremy Heywood in No. 10 always used to talk about automatic fiscal stabilisers. I wondered whether the OBR ever attempted to measure what these are and, if so, whether they could be published?

James Smith: The OBR has talked about automatic stabilisers, which enable the tax system to retreat in bad times and the welfare state to expand, but it has not focused on the issue. There is some academic work in the US that focuses on it. Having spent a lot of time looking at this I would say that automatic stabilisers give a fairly low level of stabilisation. It is true that you have cyclicality to spending and taxes, but in terms of stabilising the economy, you have to do much, much more.

Lord Liddle: You have to have a discretionary element to policy.

James Smith: Yes, and that is particularly true given our relatively ungenerous benefit system internationally.

Lord Burns: What work has the OBR has done in terms of showing the range of uncertainty around the numbers to make a fiscal buffer to be able to bet on those ramifications? The one thing we have is a long history of errors that have been made in Budget forecasts, et cetera. I am not sure that one needs a separate panel to do this; it seems to me that the OBR, with all its data, is in a perfectly good position to be more proactive about its view of the buffer that would be needed.

Gemma Tetlow: Yes, the OBR does that; it presents various charts with fan charts around them based on past forecast errors to give a sense of the uncertainty around its central forecasts.

To my suggestion of doing an assessment of what you would need to have, say, a 70% chance of meeting it, certainly the OBR has a lot of the analysis and capabilities to do that. What I was suggesting, which would be different from the current fiscal framework, was simply to have an independent assessment of that question and then to provide advice to Government on what the headroom would need to look like as a result of that.

Lord Davies of Brixton: I do not think people really understand fan charts. The whole presentation is totally deterministic and it really does not work.

Gemma Tetlow: It is difficult to get uncertainty across to people. The Bank of England has obviously been trying to do this for a long time; it religiously presents its fan charts without a central line on them, and journalists always work out what the central line is and report that number, so it is not easy.

Having said that, there are ways that the OBR could put more emphasis on the uncertainty. For example, the headline of its press release from the March Spring Statement said something about the Chancellor restoring headroom, which was very much a focus on a point estimate of this specific number. Its hands are somewhat tied by its remit because, as I say, I has to do a pass/fail judgment on whether they have a more than a 50% chance. There are some things the Government could do to make that better; if they gave the OBR a bit more licence to give a more subjective narrative assessment of compliance with the fiscal rules, that might help somewhat. But it is very hard to convey uncertainty and get people to talk about that rather than the central estimates.

Q19 Lord Petitgas: My question is about the effects of the fiscal framework in the short term and the long term. Inevitably, when you think about this the short term is about tactical movements and the long term is about the big picture, investment and strategy. First, are we being condemned by the fiscal framework to do little things in the short term and forget the big strategic picture? I know there have been some changes to borrowing for investment as opposed to borrowing for other reasons, but please give us your view on that. Secondly, what is the international experience of other systems? Are they better at managing both the long term and the short term?

James Smith: I will refer back to my earlier answer as I covered some of that already so I can be quite brief.

The current framework is a vast improvement in terms of the investment side. If you have a fiscal rule that focuses on total borrowing and total debt, that gives an incentive to cut investment when times are hard. That issue has been taken off the table to a large degree and we are not seeing any sign that belt tightening is going to be the way of the next Budget, so that is a really important innovation.

It is interesting to compare ourselves to other countries and the different systems I was referring to earlier. In the European system, the fiscal rules exclude public sector bodies outside the immediate central and local government. As a rule, what gets excluded from the fiscal rules gets exploited. So in Germany, for example, you see lots of quasi-public bodies doing public investment or other public spending that moves them outside the fiscal rules. The concern with the current set of rules is that such behaviour might be incentivised by having a public sector net financial liability target; basically, it means that the Government’s financial transactions create not only liabilities in terms of borrowing and spending, but financial assets at the same time. That is one aspect in which we could learn from international examples.

Gemma Tetlow: Just to add to what James said, having binding targets three years out inevitably makes your focus somewhat short term. It is really hard to avoid that if you want something that is genuinely binding on government decision-making.

There have been some things in the last year or so that have helped to provide more of a long-term focus. It was very welcome that in last year’s Budget, alongside the EFO’s five-year assessment of what impact Government investment might have, the OBR explained what it thinks is going to happen over 10 or 20 years ahead. That, alongside the medium-term forecast, provided a bit more focus on the longer-term impacts of Government policy-making, and we could probably push it even further.

The OBR does a yearly fiscal risks and sustainability report looking at some long-term pictures, but it never gets as much attention as the biannual economic and fiscal outlooks. So there is probably more that we could do collectively to shift attention towards that longer-term assessment and how government policy is affecting that, to try to slightly shift the focus.

On the international comparisons, as far as I know, no other countries have this distinction between current budget balance and investment spending that we have in the UK. Most other sets of rules just target overall deficit. Having said that, there does seem to have been a shift internationally in realising the importance of protecting investment spending and putting a bit more emphasis on that.

James mentioned the EU rules; under those rules, if countries go off track there is normally a four-year adjustment period where they are allowed to get themselves back in compliance with the rules, but that can be extended to seven years when they have a plan that involves public investment to boost the country’s growth prospects. Canada, which targets its debt falling in the medium term, has recently introduced a new capital budgeting framework alongside that, which again is putting more emphasis on the role of capital spending.

Lord Londesborough: Can I just follow up on the international side in relation to the UK’s public investment, which has been very low? For quite a number of years, particularly in the last 10 years, it has actually been below 2% of GNI or GDP. We typically rank about 25th, 27th out of the 30 countries measured by the OECD. How much of this would you say is down to our fiscal architecture, or is it just more a case of a depressed economy?

James Smith: I would highlight two features. The first is the inclusion of investment within the targets that we have had for years; when belt tightening is needed, there is a strong incentive to reach for investment as the first lever to pull.

Secondly, there is the incredibly centralised nature of our investment. If you look at the fraction of investment spending that is done by central government relative to local government in the UK compared with other countries, it is much, much lower. Central government essentially controls the levers of public investment. Retrenchments have meant public investment is too low, but it is also too volatile. It gets cut too much and that adds up to something that not only means we have too little public investment, but that when we do it, it seems to cost more and to be less efficient. That has been a very UK-specific problem. As Gemma says, I do not think there is an international consensus that says, “Here’s a much better way to do this”, but it is clear that what the Government have now done at least takes some bad incentives away.

Gemma Tetlow: The only thing I would add is that we should probably not overstate how much the fiscal rules have driven that behaviour towards cutting capital spending because actually, we only had a fiscal target for total borrowing, not current budget, during the period between 2015 and 2019. Even before that, we had Governments that tended to cut capital spending.

Q20 Lord Blackwell: You talked about the OBR’s long-term forecasts. As you know, they showed that, because of the increasing population in retirement relative to a low birth rate, expenditure on welfare for retirees was increasing and there was a risk that spending and, therefore, taxes as a percentage of GDP would just keep inexorably rising. No Government have tackled this so far because they could satisfy the five-year or three-year rule without addressing it. Is there a case—without trying to lock in 20-year or 30-year plans—for requiring the Government and the OBR to comment on what actions they are taking not just on the deficit but to keep the level of expenditure within a target range of 35%, 40%, 45% or whatever of GDP, just to force that issue on to the table?

Gemma Tetlow: That is an interesting question. In some places, the UK has been quite successful in dealing with the pressures of an ageing population—more so than other countries. Our state pension spending forecasts, for example, actually do not look out of control because of the changes that were made a decade and a half ago as a result of the Turner commission, when we raised the state pension age. We have plans to continue raising it and have scaled back the state pension offer. That reflected the fact that the Government have acknowledged those longer-term spending problems and have been willing to take some short-term heat to address them.

The issues that are more of a threat to the sustainability of the current offer are mainly around healthcare spending and social care. On Lord Agnew’s point, if you look at those projections, it is simply not sustainable to try to keep funding the inexorably rising pressures on healthcare. The OBR is, obviously, making a bit of a simplified forecast of what unchanged policy could look like, but essentially it recognises the fact that we spend much more on healthcare for older people, and there will be many more older living to ever older ages.

Lord Blackwell: It seems strange that the OBR has put those projections out there but the Government have not been required to address what they will do about them.

James Smith: But you are talking about policy that is many elections beyond this point.

Lord Blackwell: A policy that might have to start now, though.

James Smith: If you have a deficit projection 50 years ahead that is heading off into the stratosphere then the OBR has produced those lines by saying, “We’re just going to continue the current policies we have now for ever”. It throws away all the things we have been talking about up to now in terms of the fiscal framework. It assumes the Government forget about all that for some reason, and that the bond markets will lend to them to that extent, which does not seem at all likely. These long-term projections tell you something interesting, which is that ageing is a huge problem and where it lands in terms of healthcare expenditure, as Gemma was saying, but they are not useful in the sense that the assumptions are highly unrealistic. You are right that the more interesting question is: what does a sequence of elected Governments do about that? There is a problem with the Government today trying to tie the hands of future Governments in terms of policy. That question is extremely difficult for any single Government to answer.

Gemma Tetlow: There is a difference for promises made on things like the state pension. A Government today can credibly change the rules about how entitlements are accruing, which will ultimately mean that those of us of working age now will be paid less by the Government. That is a credible commitment that this Government can make and sustain. However, healthcare is different: if you ask this Government to say anything about that, then they commit some future Government to a model of healthcare provision that they cannot commit to, because it could be changed. More helpful would be things that would encourage Governments to start dealing with that problem today, whether it is thinking about the entitlements we offer or about a model of healthcare delivery that might credibly deliver savings, in a much shorter time period, on things that you can build on for the future.

Q21 Lord Liddle: What is your assessment of the OBR’s present approach to dynamic scoring? Is it transparent? What would you recommend doing about it?

Gemma Tetlow: Overall, we have very much welcomed dynamic scoring. Over the last few years, the OBR has shifted to being more willing to dynamically score policies and more transparent about the assumptions it makes when it does that, compared to what happened in its earlier iterations. Overall, I would say we have a positive assessment of that. The OBR is pretty good at spelling things out. This often does not happen on Budget Day, when the policies are first announced, but it has been fairly good at following up those initial announcements with reasonably detailed documents explaining why it has scored a particular policy, what evidence base it has used and how it has assessed it.

There is also a potentially positive benefit in encouraging the Government to think about the growth impact of policies rather than just the immediate Budget scorecard impact, which had been an obsession in the past. Unfortunately, that seems to have driven some quite unhelpful behaviours within the Government as well, which are being exacerbated by the fact that they are operating with so little headroom. It now really matters to government departments whether the OBR scores something as being £1 billion more or less and having some small supply side impact. Unfortunately, rather than encouraging departments to think more about policies that may have positive growth impacts than they would have done in the past, it seems to have driven quite a narrow obsession with the question of how the OBR will score a policy. If the OBR will not score a supply side impact then the assumption is that it is not even worth considering because we cannot afford to do it.

It also seems to have driven an unhelpful bias against devolving responsibilities away from central government. The belief is that the OBR will score something only if a department can say, “This is exactly what the policy is going to look like, and therefore we have an evidence base to back up our claim that it will have a positive growth impact”, whereas if devolving responsibilities is a much less clear policy commitment. If you say, “We’re going to give Manchester and the West Midlands additional powers to offer some employment support programmes, and we can’t tell you exactly what that is going to look like right now”, it may therefore be harder to convince the OBR to score the growth impacts. That is definitely an unhelpful dynamic and departments should not fall into that trap.

The OBR is already thinking about ways to counteract these unhelpful dynamics. If the Government had more headroom there would be less obsession with exactly what the OBR is going to come up with. In recent years, the OBR has scored some incredibly small things. It reached a point where departments were worrying about how the OBR would deal with policies that had incredibly minor growth impacts. For instance, it scored some policies that were affecting employment by about 3,000 people a year, which is just too small. I think the OBR is moving in the direction of having a higher threshold for the significance of measures that it even considers thinking about scoring. That will leave departments to do what they are going to do on other policies without worrying about how those are going to interact with the OBR.

The fact that the OBR has dynamic scoring means that many more departments have been brought into an interaction with the OBR than they were in the past. The DWP and HMRC are very familiar with interacting with the OBR because they do that every time the OBR does a forecast on tax and welfare, but it is a bit of a learning curve for other departments to understand how the OBR thinks about these things. Some of this may start to settle down as departments get more experience of working with the OBR and understanding what evidence it wants. The positive outcome of the OBR thinking about this question and asking for evidence is that it encourages departments to be more rigorous in developing the evidence base, filling evidence gaps and making a stronger case about why policies will have growth impacts.

James Smith: I would add that few fiscal watchdogs globally do this dynamic scoring, so it is to the OBR’s credit that it is pushing in this direction, but I echo Gemma’s idea that we should raise the threshold for significance. It is somewhat ridiculous to have so many things pushed forward.

Also, we are currently expecting the OBR to mark down its estimate of trend productivity growth. That follows an extremely long period in which it looks like actual productivity growth has been weaker than its previous assumed trend, so a change is warranted but the timing of it has been absolutely mysterious. It seems to be coming at a point when productivity data are actually picking up and look as strong as they have for a long period. Having a clear and transparent process for those big judgments, including what the bar is for new data, would create a very high level of transparency from the OBR and make the process more open. I get the sense that the OBR is aware of this to some degree.

Lord Liddle: It is good that the OBR is thinking about this. If, for instance, you had a radical programme of welfare reform that tried to curb benefit spend but transfer that spend into mental health programmes for young people who are NEETs, or things like that—an active labour market policy—do you think that the present arrangements are such that a switch could be justified?

James Smith: If the benefit changes were credible and clearly specified then the OBR would score them. Recent experience has been that vague hand-waving and saying, “We’re going to reform health-related benefits”, is not going to get over the bar of being scored by the OBR. When such promises have been made they have, to a large extent, not been delivered. The OBR is right to demand highly specific, credible policies to get over the bar, but if a well-designed reform to the benefit system such as you describe—which sounds extremely sensible to me—were channelled in, we would expect it to be scored.

Q22 Lord Davies of Brixton: You have answered part of my question, which was about the production schedule, getting hold of the information and how it feeds in, but there is the big issue, even if you agree that you want the fiscal rules and you could agree the parameters: is it helpful to have two forecasts a year, or is there a better way of handling that?

Gemma Tetlow: It would definitely be a much better world if we had a single fiscal event a year, rather than the Government changing fiscal policy twice a year. The UK is pretty much unique internationally in having two substantive fiscal events a year. The question is, how do you get to that world? We have had multiple Chancellors take office and commit to having only a single fiscal event; all have then been tempted to announce measures twice a year. Having the second OBR forecast definitely creates political and media pressure for Chancellors to do something.

Lord Davies of Brixton: That is particularly the case when the headroom is so small.

Gemma Tetlow: Yes, and if the forecast moves against a Chancellor so that, without action, they would have a less than 50% chance of meeting their rules, then there is strong pressure to be seen to do something in response. There are a few ways you could try to get around that. I mentioned before that, from 2027 onwards, the Chancellor will be targeting a range of deficits, from 0.5% deficit to 0.5% surplus. In principle, if you have that range in place then there is greater scope for not needing policy action and the OBR will still say that you are meeting your rules. It remains to be seen in practice whether the Chancellor would feel that was enough cover to avoid needing to do more.

Getting rid of the second fiscal forecast would perhaps be the more extreme version of this, to avoid creating that moment when the public, Parliament and the media get a new set of forecasts. The downside of doing that is reduced transparency. The IMF says that best practice is to have two fiscal forecasts a year. That would not remove as much information as might appear to be the case. A lot of other independent forecasters produce economic forecasts and more would come in and fill the space of producing a fiscal forecast off the back of those updated economic forecasts.

Maybe the biggest risk of getting rid of the second OBR fiscal forecast is how it might affect political dynamics. The wider world gets some sense, at least twice a year, of how the economy is moving, whether things are moving against or in favour of the Government. The question is how Ministers respond. For me, the big win of having a single fiscal event is that you would have much more time to develop good policy between your annual fiscal statements: you can take economic news on board, your Treasury officials can feed that to you, and you can spend more time developing your policies before your annual fiscal event. The problem would be if the Chancellor and Prime Minister really do not face up to any new fiscal realities until the OBR specifically presents them with the forecast, in which case you are then back to the world that we have at the moment of quite rapid policy development.

Lord Davies of Brixton: This is a question we should have asked the OBR, but to what extent is it privy to information that is not generally available? Could anyone produce the OBR’s forecasts to a minimum level of plausibility?

Gemma Tetlow: The OBR definitely has access to information that some other people outside government do not. It gets more detail on specific tax receipts coming in, for instance.

Lord Davies of Brixton: Is that a timing or an access difference?

Gemma Tetlow: It is an access difference: it can get its hands on more detailed internal HMRC data, or it can ask HMRC to do analysis that the rest of us cannot. Having said that, other people can get information for bigger changes in the fiscal position. When I was at the IFS before the creation of the OBR, we used to do our own bottom-up forecast for the economy in our annual green budget and we were never that far away from the true picture that ultimately came out from the Treasury.

Lord Davies of Brixton: So if we went to one fiscal event a year, people would still produce the equivalent figures half way through the year in any event?

Gemma Tetlow: Yes, broadly, with the positive impact that we would not be completely in the dark about the UK’s fiscal position. Having independent people doing that, rather than having an official OBR forecast that is presented to Parliament, as the current OBR second forecast is, would substantively affect the political and media dynamics.

If we got rid of the second OBR forecast we could use the space to create more emphasis on something else. One thing you may still want to do twice a year is the near-term gilt issuance forecast, because gilt markets need to know what the Government are going to issue in the next year or two, but you could also create the space to put more emphasis on that long-term 50-year OBR forecast that we were talking about.

James Smith: There is a really important distinction between a fiscal forecast and a fiscal event. It would be a retrograde step to get rid of a second fiscal forecast but I do not think there is anything wrong with aspiring to having one major fiscal event a year. The Government say they want to do that. In normal times, that would be a decent frequency to change policy. What determines that is that it is co-ordinated with Bank of England policy. The way that co-ordination happens at a macroeconomic level is that monetary policy is set much more frequently and it takes fiscal policy as given, so it makes sense for the fiscal policy to be the slow-moving thing and the Bank of England to be the fast-moving thing. That is the constraint.

There are also the practical constraints that Gemma is talking about in terms of a gilt remit, setting within-year spending totals—all those things—so there are some additional reasons for doing two forecasts a year. Having an independent OBR forecast makes a lot of sense. Pretty much every rich country has two forecasts. They differ on events, as Gemma said, but we are in a world where we need high levels of transparency as part of our fiscal framework. Stepping back from that would be worrying.

The Chair: Assuming there were two fiscal forecasts but one fiscal event a year, if the chairman of the OBR, in the spring fiscal forecast, which is not a fiscal event, is asked the question that every journalist would immediately ask, which is, “What’s the implication of your forecast for how far we currently are from hitting the buffer of fiscal rules”, does he answer it or not? He has to, right? Does that make it a fiscal event?

James Smith: It is pretty clear. People like me will answer that question. The question is, could the Chancellor get away with a fiscal forecast which showed that the fiscal rules were being missed? That is obviously a decision for the Government, but it is exactly the point I am trying to make. We are in a position where transparency is important. The fundamental problem here is a tight fiscal position, not fiscal rules or fiscal transparency. Responding to that transparency is important, even if it is inconvenient.

Lord Davies of Brixton: Hiding it away does not help anybody.

Q23 Lord Burns: I would hate to have the job of having to go out to sell why having fiscal rules means that we have to abandon a 50-year policy of having two forecasts a year and have only one a year. It would require quite some selling to persuade people that this is an enormous advantage over the situation we have. We have had two forecasts a year for a long time. Sometimes it has required action in between them but there have been a lot of times when it has not.

Does the OBR have the right mandate? Are there ways in which it should be extended or narrowed? How can it get more attention to some of this longer-term work that it has been doing, whether on welfare or on fiscal sustainability? You rightly say this goes into periods where you have future Governments, but many of the things that have to be done inevitably have implications for future Governments. Lots of investment projects have this characteristic but we still go ahead. Surely it is still important that the Government today are thinking about some of the challenges which extend beyond its lifetime and that more attention should be given to these other things that the OBR is doing. Do you have any suggestions on the nature of this? Is it the remit that somehow is not quite right and not getting enough attention to some of the sustainability work it has been doing? Are there things it is doing that it should not?

Gemma Tetlow: The OBR’s high-level remit is really quite broad and gives it cover to do quite a lot of the work that it then does on longer-term sustainability. The main duty of the OBR is “to examine and report on the sustainability of the public finances”, which is a pretty broad remit and is helpful to allow it to look at quite a broad range of issues, but most of the focus on its work, publicly and politically, is on the five-year forecasts and the words that go around them.

A change I would suggest to its remit, or to the charter for budget responsibility, is to get away from this yes/no assessment of whether the rules are being met with a greater than 50% chance. It should have the ability to give a more narrative statement on the Government’s compliance with their fiscal objectives more broadly. As James said, you would ideally want the Government to have a broad fiscal strategy from which the fiscal rules flow and are a summary of that strategy, so rather than just assessing yes/no whether they have a 50% chance of meeting the rules on these forecasts, a more narrative assessment from the OBR that says, “The Government have a 50% chance of meeting the letter of these rules, the setting of policy is broadly consistent with the Government’s higher-level stated aims of having sustainable public finances”, and a sense of the reasons behind that would be one way to go. As I said before, even without a change to its formal remit, there is more the OBR could do in the way it presents its forecast to put more emphasis on the probabilities around meeting these things and the degree to which the Government really face a coin toss rather than having a good chance with the kind of headroom they have at the moment.

James Smith: For me, thinking in big picture terms, the key thing is whether you move the OBR to a position of having more or less power over fiscal policy. If you imagine a situation where it has less power, does not give a pass/fail on the fiscal rules and just gives some advice on the Government’s plans, a bit like the Irish Fiscal Advisory Council, I think that would be a mistake because it takes the independent forecast and forecast evaluation out of the OBR. If you imagine going the other way and giving it more of a role in advising policy, for example, it would be overstepping at that point and moving into a realm where it steps on the toes of elected politicians who are making distributional choices about the types of policy that can be delivered. Broadly speaking, its mandate is in broadly the right place.

If you look at it in terms of what it publishes, the reports it does, the fiscal risks and fiscal evaluations, it is extremely transparent. I agree with a lot of Gemma’s suggestions about how it could go a bit further and be clearer on what is going on with risks, but for almost every country in the world it comes down to some binding constraint. It just so happens the UK is in a tight position where it is up against those constraints, which is the big issue and the frustration. It is not the OBR getting in the way; it is the rules and the fiscal challenges we face.

Lord Burns: I did not see the Chancellor give her statement this morning—I have only read some snippets—but there seemed to be rather more emphasis in her remarks about getting the level of the debt ratio down than there has possibly been before in terms of her comments. Would that be one of the things that you might think of in terms of an overall fiscal strategy, as opposed to some of the detail that we currently have?

Another question I have is, you say, “Is it more or less powerful?”, but I tend to think of it more as more or less influence. I have a sneaking feeling that it has too much influence in short-term decisions and possibly not enough influence on the longer-term decisions. Is that remotely your view?

James Smith: First, on debt, fiscal rules and setting out the plan, what we heard from the Chancellor is broadly consistent with that plan and that is what we will see as part of the Budget in a few weeks’ time. If you are saying that the OBR does not give Governments a pass because it does not allow them to spend more on, say, investment and clearly reap the benefits then you could always quibble with the exact way that particular dynamic scoring is done. It is admirable that the OBR has moved in the direction of doing more dynamic scoring and being very open about how it does it. If you look at its public investment impact estimates, it takes an incredibly long time for the announcement of public investment plans to lead to higher output in the economy by that infrastructure getting in place and starting to have an economic effect. So you can quibble with what it has done and say that that is maybe constraining things too much, but at least it is setting out its assumptions on exactly how that is done. I feel that is a better debate than the one you could have, which is basically, “Oh my God, it’s just the OBR holding everything back and if we didn’t have the OBR, things would be easier”. That is not the case. I feel like I am repeating myself a lot, but the problems we have on tight fiscal policy are to do with low growth, broader problems in public services and taxation, not about the OBR.

Gemma Tetlow: On your question about short-term versus long-term influence, I agree that it is the case that the OBR seems to influence more how Government think about short-term policy reaction rather than the long term, but I do not think that is a feature of the OBR. The existence of the OBR means there is more transparency and more pressure on government to think about the long-term than there would be in a world without the OBR.

On the dynamic scoring question, one thing I did not say before is it is right that the OBR is a bit sceptical in how it deals with dynamic scoring of policies for various reasons, including the fact that Government are always going to be much keener to tell the OBR about the new thing that they are going to do that is going to boost growth and much less likely to tell it about the thing that they are cutting back within departmental spending that might be bad for growth. It is much harder for the OBR to pick up on those things, so there is a danger of asymmetry in what the OBR is aware of.

Q24 Lord Blackwell: In a way, this is a variant of what Lord Burns just asked. When the OBR was set up, the Government in effect outsourced official forecasting to the OBR. Is that the best way of doing it, as opposed to the Treasury still doing the official forecast and the OBR having the role of critiquing?

There are two reasons for raising that question: one is concern that economic forecasting within the Treasury gets and has been hollowed out, and that Ministers, in making judgments about policies, are now dependent on, as it were, passing their proposal on a piece of paper across to the OBR and waiting for the action back, as opposed to being able to have that informed advice within the Treasury.

The other reason, again touching on what Lord Burns said, is that economic forecasting is not pure science. There are judgments, some of which are political. For example, we were having a slight debate earlier about the view to which levels of taxation impact on growth. A Government might have a view that a certain policy which had, say, a lower level of taxation and they said enhanced growth would lead to more taxes, or conversely that a higher level of taxation might impact lower growth and lead to lower taxes in the end. If they were making the forecast, they would have to make that argument, whereas at the moment they cannot make that argument in the first place: they would have to counter whatever view the OBR took. I wonder whether it is worth reconsidering whether the official forecast ought to be coming from the OBR or the Treasury.

Gemma Tetlow: The OBR is slightly unusual in being an independent fiscal council that produces the official forecast. The CPB in the Netherlands does the same, but many other fiscal councils do the alternative that you were just describing, which is to conduct an independent audit of the Government’s own fiscal forecasts. The hollowing out of Treasury expertise seems to have been what happened when the OBR was first created, partly because many of the people in the Treasury teams who had been doing the forecasting transferred to the OBR. It was not intended to be the effect of creating the OBR. The intention was always that the Treasury would retain its own in-house macro forecasting capabilities and jointly own the models with the OBR. The Treasury has been building up its capacity more recently to do macro forecasting. I agree that it is not a desirable world when the Chancellor does not have in-house expertise that he or she can draw on to help inform policy development, but I do not think that is a necessary consequence of having an independent OBR produce the official forecasts.

For me, one benefit of having the OBR produce the official forecast is almost wrapped up in the second part of your question, which is that economic and fiscal forecasts are not a science; reasonable people could disagree. The challenge of having an independent body that audits the Government’s own forecasts is that, on any individual judgment, it may be very hard for the OBR to say, “This is a clearly unreasonable assumption to have built into your forecast”, but collectively you could have a number of judgments that all go in a similar direction and would end up with something that looks more optimistic than the OBR’s own forecast that it would construct bottom up. Having the OBR produce the independent forecast probably puts a bit more discipline on the Government not to be so reliant on a set of optimistic judgments. Having said that, the fiscal framework allows the Government not to use the OBR’s forecast. They could use their own forecast if they really felt that the OBR was not right in how it was thinking about the impact of particular tax policy changes on growth, for example. It is within the Government’s gift to say, “We acknowledge the OBR forecast. We take a more optimistic view of this. Therefore, this is the policy setting we are going to go with”.

James Smith: I agree with Gemma that there is a virtue to the OBR independently producing the forecast. I would not advocate the Treasury producing the forecast, for the reasons Gemma said and for the reasons we are talking about in terms of its overall role in the fiscal framework. The issue of Treasury economics expertise is a bit of a separate thing altogether, which has waxed and waned over the period that we have had an OBR, and the scale to which its capabilities and decision-making have shifted over that time. If you compare, for example, the level of economics expertise at the Bank of England to the Treasury, it is very clear that a vast amount of the public sector’s macroeconomics knowledge is concentrated in Threadneedle Street and much less of it is over at the Treasury. I would have thought the exchange rate of economists between those two would be fairly extreme in terms of the Treasury benefiting from having more people with that expertise. For purposes of this, I do not think moving the forecasting function back to the Treasury would guarantee that. That is about Treasury resourcing, which is being cut once again. It is under pressure, and that is not going to help in terms of the things we are talking about here.

Lord Blackwell: Can I quickly raise one other issue? There is, of course, another player in the economy impacting on forecasts, which is the Bank of England. Is it anomalous that the Bank of England’s actions and its potential impact on the economy are outside this process, as opposed to also being part of what the OBR considers and passes judgment on?

James Smith: Do you mean outside the forecasting process? Are you saying that the Bank of England and the OBR do not talk to each other?

Lord Blackwell: The OBR does not score, as it were, the Bank of England’s actions. The Bank of England has its own independent forecast and its own actions, which may have a significant impact on the economy.

James Smith: Just as a matter of fact, part of the OBR’s process takes into account the market expectations for Bank of England policy as well as what it is doing in terms of its balance sheet. The way these two things are co-ordinated is that the Bank of England sets its monetary policy pretty frequently, and that has effects in markets and is built into the fiscal forecast. A two-way co-ordination process has to happen, and that happens through the higher frequency, “taking fiscal policy as given” nature of monetary policy decisions. Fiscal policy takes monetary policy into account and vice versa.

Lord Blackwell: Are you comfortable with the way that works?

James Smith: You could ask a deeper question about the fact that we have two official forecasters, and they have had quite different views about the economy. I do not think they are open about the extent to which they talk to each other and reconcile those views. For example, take the assumption the OBR makes about how quickly the Bank of England is going to sell the stock of gilts that it bought during quantitative easing. That assumption looks quite basic, relative to the types of decisions that the Bank of England is taking on that. The OBR is quite broad-brush in how it assumes the Bank of England will do that, relative to the amount of analysis and nuance around that policy at the Bank of England. You can see ways in which they could co-ordinate better and they have been in a very different position on the economy for a long time, with the Bank of England being much more pessimistic and the OBR more optimistic. How that gets reconciled through fiscal and monetary policy is an issue that gets too little attention, frankly. There is a co-ordination issue there, but in terms of whether they take each other into account, that is something that happens.

Q25 Lord Londesborough: The final question is in two parts: the first is sticking to the hymn sheet and following up on the issue of the OBR having greater influence. You could argue that is the case because the sensitivity of its forecasts has raised its profile, partly because of the very narrow margin of error, which you could say is the responsibility of the Chancellor and the Treasury. What it has certainly led to is the OBR copping a certain degree of flak in terms of commentators describing it as policing government policy and constraining scope for action. I will give you two examples. In the FT a couple of weeks ago, Andy Haldane described the OBR as “an inhibitor, not enabler, of growth”. Last week, Louise Haigh MP accused the OBR of dictating “the limits of Government ambition”. Is this shooting the messenger—shooting the forecaster, at least—or do you think there is some truth to these charges? What is your assessment?

Gemma Tetlow: I do not think it is right to point the finger at the OBR for constraining government policy. Fundamentally, the OBR produces economic and fiscal forecasts and, on the basis of those forecasts, judges whether the Government are meeting the fiscal rules that the Government have chosen that they want to meet. The reason the Government’s room for manoeuvre is constrained is just the reality of the economic and fiscal situation. To make the argument that the OBR is an inhibitor of growth, you would have to point to something in the OBR’s forecast where you think it is making significant errors in how it thinks about what the prospects for UK economic growth are or what the impacts of different types of policies are. The OBR is really quite transparent about how it comes to its judgments on the impacts policies will have. If you want to make that kind of argument, you need to engage with the sort of judgments the OBR is making and provide credible evidence of where you think it is misreading what is likely to happen.

James Smith: The OBR is by definition providing a constraint. To be clear, what I mean by that is that is enforcing a constraint. You are asking an independent body to judge the Government against their fiscal rules. In a way, this is worse than shouting at the referee at a football match. This is a game that the Government have invented for themselves. They set the rules and the headroom. To then turn around and say that the referee we have invited in to police this is the thing that is constraining is obviously total nonsense. I agree with Gemma 100%: the key issue is the constraints put on the Government by slow growth, a tight fiscal position, and low buffers against fiscal rules. I do not think it is at all fair to say that the problem is the OBR, as some coverage you just referenced suggests; the problem is the wider economic problems rather than the way this is done.

Lord Londesborough: It is, essentially, the low-growth environment. Taking your referee analogy, and I hesitate to bring in VAR, but I will for a moment, the referee’s decisions—or surveyor’s decisions, in terms of the OBR—have actually been pretty generous. Another way of saying that is that it has been overly optimistic in relation to productivity, fiscal deficits and when we will go back into surplus, if you look at the last 10 years of its forecasting. It could be accused, on that side, of being too generous rather than an inhibitor.

The second part of my question really is going a little off-piste, but if we boil down government economic policy essentially to stimulating growth while maintaining fiscal discipline, which I think both Labour and the Conservative nod their heads to, then the OBR’s mandate is in relation to the latter part: ensuring, or certainly covering, fiscal discipline. Is there an argument for an office for productivity to counterbalance the OBR, since we have such a poor record on productivity—that is, qualitative growth? Some commentators think there has been too much focus on fiscal discipline to the detriment of GDP per capita growth.

Gemma Tetlow: I do not think I would phrase this as counterbalancing the OBR. The OBR has a view to longer-term fiscal sustainability and is very clear that one of the big drivers of whether the fiscal position is sustainable in the long term is the growth prospects for the economy, and things look much easier if you have much stronger economic growth.

Is there a case for more emphasis on growth and productivity-enhancing policy within government? There are certainly areas of policy where that does not seem to have been enough at the forefront of Governments’ minds. James talked about growth-enhancing tax policy reforms. We have had a series of Governments whose main approach to tax policy seems to be tinkering at the margins to raise just enough revenue at a Budget Statement. You could take a step back and look at the UK tax system. Even if we wanted to raise as much or possibly even more revenue, you could structure the UK tax system in a much more effective way that would do less to distort and disincentivise economic behaviour. Yes, there is a case for trying to increase thinking in government policy development around trying to drive growth and productivity, but I would not see that as a counter to the OBR and I am not sure a separate body is needed. The potential disadvantage of a separate body is whether it really has leverage where it matters within government, or whether it would be more effective to think about how some key players in the centre of government can really emphasise that and drive that thinking through.

James Smith: If you are arguing for a stronger growth policy, that is something we could all get on board with. If you are talking about there being another body that is duking it out with the OBR about whether we actually need to stick to our fiscal rules versus spend a bit more on that growth policy, I do not think that would be helpful. Just think of financial market volatility, higher interest rates and all these things: the effect on growth would be negative. The OBR is doing a narrow job in terms of providing that independence on the fiscal rules, which is making a contribution to growth—do not forget about that side of it. The broader thrust of government policy should be viewed as a separate thing, particularly when you are talking about the kind of supply-side reforms that the Government seem to be favouring. They could have stronger policy in that area, but that would be a separate issue from the things we are talking about in terms of the OBR.

Q26 Lord Agnew of Oulton: Gemma, you mentioned a few moments ago that the OBR has made some strange microeconomic judgments. You gave an example of a couple of thousand people. Do you think it should be opining on the Employment Rights Bill though?

Gemma Tetlow: My point was not that I thought its judgment was strange in the sense it came to the wrong number, necessarily.

Lord Agnew of Oulton: You said it was freezing behaviour in departments because everyone was getting paranoid because the OBR was poking into tiny, micro activities. That was how I interpreted it.

Gemma Tetlow: My point was that it was going into too many, too small policies, which was not helpful.

Lord Agnew of Oulton: Where would you rank the Employment Rights Bill in your categorisation?

Gemma Tetlow: James may actually be better able to talk to this; I know the Resolution Foundation has done some thinking about this. Partly, it is unclear at the moment how impactful the Employment Rights Bill will be because some really key features of it are yet to be decided. The difficulty for the OBR is the point at which it has enough clarity about exactly what it will do to then judge whether it is big enough for it to worry about in its numbers.

James Smith: This is very straightforward: the OBR has said it will score the Employment Rights Bill when it has sufficient information to do so. I would think that it is basically close to that position, so we may well get something at the Budget, but I would say it is over the bar for the type of policy we are talking about and which the OBR should be scoring. The problem is lots of tiny policies that end up occupying the OBR and stopping it looking at bigger reforms like the ones we are talking about.

Q27 Baroness Wolf of Dulwich: Could I ask one other factual question just to show my ignorance of the details of OBR reports? How often does it go back and report in any detail on whether it got things right or wrong?

James Smith: It does that pretty systematically.

Baroness Wolf of Dulwich: It does that pretty systematically, but does it produce an annual summary? You probably dig deep into OBR stuff all the time, but when somebody like me does I find all sorts of interesting things. Of course, its impact is overwhelmingly through the “big bang” things. I suppose my question is really about whether it should be doing a couple more things like that, which would cut through to a lot of people in this building and to newspapers more generally, rather than only to people who really dig deep.

James Smith: It produces an annual evaluation of its forecast that includes a lot of detail on the things that it has produced estimates on. You are going to see the Bank of England start to copy the OBR and give a little more detail on its forecast errors, so it is setting a standard in terms of transparency on that basis. That information should be there. If you are talking about specific policy scoring, I do not know whether it—

Baroness Wolf of Dulwich: I am talking about specific policy scoring, actually.

Gemma Tetlow: It does revisit its policy scorings. I agree that it can be a little hard to track down the various iterations of the numbers. It is also entering into a slightly new phase of this with the dynamic scoring. It has set up a process with the Treasury to get departments to report back on their monitoring and evaluation of policies that the OBR has scored dynamically, but that is in the “we’ll see how it works” phase, because the OBR will be very reliant on being able to get departments to evaluate those policies properly; then they can update their costings.

Q28 The Chair: Just on that, maybe as a final quick question, I wonder if you want to say anything more about the wider Whitehall effect of our fiscal architecture and fiscal framework. You talked about some aspects of this. There are issues about dynamic scoring. Are departments systematically incentivised to have deliverable, dynamically scored projects rather than other things that may be good ideas but cannot be proven to the Treasury urgently? More widely, are there unintended consequences for the way Whitehall works from this system, such as working up certain kinds of policies and not others, or weaker incentives to develop policies which are properly costed from the outset? What is your view of that?

Gemma Tetlow: I have talked a bit already about some slightly unhelpful dynamics that seem to have evolved from the dynamic scoring. On the OBR’s normal policy costings process more broadly, my take is that that has been a positive set of interactions. The OBR does much more interrogation of the way the DWP and HMRC are modelling welfare and tax receipts. Over time, that interaction is improving the models that those departments have, which is positive, and the OBR is a lot more transparent about the way those models work and the policy costings.

With other departments, over time the dynamic scoring approach—particularly if the OBR systematically highlights where it thinks there are gaps in the evidence base or where it is finding it harder to credibly score some policies that departments are thinking about—could also be a helpful dynamic to encourage departments to develop their evidence base, but also to help the wider research community to understand which questions are key to government and start to fill some gaps. At the moment, it has ended up in a slightly unhelpful place.

Q29 Lord Petitgas: Something that bugs me about the OBR is that, in a way, you have the Government on one side trying to increase spending, reduce tax or whatever, but there is a sense that the OBR is the holder of the truth: there is one version of the truth on scoring, which is that you come with a particular view or a particular policy, the OBR will score it and people in government will say, “Well, I disagree”, but maybe they will have to accept the view. There are people who would say that economics is not just one version of the truth. If Arthur Laffer was running the OBR, he would have a view of where the Laffer curve might be and there would be people in the OBR who disagree. It would be like a market, so the only way to find the truth afterwards would be to iterate and iterate, and find that perhaps we thought it was going to have this impact, but actually it did not. I go back to Baroness Wolf: it is very difficult to get it right.

The thing that bothers me a little is the idea that the OBR is the temple of economics, where there is one way and it will be right. We do not know if it is right. It is possible that other people may have a different view on the impact of certain tax increases. A good example last year was the whole thing about non-doms, and now there is this idea of the exit tax. We do not know: we took the view that people would say, but they did not, so there has been an impact. We do not know; it will take time. Will we look back on it and reflect that we were right, wrong, or that we learned something? That is the bit that is unclear. This is a much longer conversation and probably not one we can have here, but I am curious to understand the OBR better in that sense. It feels like it has the key to the truth and I think there is not only one truth here.

Gemma Tetlow: I do not think the OBR is the one version of the truth and I am not sure it thinks it is. It has to come up with a judgment on everything because it has to produce one forecast. What is really important is that it is transparent about the various judgments it has made and the evidence base that it has drawn on to reach those judgments. The OBR is pretty transparent about that—not everywhere, but in lots of places. The way this works most helpfully is if people outside look at what the OBR says and look at the evidence base it has drawn on; if you disagree with it then absolutely say why you disagree and put forward alternative evidence. We can take as an example the way it scored investment spending in last year’s Budget. Other people looked at its paper and evidence on that and pointed out where they thought the OBR may have missed some relevant evidence in how it had scored it. The OBR then updated its costing in the following March Budget, so it is open to the dynamic of people coming forward with better and new evidence and revising the way it thinks about these things.

Lord Burns: I think the OBR set out its assumption about the number of non-doms who would leave.

Lord Petitgas: I am not saying it obscures. The time will come. My point is that it does not mean it is right.

Lord Burns: No, but the time will come when you can check whether it has made the right assumption.

The Chair: We should wrap it up; I have to watch my team get—I hope—some beneficial VAR decisions tonight in a game against Real Madrid. Thank you very much, Gemma and James. We have put you through a lengthy session. We really appreciate you responding to all the questions. With that, I declare this meeting finished.