Treasury Committee

Oral evidence – Budget 2014, HC 1189
Wednesday 26 March 2014

Ordered by the House of Commons to be published on Wednesday 26 March 2014

Watch the meeting

Members present: Mr Andrew Tyrie (Chair), Mark Garnier, Andrea Leadsom, Mr Andrew Love, Mr Pat McFadden, John Mann, Mr Brooks Newmark, Jesse Norman, Teresa Pearce, Mr David Ruffley, John Thurso

Questions 98-211

Witness[es]: Robert Chote, Chairman, Office for Budget Responsibility, Steve Nickell CBE, Member, Budget Responsibility Committee, and, Graham Parker CBE, Member, Budget Responsibility Committee, gave evidence

Q1    Chair: Good afternoon. Thank you very much for coming in. I am sorry that this meeting start has been delayed. We have had a bit of private business to get through this afternoon. The further piece of bad news is that there is going to be a vote at 3.23pm, we think, which is in just under 30 minutes. Hopefully, we will adjourn for only 10 minutes and then resume. Can I begin by asking you to give us an assurance that there has been no political interference or pressure in any way in your work and that you have been able to obtain all the resources that you need in order to complete the job?

Robert Chote: Yes. No problems.

Q2    Chair: You have judged that the recovery thus far could be attributed to stronger demand that was not accompanied by improved underlying supply potential. Is that right?

Robert Chote: That is correct.

Q3    Chair: In effect, the increase in demand has not been accompanied by an increase in the capacity to supply. That is an indictment of supply-side policy and reform, isn’t it?

Robert Chote: No. I think what we are looking at here is the comparison between what we were expecting at the time of previous forecasts, and this would have been true comparing from now and comparing from December back to the previous budget forecasts a year ago. Over that period we were expecting growth in potential output to be picking up. What we are basically saying is that we do not think the fact that actual GDP has outperformed our expectations is evidence that we were also being unduly pessimistic about the pickup in the supply potential. So it is not that we have been additionally positively surprised. We have assumed for some time that the growth rate of potential GDP was likely to pick up. That is primarily down to the gradual normalisation of credit conditions and conditions in the financial sector. Over the longer term we assume the growth in potential returns to something in line with its longer-term historical average, for want of anything better to pin it to.

Q4    Chair: Your estimate of the output gap—and correct me if I am wrong—the difference between the current and potential output, is larger than suggested by the cyclical indicators, which, of course, has generated a rosier outlook for cyclically adjusted public finance variables. Why did your judgment deviate from the data?

Robert Chote: What we looked at was the pace of what would have been suggested by the decline in the output gap and the reduction in spare capacity in the economy that would have been applied, taking those things at face value. It was not obvious to us why, given what else was going on in the economy, that that looked a particularly plausible story to tell during 2012 and 2013. If you took the cyclical indicators at face value, we would have probably one of the smallest output gap estimates of the range of independent forecasters. We looked at the continued weakness of productivity growth, the evidence across a number of indicators that conditions in the labour market were tightening, for example, and the fact that the pickup in consumer spending relative to expectations seemed to be driven more by a reduction in saving than by a pickup in real incomes.

All of those things together suggested that a picture in which the spare capacity in the economy was being used up more quickly seems to be a more plausible story. We drilled down a bit into the component elements of the cyclical indicators. A couple of things were striking from that. One is that if you look at what firms are saying about capacity utilisation, the answers they are giving at the moment are consistent with what you would have expected to see in boom conditions in the past and it does not seem, from looking at the wider evidence in the economy, that that was most obvious.

The other thing was that we looked at what drives some of the measures of recruitment difficulties and we found there that the changes in reported recruitment difficulties seem to owe something to the speed with which unemployment is falling and not just its level. For that reason, again, we thought there were a number of arguments for saying that the apparent tightening in the output gap implied by the cyclical indicators was probably overstated. As you recommended a couple of reports ago, I think, and which we agree with, it seemed sensible to look at a range of indicators in reaching a judgment on this rather than placing all your eggs in one particular methodological basket.

Q5    Chair: To pick up briefly on something you said a moment ago; you said that, in forming this view, you noticed what the range of independent forecasters were saying. I hope you can give us assurances that you do not do your work with a view to trying to cluster yourselves in the range.

Robert Chote: No. We report over time how our estimates of the output gap compare to the range and the average of the independent forecasters. We moved from a position some while ago where we had a rather larger output gap than the average to a situation where, in the last couple of forecasts, we have had a smaller one than average.

Q6    Chair: Everyone has agreed that there was some structural damage to the economy, to potential output, that is never going to be reversed. How much of that lost output do you think will never be recovered?

Robert Chote: Our forecast would imply a reasonably large proportion of that. If you look at what is implied by our output gap forecast and the projections for potential GDP, you are some way away from the trend that would have been implied by simply pushing forward the forecast. If you take the budget 2008 forecast as a pre-budget one, then significantly more of that is permanent loss rather than negative loss.

Q7    Chair: Is it half or two-thirds? I don’t think that we need to be more precise than that, but I am looking at the higher end.

Robert Chote: At least.

Chair: At least two-thirds?

Steve Nickell: Yes, I would say. But there is an issue about the question of the counterfactual here. A lot of people, when talking about these things, tend to say, “If the economy had just carried on at the same rate of productivity growth and total factor productivity growth as before, then we are long way below”. The fact is that, while historically we see a fairly steady rate of total factor productivity growth, that is extra output once you have taken account of all the inputs, I think it is safe to say that our understanding of where that comes from and why it happens is not a very complete understanding. In some sense, a lot of this has been “lost” but historically, since we do not understand how it is found, its loss is—

Chair: That is a very profound philosophical point, Professor Nickell.

Steve Nickell: I don’t think it is philosophical. It is quite practical.

Q8    Chair: Yes, with practical implications. We have taken it on board and it is very helpful.

Could I ask one more question about the output gap, Mr Chote? I am sure you have seen what the Bank of England said, but when they gave evidence to us their definition and assessment of what constituted economic slack turned out not to be what you thought constituted the output gap. This was a surprise to me. Was it a surprise to you and what store should we set by this distinction?

Robert Chote: No, it is not a surprise. The obvious reason for the distinction is basically the time profile over which we are looking. The Bank of England is obviously concerned about what is driving inflation over a policy horizon of two to three years or thereabouts. We are looking at a longer five-year horizon. For example, I think an obvious distinction is what, in the long term, do you believe is the sustainable rate of unemployment that would be consistent with keeping inflation stable. There, in the long term, the Bank and we have fairly similar views, that the long-run sustainable rate of unemployment is probably about 5% and a bit.

The Bank would say, “Yes, but in the medium term you couldn’t push unemployment straight down to that sort of level without running into inflationary pressures in the meantime.” They have an additional medium-term notion of what the sustainable rate of unemployment is, which would be 6% and a bit. That is partly because you assume that when unemployment rises you have greater long-term unemployment; it detaches some people from the labour market; they are less able to put downward pressure on wages.

Over the time horizon that we are looking at, it would be reasonable for those people to be brought back into active participation in the labour market. I would make the major distinction the time horizon. It is a medium-term view of what the sustainable level of unemployment is. It is also a medium-term view of trends in average hours worked. In the long term we note the fact that average hours worked has been on a much sustained downward path for a long period. In the medium term, the Bank would say there is some scope for hours to rise consistent with stable inflation. We are in the position where we have roughly the same answer but to two different questions. We thought this was likely to be confusing, so we do have a box in the report that explains the difference between the two as best we can but, as the Governor said to you, the Bank does not publish an output gap on a consistent basis with ours. So you can’t make the comparison directly.

Chair: What a thoughtful and interesting reply.

Q9    Mr Newmark: The OBR is forecasting growth at 2.7%, a figure that sits vaguely within the range of other forecasters but certainly seems to be at the lower end of the spectrum that I have seen. Can you explain why you are slightly more at the pessimistic end?

Robert Chote: We are in line with the average of the outside forecast as reported in the Treasury’s last forecast. It depends; different people have different reasons for being more or less pessimistic. Let us take the Bank of England, who are at the relatively optimistic end of the spectrum.

Q10    Mr Newmark: While you are answering the question, it would be useful to know what the Bank of England are looking at in saying it is going to be almost half a point higher than you versus the way you are looking at things now.

Robert Chote: Fine. There is a combination of factors there, one of which is that, when the Bank does growth forecasts, they forecast the revisions to past data; so they engage in backcasting. They look at the pattern of past revisions to initial data and make an adjustment for that, which we explicitly do not attempt to do. We take the ONS’s judgment as being the best one that is available in back data. That is a relatively small part of the reasoning.

Then you can look at the various components of GDP. We have a table in which we lay out the comparison between our forecasts for the particular components of GDP and the Bank’s. One notable example would be that the Bank is more optimistic than we are about business investment over the medium term. While we have year-on-year growth rates of business investment at 8%, 9% and 10%, they are at 12%, 13% and 14% year on year. They also have more of a contribution from—

Q11    Mr Newmark: To drill down on that a little bit, the business confidence index is at an all-time high at the moment. In making your judgment versus the Bank of England, would the Bank of England be looking at the confidence index and you would not be looking at the confidence index, or is that completely irrelevant?

Robert Chote: We certainly look at all the available indicators and draw on them as best we can and I am sure they do the same thing. There will be different interpretations. One thing you obviously have to look at, and we have discussed this here before, is that the business investment numbers are very volatile from quarter to quarter and also revised quite heavily. You can see that by comparing the business investment data for autumn 2011, 2012, 2013 and the latest numbers. As I warned on the—

Mr Newmark: Again, that is driven by confidence. I don’t want to get into somebody else’s questions but—

Robert Chote: No, that is driven by the fact that you do not know what was happening in the past and that view of history is rewritten. I did warn at the time that one of the reasons we have raised our forecast since December is better news on business investment, a roughly 8% rise from the fourth quarter of 2012 to the fourth quarter of 2013, but what the ONS giveth the ONS sometimes taketh away and you need to be slightly aware of that.

Q12    Mr Newmark: Again, I do not want to tread on somebody else’s territory, but the investment allowance was increased tenfold and has now been doubled. Is that messaging from the Chancellor turbocharging that confidence or is it, again, completely separate from confidence in where the economy is going compared to the tax incentives to, “Let us let go of some of your cash that you are hoarding at the moment and start investing it”?

Robert Chote: It is impossible to be precise about quite how much of a contribution these individual things make. I think it is more of a big picture story about the various factors that have been such a drag on business investment over the period of the recession and the relatively muted recovery in terms of those firms for whom there is the hindrance from credit conditions, anxiety about what is going on in the eurozone and uncertainty about domestic demand. We do make adjustments, as you know, to the business investment data, directly reflecting corporation tax changes, for example. Those would be relatively modest.

Q13    Mr Newmark: Sorry, Mr Chote, but in layman’s language why is the Bank of England 50 basis points higher than you in terms of its outlook on growth versus you? What is it that you see different that leads to a certain level of less optimism—I won’t say pessimism—than they are?

Robert Chote: We do not do a forecast on that comparative basis. We look at the data and come up with the best judgment we can. They look at the data and they come up with the best judgment they can. People will differ on these things. That is inevitable and is always true of these forecast ranges. I think one notable feature is—and I think this is still true for both of us—that, although the growth outlook has clearly improved and that has been recognised in past output data, we are assuming that, although we are more optimistic than we were in previous forecasts, we are still expecting to see the recovery slow somewhat over the course of this year. That is partly because the pickup in consumer spending that we have seen seems to have been driven more by people reducing their saving rather than by a pickup in real income growth.

Q14    Mr Newmark: Yes, but a lot of that also, as you know, is driven by perception. It is a psychological thing. As asset prices start to rise, people feel more confident that they can spend money, as we have seen historically.

Robert Chote: Indeed, and anxiety over the potential risks from the eurozone is getting less than it was. That can have had an impact as well.

Q15    Mr Newmark: We had a long period of stagnation. In fact a year ago we were facing a triple dip recession. Why do you think the recovery has particularly taken hold now?

Robert Chote: It is a combination of factors: a general improvement in confidence; the fact that the external environment is seen to be less threatening; looking directly at it, you would infer there is slightly less of a drag from fiscal consolidation over this period than in the earlier period as well, so that would have an impact. On the business investment side, in addition to demand issues, you also have a greater need for replacement of investment, and the longer investment is weak the more powerful that becomes as a factor.

In terms of knowing exactly why we moved from essentially being flat to suddenly moving at an annualised rate of 3% to 4% a year, that is not straightforward to explain. One thing I would have a small bet with you on is that when we look at the ONS numbers in 10 years’ time it probably will not look as sharp a distinction as it does today.

Q16    Mr Newmark: That begs the next question. Is this sustainable and why, suddenly, do we have this pickup but then you are saying it is going to slightly drop off next year? Why is there no momentum behind it?

Robert Chote: There is momentum and there is greater momentum. As I said, the reason that we have some slowing is that consumer spending was driven in part by the fact that you have the saving ratio falling from about 7.2% to 5% during 2013, contributing to greater consumer spending, and that we would not expect the saving ratio to be able to continue to fall at that sort of rate. What we have is consumer spending moving more into line with underlying income growth, and underlying income growth, in time, will be boosted by improvements in productivity growth, we hope. However, over the next few months the most likely outcome looks to us as though you basically have some of that saving reduction-driven consumption coming out and moving to a path that is more consistent with real income growth. We are talking 0.1%, on average, on quarterly growth rates. It is not a huge distinction.

Q17    Mr McFadden: I want to turn to the nature of the recovery. You say in your report that consumer spending, supported by a falling savings ratio, has been the biggest driver of recent growth and export performance remains disappointing. What does that verdict lead you to conclude about the sustainability of the recovery?

Robert Chote: In terms of sustainability, the key thing you are looking for is a pickup in productivity growth bringing with it a pickup in real earnings growth. That is an important driver of consumption and you would expect it to be a key underpinning for the recovery as and when it comes. Implicit in our forecast is that you do start to get that real income growth. We have average earnings beginning to rise more quickly than CPI inflation this year and by a somewhat greater margin as you go through but, as you know, and we have discussed this before, we have been waiting for this pickup in productivity growth to come for some time. One of the factors that we highlight as a risk to the forecast that we set out here is if, once again, we are disappointed on that productivity picture. If you are asking for one single question mark over sustainability, that is probably the score.

In terms of trade performance, in this forecast we are not relying at all, over the five-year time horizon, on a pickup in net trade as a driver of growth. It basically makes a zero contribution right the way through. Business investment, alongside consumption, is the second most important driver. Again, as we have discussed previously, we have predicted pickups in business investment before that have not materialised. The data is hard to interpret. There is tentative evidence. We have an 8% rise through last year and, if that is maintained at the sorts of rates that we are seeing, that is an important contributor to the recovery. As we discussed earlier, the Bank of England thinks that business investment is going to pick up more strongly over that period. So there are risks on both sides of that.

As I say, I think productivity, earnings and the consumption story have to come right. In business investment, the recent tentative signs of improvement need to be sustained. We are not, though, hugely dependent on an improvement in net trade to bring about the sort of numbers we are looking for.

Q18    Mr McFadden: You have used the word “disappointing” to describe the trade performance in your last three reports. Is it beyond the OBR’s remit to speculate as to why it continues to be disappointing?

Robert Chote: Part of the reason is the time it has taken for our major trading partner, the eurozone, to pick up and get back to the sorts of growth rates that, if you go back three years, people would have been expecting to be there by now and be helping to improve things. We had a significant fall in sterling, which one would have assumed would buoy trade performance, and the central picture there is quite complicated. If you recall, a while back we were highlighting the weakness of financial sector services. Exports is a particular puzzle. The data now suggests that that is less so. You have seen, broadly speaking, the decline in sterling slightly slowing the UK’s loss of international market share, but we are not expecting anything more dramatic.

Q19    Mr McFadden: We ought to do better than arrest a decline in market share.

Robert Chote: As other rapidly-growing, emerging-market countries in other parts of the world are trading more with each other, that increases the overall magnitude of world trade. Even if the UK is doing the same amount of exports, our share of that falls. So it is a slightly more complicated picture than that suggests.

Sitting suspended for a Division in the House.

On resuming––

Q20    Jesse Norman: Mr Chote, could I ask a question just picking up on something the Chairman said earlier? Is there a danger that these different measures about the output gap could come unstuck relative to each other so that the Bank worries about tightness in the labour market and starts to raise rates before the OBR would judge sensible from an output gap perspective on its measure?

Robert Chote: Our output gap is not designed as a guide to when you start raising interest rates.

Q21    Jesse Norman: No, but inevitably you would be looking at the thing to say, “Are we taking the full value out of the economy”.

Robert Chote: Yes. Obviously we are a non-policy-making institution, but there are different time horizons that are relevant for policy. In terms of judging the long-term sustainability and long-term setting of fiscal policy, you are happy to see those medium-term considerations play their way out. I think it is horses for courses rather than an inconsistency.

Q22    Jesse Norman: Except it could be a situation where we never get to the point where the output gap is closed as much as one would like on your measure because it has been choked off because of changes in interest rates from the Bank operating on a labour market measure. Isn’t that a possibility?

Robert Chote: Obviously the working assumption is that over time, if the Bank is successfully targeting the inflation target, then that would be consistent with a zero output gap on both measures.

Q23    Jesse Norman: Let us hope so. I want to ask you about business investment, but on your expenditure contributions to growth obviously one of the things you have done is to model Government GDP contribution and that falls off a cliff. You have it at 0.5% this year; -0.1%, -0.2%, -0.4% and -0.2% going forward. Have you done any risk assessment of that? Obviously there is a significant political risk that, if there is a change of Government, those numbers could alter significantly.

Robert Chote: There is, but what Parliament has asked us to do is to prepare the projections on the basis of current Government policy. What we are doing is taking into account the clear departmental plans set out to 2015-16, which include distinctions between capital and current. Further than that, we are basically taking the Government’s expressed policy assumption about total spending. You remove our bottom-up forecast for things like debt interest and social security and that leaves you with what you would you spend on public services and investment underneath that.

On Government investment, I think one other wrinkle, if you look at it in the near term, is that we look at an overall picture there. Transport for London, in particular, has quite a volatile path and that is a public corporation. It messes up the smoother line you would have in those sorts of numbers because we do an aggregate public sector investment view, but some of that will look quite volatile.

Q24    Jesse Norman: There is no political risk assessment built into this. This is just what the numbers seem to say based on an unvarnished view of current policy.

Robert Chote: We are instructed to take current Government policy and that is what we do.

Q25    Jesse Norman: That is interesting, thank you. Obviously the principal driver of recovery to date has been greater consumption, but there does seem to be growing optimism that we will start to see greater business investment. What factors are holding back business investment at the moment?

Robert Chote: If you look back at the weakness of this over the recovery date you would identify a number. For some firms there is access to finance and there, obviously, you can distinguish between larger firms with relatively healthy balance sheets and a reasonable amount of cash on the one hand—

Q26    Jesse Norman: Many people have been hoarding cash in some respects.

Robert Chote: Indeed. Lack of access to finance is not a good explanation for them, but it is clearly more so for smaller and medium-sized enterprises. While they do not account for a huge amount of business investment, it is a non-trivial proportion as well. If you are then trying to have an explanation for why the firms that have lots of money to invest if they wanted to have not, one obvious answer would be uncertainty and pessimism about the long-term path of demand. That may be down to not seeing consumers spending. It may be looking at what is implied by Government expenditure. It may be anxiety about the eurozone and so on.

I think the other issue is whether firms see profitable investment opportunities. One consequence of the weakness of productivity growth is that you have seen profitability relatively weak compared to our forecasts. If that then feeds through to firms expecting that projects would not be particularly profitable in future, there would be not merely a lack of ability but a lack of willingness in some cases.

It is a combination of those things and there are reasons to believe that, to differing degrees, those headwinds are less powerful than they were. In the data it looks promising but, as I say, do not bet the farm on it.

Q27    Jesse Norman: One thing that is curious is you are forecasting a historically high level of business investment. It will be something like 11% on your projections. I have a graph here that goes back to 1980 and it has not been that since then. The question is: why do you think business investment at 11% of GDP is a reasonable projection?

Robert Chote: One thing we have done is to look at an international comparison to help shed some light on this and what is quite striking is that investment, in aggregate, tends to be relatively low in the UK compared to other countries and there may be a variety of long-term structural issues that help to address that. For example, planning could be restricting investment across a wide range of areas, but the sorts of increases in investment ratios as a share of GDP that we have in this forecast would still leave us with a rate that looks relatively modest compared to the OECD average over the past 10 years or so.

Clearly, there are uncertainties here. The Bank, as I say, has a more rapid pickup than we do. Others would have less so. There is the anxiety because of the uncertainties that the data throws up but, taking all those things together, that seems a reasonable path.

Q28    Jesse Norman: That would point you in the direction of something of a rebalancing in that area because it would suggest that business was starting to ramp up on some of these categories.

Robert Chote: You would expect that at this stage of a more normal recovery, when you start to get the consumer going as well. Businesses are not generally leading the recovery, but you then start to see that picking up and, because in business investment the falls are bigger and the swings up are bigger, you would expect to see that rising as a share of GDP in the recovery phase.

Q29    Jesse Norman: The final area I just want to touch on quickly is the question of the annual investment allowance where you project a total of under £1 billion of business investment being brought forward from 2016-17 to 2014-15. Where does that figure come from and what assumptions did you make in thinking about that?

Robert Chote: We used the same approach that we have taken, for example, with looking at corporation tax changes in the past. There are two important points to note. First, obviously this is a temporary measure. Therefore, it does not have any impact on the cost of capital in the long term and, therefore, you are more likely to see it shifting some investment from later to earlier rather than—

Jesse Norman: It is a deliberate attempt to bring forward the—

Robert Chote: Yes, that is part of the policy design. The other issue is noting that, of the firms for whom this is targeted in a particular area, you are still talking about 9%, I think, of eligible investment being involved here. You would not expect that to have a huge quantitative effect, given the sorts of firms that would be able to use it.

Q30    Jesse Norman: Did you model what the cost of the tax foregone would be from that? What is the cost of that policy? I do not have the number in front of me. Presumably it is in the Red Book.

Robert Chote: Yes, it is in the policy costing. We have noted it as one of the four—

Graham Parker: It is a maximum of £1.3 billion.

Robert Chote: Yes. It is costing you £1.3 billion in 2016-17 but then, because of your re-shifting thing, it is a positive effect in 2017-18 and 2018-19. It is one of the four measures in this budget where we noted that there is a significantly-different long-term effect on the public finances from the one that shows up through the early years of the scorecard. It is worse news for the public finances in the near term, but better in the longer term. The other measures are the other way round. For example, annuities change, voluntary mix—

Q31    Jesse Norman: Some of the assumptions have been that you could potentially yank it forward for the purposes of bolstering now and, in fact, it is worse for the public finances.

Robert Chote: Yes. But, in making a judgment on that, it is sensible to look at all the other measures that have similar sorts of timing inconsistencies and if you do that then we calculated that that full set of measures boosts the public finances by about £1.2 billion in the years of the forecast, but only by about £0.2 billion in the 15 years following it. For those, we thought it was worth—

Q32    Jesse Norman: You get a bump in growth as a result of this.

Robert Chote: A bump in receipt.

Jesse Norman: A bump in receipts, right.

Robert Chote: Then less receipts and a bit more spending, depending on the measure, in the longer term.

Q33    Jesse Norman: Did you say you looked at the GDP effect?

Robert Chote: We have basically assumed, on the business investment chain, shifting that amount of business investment into 2014-15 from 2016-17 is too small to trouble the score at all.

Jesse Norman: Is neutral, okay. That is great. Thank you very much.

Q34    Mark Garnier: Mr Chote, looking at households; my usual enthusiastic point. You are expecting the household savings ratio to drop quite significantly, from about 7% to about 3% or so by 2017, based on the fact that household consumption is going to outpace household incomes. Why do you think households are going to be so enthusiastic to gear themselves up again or to save less?

Robert Chote: What I think we are noting there is a much slower decline in the saving ratio than we have seen over the past year. That does continue in the near term. We are expecting it to take some time for incomes to pick up as we are still waiting for productivity to pick up and for that to feed through to real earnings. On that basis, it is rather consistent with the story we were discussing a few moments ago about being in a position where, looking back over the past year or so, you have had the positive surprises to consumer spending being driven more by savings falling faster than anticipated but, looking further, assuming that consumer behaviour moves more into line with what is going on with their real incomes rather than what I think would be an unrealistic assumption that you see the saving ratio continuing to fall at the sort of rates that we have seen over the last year.

Q35    Mark Garnier: The rate of dropping is slowing?

Robert Chote: Exactly. I think two percentage points over two years versus another 1% and a bit over the next five.

Q36    Mark Garnier: Does the same apply to the debt-to-income ratio, the household debt as a proportion of income? That has come down from 170% to about 140% and you predict it is going to go back up to 160% or so. Is that a similar sort of thing?

Robert Chote: On the household debt side, you are much more talking about a story that is linked to the housing market and basically a pickup in house prices and a pickup in the size and the number of mortgages. That is much more down to the implications of the housing market. There you have both a greater willingness of people to buy houses and a greater ability on the grounds of easing of mortgage conditions.

Q37    Mark Garnier: Do you think that is going to be the same case when we see interest rates start to rise?

Robert Chote: Implicit in the entire forecast is that interest rates rise in line with the market expectations in terms of Bank rate. What we have done as an exercise is to look at how many households might be expected to feel that it is required of them to significantly change their behaviour in response to the sort of pressures that you would see from interest rates picking up.

As you will see from the box in which we have laid that out, it is relatively modest over the next five years on the basis of the central forecast and that is partly because we are assuming that mortgage rates rise by significantly less than the base rate is expected to rise as the premium that has grown in recent years comes out. What we have done, though, as a stress test of that is to say, “What happens if the increase in base rate feeds one-for-one into an increase in the mortgage rates people are paying?” Obviously then you would have a much larger number of households who you would expect to be feeling some stress.

What we have also done in this area more widely than just looking at household consumption is to use our scenario analysis in this report to look at two scenarios in which interest rates turn out to rise more quickly than is anticipated in the central forecast. There the impact depends crucially on the reason for why that is. You can think of a good scenario in which the reason that interest rates rise more quickly than anticipated is because the economy is recovering more quickly and that incomes are recovering more quickly; in which case the effect somewhat washes out there because, yes, interest costs are rising more rapidly, but so are the incomes people have available to pay for it.

The alternative scenario in which interest rates are rising, for illustration, as a result of developments in emerging markets pushing up risk premiums, i.e. higher interest rates without the accompanying real income, not entirely surprisingly, both for the public finances and the economy, that is a more difficult scenario than one in which it is demand led.

Q38    Mark Garnier: The point I am trying to get to is that we are still expecting household consumption to represent 66% of GDP. My real question is: are you concerned that we have a recovery that is basically build on household consumption and, as part of that household consumption, we are seeing households continuing to increase their debt-to-income ratio and continuing, albeit at a slower rate, to save less money?

Robert Chote: There again you would draw the distinction between what is going on in the housing market, which is driving the balance sheet story, and consumer spending where, as I say, over the medium term I think we are assuming that changes in people’s saving behaviour becomes less important and what is more important is when people’s real incomes start to rise and the spending that results as a consequence of that. You can have an increase in the household debt-to-income ratio that is not a particularly important part of the consumption story. It is just because houses are more expensive.

Q39    Mark Garnier: Let us just stick on the consumption side of it, though. Let us ignore the household balance sheet and the houses. Are you worried that we are having a recovery that is going to be driven partly by the fact that the households are saving less, especially in light of the fact that the budget is all about savings and putting money aside and strengthening household balance sheets?

Robert Chote: The decline in the saving ratio looking ahead is relatively modest to the importance of that in explaining the surprise over the last year or so. I would not say we were particularly concerned on that score. If you continue to see the saving ratio falling at the rate that it did over the last year and that being the driver of consumption then obviously that requires you to revisit the central story. Steve, do you have anything you want to add to that?

Q40    Mark Garnier: Professor Nickell, if you want to come in on this, but do you have any idea of what would be an ideal savings ratio, which is probably—we have a vigorous shaking of the head for the record. Then again, do you have an idea of what would be an ideal direction of travel for the savings ratio for the long term?

Steve Nickell: My feeling about the savings ratio is that, before the crash, it had probably got to a level that was too low.

Q41    Mark Garnier: Also, it was falling quickly. It fell 10 percentage points.

Steve Nickell: Yes, but it got to a very low level, close to zero pretty much. I suspect that a savings ratio that is positive and does not change that much from one year to the next is probably a good thing, but it is more or less inevitable. For a variety of reasons, people do not like to change their consumption that much. They get used to things and they tend to smooth their consumption, so you end up in a situation where consumption is smoother than income and that leads automatically to ups and downs in the savings rate. In some sense, it is quite natural because it is natural that people want to maintain their standard of living in the face of fluctuations in their income. What one does not wish to see is long trends, particularly downwards, in the savings rate because that probably signals something else.

Q42    Mr Ruffley: Before I get on to questions about housing, can I just remind you of chart 3.39? I mention that, Mr Chote, because the editor of the Spectator thought this was a staggeringly interesting chart and what it demonstrates is that Government consumption is going to contract from 21.8% in 2012 to 16.1% at the end of the forecast period and you say in the text, “the lowest level on record in data back to 1948.” The political comment he makes is that it is highly unlikely that that is going to be delivered, but I am not going to tempt you on that. What is am going to ask you is: what is going to fill that gap? That is quite a precipitous collapse in Government consumption of goods and services. How is that going to be made up towards the end of the forecast period?

Robert Chote: Where will the particular cuts come from, do you mean?

Q43    Mr Ruffley: No. Assuming the cuts go ahead, I do not think it would be fruitful to speculate on whether or not the Government of the day has the political will. We do not know that. Assuming that graph is delivered upon, that will be quite a bit of economic activity, quite a bit of output taken out of the UK economy. You are confident that this is going to be picked up by the private sector.

Robert Chote: Yes, indeed. Again, if you look back at the different expenditure components of GDP, what you basically have is the recovery being driven by consumption in particular, which is not surprising as it is 66% of total activity, and business investment. Net trade is basically neither positive nor negative, but the day-to-day running costs of the public sector being a drag over the last few years of the forecast. Our aggregate GDP growth forecast is positive contributions from private consumption and business investment, offset slightly by the impact that is implied by these spending cuts.

One thing to be slightly wary of on that is that we were expecting Government spending cuts to appear as a drag on GDP growth rather earlier than they have in fact done. That is partly because of the way in which the ONS measures the output of public services like health and education. A considerable number of those are measured directly: school children passing through school, number of operations and so on. Those sorts of variables do not respond one-for-one when you cut the amount of cash that you are spending.

If you responded to cuts in education by saying you are never going to educate any child whose name ends after N in the alphabet then it would show up, one-for-one, as a fall in output, but, because of the way in which these things are measured across the wider swathe of public services, we have not seen the direct contribution of Government spending to GDP, leaving aside its broader economic effects, being as much of a drag as we would have anticipated in the forecast we came to you with two or three years ago.

Q44    Mr Ruffley: Do you see that being picked up later?

Robert Chote: Yes, you would expect that to be more apparent as we go further. The reduction in day-to-day public spending on public services, which is effectively what this graph is picking up, becomes a more important component of the consolidation as you move over the next few years; whereas, in earlier years, tax increases and cuts in capital spending were more important. This is more important to the fiscal consolidation looking forward than it has been to date.

Q45    Mr Ruffley: Turning to housing, the Green Budget, the IFS and Oxford Economics, concluded that there was no convincing evidence of a housing market bubble. Am I right in thinking that your forecasts imply the same view?

Robert Chote: I think you are basically seeing a pickup in demand for housing, partly as a result of confidence and partly the ability for people to get hold of mortgages, but you have a very unresponsive supply of housing. Therefore, you can explain an increase in house prices by fundamentals without having to resort to saying that there is a bubble going on. That does not mean to say that there may not be some bubbly components to what is going on in the housing market in particular parts of the country perhaps rather than more generally.

Q46    Mr Ruffley: What indicators does the OBR look at precisely in assessing whether or not a bubble might be forming?

Robert Chote: We do not look explicitly on an assessment of house price fundamentals as a key driver. We have models that we look at on the basis of trying to take into account the various supply in those but we do not, I think, come out with a formal view that the appropriate level of house prices at the moment is X. As I say, in terms of very rapid increases in house prices in some parts of the country, you might see bubbly activity and people being willing to buy stuff off plan and not intending to live in it and so on, but you have a broader picture than that across the country as a whole. As I say, the fundamentals, stronger demand and relatively unresponsive supply, get you quite a long way.

Q47    Mr Ruffley: The house price inflation forecast peaks at 9% within the next six months before falling back to a steady rate of about 4%. In your current house price model is it capable, with the right inputs, of predicting cycles or price bubbles?

Robert Chote: As I say, I think we are looking at a combination of factors like what you are seeing out of recent data, evidence on whether mortgage availability has improved or not, people’s income growth and so on. So there would be a variety of things on the demand side and a relatively unresponsive position on the supply side. I do not think we are particularly taking a view on, “We think that the housing market is X% or Y% over or under value”.

Q48    Mr Ruffley: Yes, but isn’t there the criticism that there always seems to be a benign return to equilibrium in your house price forecast?

Robert Chote: Over the medium term we are making what you would describe as a relatively neutral assumption that the growth in house prices is likely to return to something that is broadly in line with the growth of people’s incomes. Historically, you could argue that it is intended to be somewhat more than that.

Steve Nickell: Technically speaking, it would be pretty much impossible to construct a model that predicted bubbles. Basically, a bubble arises when demand is being driven by people wanting to get in because of expectation of price growth rather than as somewhere to live and, in that sense, you will not find models that can predict bubbles. In your model if you found that prices were rising much faster than what your model would say then you might think of yourself as being in bubble territory, but it is rather ex-post.

Q49    Mr Ruffley: Ex-post, yes, I thought so. Just going back to Mr Chote’s point, there is evidence that medium-term house price growth is assumed to be equal to the average earnings growth, but house prices over the past 40 years have grown at about 10% and earnings at about 8%. Why are you making the assumption that there is parity between earnings growth and house price growth when there is in fact, historically, a differential?

Robert Chote: We addressed this with the longer-term projections as well. Looking over the longer term, obviously it is hard to know exactly what the supply response is likely to be and how much influence there is going to be on that. This seems to us to be a relatively good neutral assumption. If you look back historically, you have seen somewhat more than that and that will be a risk on one side, but it seems a sensible neutral view to take.

Steve Nickell: The fact is you are right. The house price to income ratio has been growing for the last 40 years, but in some sense that cannot go on forever; otherwise everything you consume would be housing and there would be nothing else left. In other words, housing cannot go on rising as a proportion of expenditure. When we think about the long run, we would turn that off rather than assuming that just goes on and on because we know it cannot go on and on forever.

Q50    Mr Ruffley: Just one short final question. Does the rate of growth in house prices in Greater London pose a threat to financial stability, do you think?

Steve Nickell: I would not have thought so.

Robert Chote: No. One point to bear in mind is that some of the growth at the top end of the London market is not mortgage driven. It is overseas buyers and so on. We do have an assumption more relevant to some of the fiscal costings that you see, house price growth more rapid in London than in the rest of the country for another year or so, but then something that looks like a more consistent pattern.

Q51    John Thurso: Can I come to the productivity puzzle? In a recent speech, Charlie Bean said productivity growth is “absolutely central to the durability of the recovery.” He also went on to say that “if the productivity revival were to fizzle rather than flourish, then so too would the recovery.” Paul Krugman said, “It is not everything, but in the long run it is almost everything.” In your forecast you have described it as “perhaps the most important judgment in our economic forecast.” Why the doubt of a “perhaps”?

Robert Chote: It is maybe undue diffidence. No. As we were discussing earlier, absolutely central to the durability of the recovery is an improvement in the productivity position with that and a return to sustainable real income growth and, therefore, a sustainable path for consumption.

Q52    John Thurso: The serious question is, do you agree that this is the be all and end all—

Robert Chote: Absolutely. It has been the defining puzzle confronting economic forecasters in the UK for the duration of the relatively weak recovery.

Q53    John Thurso: Even though output is returning almost to pre-crisis levels, productivity is still seemingly stagnating and it remains 4.4% below its previous peak. Are we any closer to knowing why or understanding the components of that?

Robert Chote: Not much I would suspect. There is the same long shopping list of potential explanations that people have been playing with for quite some time. One explanation that you hope will give you confidence about the position improving in the future is the notion that the difficulties in the financial system have been meaning that capital has not been allocated efficiently away from failing firms and towards potentially rapidly-growing ones. Some people would emphasise the “zombie firms” half of that story. Perhaps more important is the inability of younger, potentially rapidly-growing, potentially innovative firms to get the capital they need to exploit, for example, the implications of the falling exchange rate and so on. As you assume that the conditions in the financial sector normalise, you would hope that that particular constraint on productivity growth would ease and that is one reason to expect that there will in time be an improvement.

Q54    John Thurso: I was struck by your commentary around chart 3.2, which goes on over the page to chart 3.3, but on page 33 at paragraph 3.10 where you are disaggregating the PCA output gap measures. You go on to say, “These show that firms are: operating at a rate of capacity utilisation typically associated with a boom; finding it harder to hire than in early 2013, but easier than would have been the case on average historically; and increasing wages at rates well below those consistent with normal levels of productivity growth and unemployment.” There seem to be extraordinarily conflicting messages in there.

Robert Chote: Indeed, which is why we felt it was important to disaggregate this and not simply take the aggregate message from the cyclical indicators at face value but to look at some of that. Obviously you never quite know over time what the mental process is that is going on when asked that question and how a particular representative of a particular firm will answer it. We have various debates about, “What do you think as being the appropriate measure of spare capacity in an estate agency?” and how they might answer those sorts of questions. One difficulty is knowing exactly whether firms are thinking about productive capacity that they could bring back into use but it is not available straight away or are they just looking at what is available straight away. There are uncertainties throughout all of these things.

Q55    John Thurso: Typically, for example, looking at engineering firms that I know in my constituency, they would be operating at full capacity on a single-shift system but the obvious increase in capacity is when they think they have done enough work to go up to a double shift or even three shifts.

Robert Chote: Yes. What you do not know is whether, in aggregate, firms are consistently answering those sorts of questions with the same mental math of the answer to that issue in their mind.

Q56    John Thurso: Exactly. The reason I ask you, as a complete non-economist as I have proved to you on many occasions in the past, is, as a policymaker, what should I be holding Ministers to account on or looking for that might help productivity, which is the central part making the recovery stick?

Robert Chote: As I said, I think part of the story is whether one is doing or not doing things that get in the way of the normalisation of conditions in the financial sector and the ability to allocate money effectively. I am sure you have had debates about whether reforms in the Banking sector were of the form that you would think would be most conducive to that. There are other policy reform areas more broadly, the planning environment for example, that you could look at as well. Obviously it is not for us to recommend particular policy changes, but I am sure those sorts of things will be ones that you will look at.

Q57    John Thurso: Your forecasts imply that potential productivity growth will never recover to rates seen before the crisis. That is how I read it and tell me if I am wrong. That seems to suggest a supply-side problem.

Robert Chote: Certainly a supply-side problem. If you go to the end of the forecast, we assume that, at the end of the day, simply by virtue of the fact that we have no better basis upon which to make the long-term judgment, is that there is no reason to think that the financial crisis should have affected the long-term growth rate of potential GDP of long-term underlying productivity performance. Therefore, over time, we are assuming that, for example as the financial sector normalises, you get back to that.

However, by virtue of having had the growth rate of potential GDP depressed for some time, you come back to this problem that we have lost a chunk of potential GDP of economic activity that is not going back in the sense that you never return to the sort of path that you might have anticipated being on some years ago, even though the growth rate of the assumed new path may be the same as the growth rate of the one that you departed from.

Q58    John Thurso: Is it possible, because this downturn was so fundamentally a financial services sector downturn, both led and in scope and size, that we have permanently damaged or permanently removed some of our productive potential in that industry and that it will take time to rebuilt across a more balanced economy? Is it part of the pains of rebalancing the economy?

Steve Nickell: You must be careful to distinguish between losing some capacity and losing the capacity to grow at the rate you used to grow at. The fact is that the financial sector has contracted and maybe some capacity has thereby been lost, but the key issue is the growth rate of productivity. We make the assumption in our forecast that productivity growth, or potential productivity growth, does not get back to its normal level by the end of the forecast. However, I think it would be safe to say that in our future forecasts, it will ultimately. We will say that it will get back to its original trend level because, unless we have huge amounts of evidence to the contrary, we are not going to argue that there has been a permanent shift in the trend rate of growth of productive potential in the British economy. After all, aside from the world wars, this has been going on for 100 years and it is very hard to argue that we are in a new regime.

Q59    John Thurso: It is more a question of the length of time it is taking rather than the doubt as to the end result?

Steve Nickell: Yes, absolutely. Aside from the World Wars, we have never had this before in terms of the length of time it takes to get back to trend productivity growth.

Q60    John Thurso: We are looking at what might be a brake and what could be an accelerator, but we are not in doubt of the direction of travel?

Steve Nickell: Yes.

Q61    John Mann: Table 3.6, employment, you are projecting 1.9 million new workers in the labour market. What is the breakdown of those new workers? Where are they coming from?

Steve Nickell: Sorry, which table are we on?

John Mann: 3.6, page 87.

Steve Nickell: A breakdown in what sense, sorry?

John Mann: Where do they come from?

Steve Nickell: You have a substantial growth in the population, some fall in unemployment and that is it.

Q62    John Mann: We can see the fall in unemployment because we have a claimant count figure there. That is significant in itself but, relative to the 1.9 million extra in employment, it is small. Where are the—

Steve Nickell: The others are new people and people coming from inactivity; that is to say people who would otherwise have not been working, but not been unemployed.

Q63    John Mann: How many of each of those?

Robert Chote: We can dig that out, I think.

Steve Nickell: We can write and tell you.

Q64    John Mann: It is a significant figure. The projections on tax take and the rest are coming from calculations on productivity, of course, so—

Steve Nickell: Yes. Employment growth is significant. Where the people come from is not something that we currently carry around in our heads, but we could work it out.

Robert Chote: One thing you might want to note is the relationship between movements in the claimant count and the movements in the survey measure of unemployment, of people who describe themselves as unemployed, has been quite sharply diverging recently. You have had the claimant count falling a lot more rapidly than would be implied by the number of people responding on survey sites doing that, but basically you have less of that and, as Steve said, you have more population. Activity has held up in the UK much more than, for example, in the United States, where the big surprise is inactivity is a much more serious part.

Q65    John Mann: So this “more population”, how much more population?

Steve Nickell: Over the last five years we have had 1.4 million, something like that.

John Mann: Increase in population?

Robert Chote: Yes. So it is one reason why—

Q66    John Mann: Where has that come from?

Steve Nickell: I think about 40% immigration and the rest of it falls in death rate and rises in birth rate. That is right; increases in longevity and rises in fertility.

Robert Chote: The increase in population is one of the reasons why the per capita GDP story, in terms of returning to the pre-crisis peak, is some way away relative to the overall GDP.

Q67    John Mann: Increases in population and increases in people living longer does not necessarily mean people living longer are economically active for those longer years.

Steve Nickell: That is true, but there is a continuous increase in the activity rates of people over the age of 65.

Q68    John Mann: You say “increase in the birth rates”.

Professor Nickell: Yes.

John Mann: I looked at the ONS statistics for the last 30 years. I do not see an increase in the birth rate working through into the current population.

Steve Nickell: No. The increase in the birth rate has been in the last 10 years.

Q69    John Mann: For these figures, working through, if I look at the number of young people and the birth rate, I do not see where you get increased numbers of 16, 17, 18 year-olds entering the labour market. In fact, if anything, it might slightly dip.

Steve Nickell: Of working age people, they come from net migration and inactivity. There has been a fall in inactivity rates; that is to say a rise in the number of people who were otherwise not unemployed and not working.

Q70    John Mann: If the 40% is from net migration—

Steve Nickell: That is the 40% increase in the population, because the increase in the working age population will probably be a bit higher as a percentage.

John Mann: As a percentage?

Steve Nickell: Yes.

Q71    John Mann: Not much higher, but a little bit higher?

Steve Nickell: 50% or so.

Q72    John Mann: That would then indicate around 1.2 million new net migrants of that 1.9 million in the labour market.

Steve Nickell: Over the last five years.

Q73    John Mann: And into the next six years.

Steve Nickell: In our assumption, we are assuming a slowdown in net migration.

Robert Chote: Yes, we basically take the ONS’ population projection. I think we have that basically declining from about net inward migration of where it has been recently at 200,000 a year to about 105,000 net by the end of the five-year horizon.

Q74    John Mann: By the end of the horizon, but it is a slow decline down.

Robert Chote: I think it is a relatively straight line in the way the ONS does the projections.

Q75    John Mann: I have looked at their projections here. That still would indicate then around 1 million new net migrant workers. That is what these assumptions are based on.

Steve Nickell: Probably a bit less.

Robert Chote: A bit less, if you are starting at 200,000 and ending up 100,000 and going over five years.

John Mann: I am just trying to get a figure.

Graham Parker: About 750,000.

Q76    John Mann: 750,000 to 2018 is what you would—

Graham Parker: You start at 200,000 and go down to about 100,000, yes.

Q77    John Mann: Sorry, what I am trying to ascertain is the figure that you are putting in in your projections for the number of new net migrant workers.

Steve Nickell: We just have net migrants. We do not say they are workers.

Robert Chote: So net migrants are obviously more likely to be of working age than the population on average, but they are not all of working age. The net migrants is including people of all ages, most of whom, and a higher proportion than the average, will be of working age.

Q78    John Mann: Yes, but nevertheless, as you have projected the labour market increasing by 1.9 million, the figure Mr Parker is saying, as I understand it, of that 1.9 million increase, 750,000—

Graham Parker: No, that is the total for net migration.

Robert Chote: You have to take off the number of the net migrants that are not working age, which is not something that we do in the way we do the projections.

Q79    John Mann: So you are saying it is a lesser figure?

Graham Parker: Yes.

Q80    John Mann: In fact, we are talking about 1 million people who are currently economically inactive becoming active as part of your calculation.

Steve Nickell: Where are you getting 1 million from?

John Mann: There is 1.9 million extra people in the labour market.

Steve Nickell: Where is that number?

John Mann: That is your figure.

Graham Parker: That is going from 29.5 million in 2012—

John Mann: To 31.4 million.

Steve Nickell: Oh, we are starting in 2012, not the future.

Graham Parker: So we have another 1.5 million to go from the end of 2013.

Q81    John Mann: No, I am just trying to clarify table 3.6.

Steve Nickell: Yes. You are starting from the first number.

John Mann: Yes, that is your figure.

Steve Nickell: That is two years ago.

Q82    John Mann: Okay. No, that is fine. I thought you were talking about the forecast. Fine, that is 1.9 million. You are saying for the forecast it was 750,000 net migrants, not necessarily all economically active, is the basis—

Steve Nickell: We know in the last two years we have had about, I do not know, about 180,000 a year on average. That is 2012 and 2013. Quite a high proportion of those would be of working age and quite a high proportion of those would be in employment, but I cannot tell you exactly the number. Then, going forward, you have another 1 million new employees left from 2014 to 2018 and I would say a significant proportion of those would probably be migrants.

Chair: I just wonder whether we could pursue this in written form. I think it is a reasonable question to get to, but—

John Mann: No, Chair, I have the information on this.

Chair: You have the information you need?

John Mann: If there is more information, I am happy to get it.

Chair: We are going to have to move on.

John Mann: Just one other question.

Chair: A very quick reply, and if you do not know the answer then do write.

Q83    John Mann: You are projecting wages and salaries going up 3.8% this year. What would you then anticipate inflation would be by the end of the year?

Robert Chote: Sorry, what do we have? Inflation is 2%.

Steve Nickell: Sorry, do not forget wages and salaries is earnings times employment, so it goes up because of employment as well as because of earnings. Inflation will be, by the end of the year, 2%, 2%-ish.

John Mann: 2%-ish.

Chair: I am going to have to move on because we have several colleagues who need to get in and, to one colleague, I promised that we will finish by 4.40pm or 4.45 pm, if you do not mind, John. We can have a private discussion and work out how to frame some particularly detailed questions for the OBR to answer.

Q84    Mr Love: Can I come back to the outlook gap and its impact on the cyclically-adjusted current budget? The IFS, in its recent Green Budget, did a study of different estimates of the size of the output gap and how that led to large variations in the cyclically-adjusted current budget. Since the Autumn Statement of 2012 up to today there has been quite a variation in your estimate of the output gap. How sensitive is one to the other?

Robert Chote: The size of the cyclically-adjusted deficit?

Mr Love: Yes.

Robert Chote: Roughly speaking, for every one percentage point change in the output gap, it makes about 0.7% of GDP difference to the size of the structural balance. If you look at the room for manoeuvre by which we would expect the Chancellor to hit the fiscal mandate at the end of the forecast horizon then you would need the potential output to be about 2% smaller or the output gap to be two percentage points less favourable for that margin of error to disappear.

Q85    Mr Love: Is this something that we should be worried about? There are huge variations currently in the output gap and nobody knows where it is. We are all exercising judgment.

Robert Chote: Indeed, absolutely. You can see the range of views that people have on page 36. We have things ranging from a negative output gap, i.e. output about 5% below potential, to 1% above potential in 2014 from most people’s forecasts. Those people with long memories will recall that Ken Clarke once had a group of wise people that he convened and I seem to remember that in the summer of 1986 he asked them to estimate the contemporary size of the output gap. Astonishingly, the difference from the largest to the smallest was six percentage points of GDP; so some things change and some things do not.

Q86    Chair: Wasn’t that in 1996?

Mr Love: You must have been there.

Robert Chote: Yes, probably.

Chair: I was not there. I was working abroad at the time.

Robert Chote: The decades fall away.

Chair: I left the Treasury in 1990.

Robert Chote: Indeed. Yes, absolutely. One of Mr Clarke’s many innovations in economics—

Q87    Mr Love: I have to say, the optimistic estimate of the output gap is much more to my liking than the pessimistic for the impact it will have, but anyway—

Robert Chote: The same is true of policymakers. I am sure they would much rather it was larger than smaller.

Q88    Mr Love: Earlier on, the Chairman asked you about the reasons why you had deviated from the cyclical indicators and, indeed, this has been a theme since 2012. What would have been the impact on the cyclically-adjusted current budget if you had stuck by the cyclical indicators?

Robert Chote: I think we would have been looking at an output gap about probably the two percentage points difference. I suspect, if you took them completely at face value, we would be at the very small end of the spectrum and it would use up most of the room for manoeuvre against the mandate.

Graham Parker: What matters for the mandate is what the output gap is in 2018-19 and it may not have made much difference to that.

Robert Chote: Yes, that is true.

Graham Parker: If the output gap was close to closed now, we would probably have a forecast that kept it about the same level, wouldn’t we?

Robert Chote: Yes.

Q89    Mr Love: Forecasters at a major newspaper, which will be known to you, have estimated that it was roughly equivalent to £20 billion. Would you dispute that figure?

Graham Parker: No, that is not far off.

Robert Chote: That is not far off.

Q90    Mr Love: You are saying the Chancellor gets very close to the contingency he has allowed himself at the end of the process. Would this have required further tightening on his part?

Robert Chote: I do not know. I think it would be quite close, the amounts. Where are we? The cyclically-adjusted surplus in 2018-19, we are meeting the mandate with 1.5% of GDP to spare relative to 1.7% of GDP, which we would have said in the last forecast. For the cyclically-adjusted balance to be different by 1.5%, you would need the change to the GDP to be different by a bit more than 2%.

Q91    Mr Love: Clearly this is a subject that depends on the volatility of the output gap. There are almost as many options as there are forecasters in terms of output gap. Is that volatility likely to continue or are we coming back into a period where there might be more consensus about what the level of the output gap is?

Robert Chote: I would not bet on it. If you look at the way in that the range of output gap estimates has changed over the last couple of years or so, on average it has clearly declined. Two-thirds or so of the forecasters assume that the output gap is about 2% and we are in that bunch. Then you have a selection of people who think it might be in the 4% to 6% range. I would say you are moving to a situation where it is slightly easier to distinguish two camps of quite big output gaps and relatively small ones, whereas I think if you had looked at the same chart in the forecasts two years ago it would probably have been a rather smoother and a rather more linear range of estimates.

Q92    Mr Love: That brings me to the question of the fiscal mandate, which is, of course, based on the cyclically-adjusted current budget. How secure is the fiscal mandate as a way for the Chancellor or the Treasury to test themselves on whether or not they are delivering on their economic objectives?

Robert Chote: This is one of the two fiscal objectives that they have set themselves. It is not for us to say whether they are the right set of objectives or to comment on what ones they should have. I am sure, if they were here, they would say that they believe that delivering a sustainable medium-term fiscal path does help deliver your broader economic objectives. I think the key point to bear in mind is that, as you say, you do not know with confidence what the output gap is going to be at that sort of horizon, which is one reason why, in every forecast that we have produced, we do a sensitivity analysis to show how wrong you have to be about that in order for the rule to be in danger of being breached.

The other uncertainty, of course, even if you know what the activity is, is whether you get the forecast of the unadjusted deficit right over that horizon. Clearly that is not straightforward either, so you have two sources of difficulty there. I think the key point is that at the moment, primarily as a consequence of having taken, in recent years, the decision to extend the fiscal consolidation by a further couple of years implying further, in effect, structural cuts in public spending over the longer-term time horizon, the Chancellor now has a larger margin by which we would expect him to meet the mandate than would have been the case when you looked at our forecast two or three years ago. That is partly because the forecast date that is relevant for the mandate is now 2018-19, and a couple of years ago it would have been 2016-17.

Q93    Mr Love: What changes would make the fiscal mandate more predictable than it currently is?

Robert Chote: Again, it is not our job to say what the target ought to be. You have the question of: what is the path of the economy over this period, what happens to receipts and spending if the economy moves in that sort of way and then a related but separate judgment of how much of that is then structural or cyclical and how much remains as a fiscal deficit that is a consequence of the economy still being below potential? You have at least three sets of uncertainties there in making all those judgments.

Q94    Mr Love: Yes, I understand that and the people who read your report and read the budget Red Book will understand that. They will sympathise with your need to adjust not just for the cyclical indicators but for other aspects of the economy, but it is the public out there who will see adjustments being made that just happen to, at certain times, conveniently help the Chancellor or hinder him, depending on your point of view. How do we reassure the public that they should have confidence in the forecasts that are being made and not just consider them guesstimates or, at worst, a forecast unreasonably influenced by politicians?

Robert Chote: We try to do that by being as transparent as we can in the elements of those judgments and therefore explaining at length why, for example, we have decided to take a view on the output gap that is not simply taking mechanically what is suggested by the cyclical indicators; explaining as clearly as we can how we think the components of nominal GDP will move; how the particular elements of spending and receipts will move. You can clearly have a target that is not a cyclical one and, at one level, that is simple. The Chancellor has suggested he would like to be in a situation where you are looking for a simple, straightforward surplus on the overall budget. That is clearly easier to understand and to interpret than a cyclically-adjusted surplus or balance on the current budget, but it is way above my pay grade to say whether that is a better target or not. That is for you and Parliament to decide.

Chair: That is very helpful. We are going to have to move on and if you could be brief I would be extremely grateful.

Q95    Teresa Pearce: Tax avoidance: the Government has projected that £4 billion could be raised by their accelerated payment anti-avoidance scheme. What work have you done on that estimate?

Robert Chote: On the accelerator specifically, the issue there is basically to see what you think is the total amount of tax receipts that are in dispute related to marketed anti-avoidance schemes. You can start off with that as a relatively aggregate figure and it is about £14 billion, judging from what the various people responsible for this at HMRC would report back in getting a central figure.

Q96    Teresa Pearce: You are looking at particular schemes, particularly anti-avoidance schemes and—

Robert Chote: Yes. Basically, in doing this, I think HMRC talked to the people who are responsible for the various cases.

Q97    Teresa Pearce: Has the original estimate come from HMRC?

Robert Chote: Yes. The first thing you do is get an aggregate number. You then say how much of that is within scope for this particular measure, which is a smaller proportion of that. You then have to make assumptions on things like what is HMRC’s win rate.

Q98    Teresa Pearce: But the OBR said that it was based on a number of assumptions. What would those assumptions be? Would they be exactly what you said, the win rate?

Robert Chote: Exactly. For example, we have assumed an 80% win rate, which is the average rate from 2010 to 2013. You have to make assumptions as well—I do not think we have precisely quantified this—for example, some people will have paid the money but still be disputing whether they paid the right amount of money. So there are wrinkles in that as well.

Q99    Teresa Pearce: Have you factored in any behavioural response; any sort of thoughts that people may be less likely to engage in this because of this new way of looking at it?

Robert Chote: There is an element of behavioural response, but by far the main bulk of it—

Q100    Teresa Pearce: Do you think it makes it more risky for people because of the fact that if one fails then they all have to pay up?

Robert Chote: Yes. What is hard to know is for how many people the cash flow penalty of pursuing this—if you still have to hand over the money in the first place, how much of a deterrent that is to them disputing the thing in the first place once somebody else has lost a case. There are behavioural uncertainties around that but, in terms of the amount of money that is in dispute, that is a fairly—

Q101    Teresa Pearce: Do you think that £4 billion is the best estimate? Do you think it is the top end of what they could possibly get in?

Robert Chote: It is not the top end. It is our best assessment of what looks central to us.

Q102    Teresa Pearce: When they have estimated that figure, have they included in there any extra staffing they would need, any resources, or is it just based on their past performance, do you know? Maybe I should ask them.

Robert Chote: I think you need to ask them. In coming up with the costing of the measure, we do not net off the administrative expense because that comes within HMRC’s departmental expenditure limit. I think he allocated an extra—

Graham Parker: Yes, we do look at things like opportunity costs. If they had to divert people on to this from other things, which would have had their own compliance yield, that should be allowed for on the costing.

Robert Chote: But it is not clear that getting them to pay earlier than they otherwise would be required to do is particularly labour-intensive.

Graham Parker: There is a little bit more work in issuing payment notices and this does not assume that everybody pays upfront just because HMRC tells them to. There is quite a bit of collection to do.

Q103    Teresa Pearce: But in the new anti-avoidance changes announced, firms who are in disagreement with HMRC over the tax avoidance schemes will have to pay the disputed sum over and, should HMRC fail, they will get their money back with interest. Has that been calculated in? What contingent liability might be in there for HMRC if they take the wrong case to court?

Robert Chote: It is not a contingent liability. It is basically an assumed 80% win rate with the financial consequences of—

Graham Parker: But interest is allowed. Repayment supplements are allowed.

Q104    Teresa Pearce: But if you remember when HMRC was going to embark on the tax litigation strategy, instead of negotiating settlements it was just, “Let us go to court”, that never really happened because they did not seem to have the expertise to do that or to pick the right cases. Maybe I should ask them these questions. I am just a bit concerned that they are being over-optimistic.

Graham Parker: The original £14 billion was based a pretty detailed trawl of all the HMRC records, because they have all these cases logged already. They know how much is in dispute, so the actual baseline is based on a lot of work that inspectors of taxes have done across the country to identify these cases and identify the amounts involved. It should be—

Robert Chote: The baseline is probably more robust than for many other anti-avoidance—

Graham Parker: Than normal, yes. It is better than most anti-avoidance costings.

Robert Chote: Take as much reassurance from that as you would like.

Q105    Andrea Leadsom: I would like to race through, in six minutes, a whole load of pensions and savings stuff, if we could.

Chair: Quick answers.

Andrea Leadsom: Very quickly, yes. The Chancellor has said that excessive borrowing and insufficient saving is one of the biggest weaknesses of the British economy. Do you agree? Too much borrowing and not enough saving, is that one of the biggest weaknesses?

Steve Nickell: No comment.

Robert Chote: No, as I say, we—

Q106    Andrea Leadsom: Are you allowed to comment? Surely you are allowed an opinion on that?

Robert Chote: As we discussed earlier, we do not take the view that there is an optimal level of the saving ratio for which we are aiming, but clearly we are worried if it is very low and falling like a stone.

Q107    Andrea Leadsom: Could the ability to take pensions as a lump sum raise household consumption and lower the savings ratio further? Are you worried about that?

Robert Chote: We are assuming that, if you look at the set of pension and saving measures in total, there are effects going in both directions and, therefore, we have not made an explicit adjustment to the forecast for that. That is not because we are very confident that the answer is zero. It is because there are things going in both directions and we do not think we can be clear which way wins out. For example, clearly, if you are having people attracted by the idea of drawing down and getting their mitts on the money earlier and spending it, that is an upward pressure. However, the fact that people will decide whether to engage in saving in part on how easy it is to access the money in the future could make it more attractive. The ISA measures are going on in the same place. I think you have a series of influences going in both directions and it does not seem to us, that there is powerful enough evidence to say we can be very confident the effect is either net positive or negative net.

Q108    Andrea Leadsom: So you are assuming neutral?

Robert Chote: Yes.

Q109    Andrea Leadsom: A bit like when you assumed neutral on the impact of the eurozone crisis on the UK economy, it is slightly a cop-out. You are not doing any sort of scenario testing on what the expected result is of these measures.

Robert Chote: As I say, for the central forecast, we reach a judgment on that. We would assume if there is an impact on consumption that it would be relatively modest. There is the sense that you are certainly likely to see people perhaps changing the way in which they allocate their assets rather more than the total amount of saving they do and the total amount of assets they have.

I think one reason to underline the uncertainty here is how quickly people can move relatively large amounts of money from one form of holding wealth to another, and we have a box highlighting the pace and scale of movements between site and time deposits in banks. It is a cautionary reason to note that these things can move unexpectedly and there are big uncertainties, but we still think, as a central judgment, assuming that it washes out, it is probably the best we can do.

Q110    Andrea Leadsom: Okay, but I say again it would be very helpful to have some scenario testing. If it did end up being the case that retiring workers decided to spend all of their pension pots rather than save it, it would be helpful to see some kind of scenario on the impact that that might have on the economy on your central forecast.

Robert Chote: Yes. One of our scenarios is obviously showing the fiscal implications of what happens if you do have a stronger and more robust recovery, so you can get some flavour of the degree of sensitivity through to the fiscal position from that. I would not have thought that the margin of uncertainty was large enough to make a very major difference to the medium-term fiscal position, which we are obviously here fundamentally to look at.

Q111    Andrea Leadsom: The Treasury estimates that one in three retiring workers, which will be about 100,000 people, a year until 2017 will draw down their pension faster. Is that a fair assessment?

Robert Chote: That is the central assumption that underpins the costing. I think in that you are thinking, in particular, of two categories of people who are more likely to respond in that way. One of those would be people who have relatively large amounts of expensive debt and this is an attractive way of getting the money to pay that off and to stop having to do that, which is therefore obviously not something that is likely to feed through into consumption, if that is what they are doing.

You have people at the other end of the wealth spectrum who have relatively strong returns from other activities. There is probably a bit of a U-shape in terms of where that response is likely to be greatest, in the most indebted and people who are relatively well-off, rather than in the middle.

Q112    Andrea Leadsom: Yes. Obviously people who draw their pension pot to pay off a mortgage, for example, could be a good use of a pension drawdown; whereas people who do the proverbial spend it on a Lamborghini would be a bad use. Would that be a reasonable—

Robert Chote: I think the relative morality of paying off your mortgage versus buying a Lamborghini is a matter for parliamentarians, not for us.

Q113    Andrea Leadsom: All right. Looking at the potentially negative impact on the economy of retirees drawing down their pension pot and then making themselves dependent on the state, have you done any assessment of the likelihood or the impact of that in terms of increased social care bills, for example, increased housing benefit needs and that sort of thing?

Robert Chote: We have not specifically, partly because of the relatively short time horizon over which we look for these sorts of forecasts. I think it is a question that we will probably want to return to in the longer-term fiscal sustainability report, as to whether that is something we want to make any sort of an adjustment for, but I think the chances of much of that showing up as a serious pressure within a five-year horizon are relatively modest.

Q114    Andrea Leadsom: In terms of where you would see your responsibility lying, would you feel it was for you to make the case that the Government needed to reassess the overall cost of long-term care in light of changes in behaviour of pensioners? Would you make the recommendation that it was sensible to do that?

Robert Chote: No. That lies beyond our remit in terms of that sort of policy recommendation. What we want to do is to see what a sensible long-term projection of social care costs was. To date, we have done that very much looking on an assumption that is based around demographics rather than this sort of influence. I do not know whether, when we looked at it, we would think that was something that we could bring a particularly informed additional view to, but we will have a look at it.

Chair: Thank you very much for giving evidence. We look forward to seeing what you have to say on those very points that Andrea has just raised and perhaps you ought to take a look at overseas experience; Australia with double-dipping, for example, and the problems they have with the rule of compulsion. Thank you very much indeed for giving evidence.

              Oral evidence: Budget 2014, HC 1189                            31