Finance Bill

Lord Stern of Brentford Excerpts

Monday 26th July 2010 Lords Chamber

[Lord Stern of Brentford]

My Lords, many of the challenges we face in the world economy in the coming years are structural and profound. These include high public deficits in some countries and major imbalances in savings and investments with correspondingly large external surpluses or deficits in key economies of the world. Both can feed, and have fed, instability. Over this decade, we will continue to see fundamental changes in the international division of labour, which will imply great industrial change and some dislocation in both the rich and the poor world, and our international financial and economic system will have to change to reflect the new realities. Still more profound is the necessary acceleration of the energy and industrial revolution, which will be not only innovative, creative and dynamic but critical to our building of the low-carbon economy which is essential for managing climate change. If we see these related challenges together, we will do much better on each than if we try to tackle them one by one or in sequence. This decade in the world economy is of special importance. In the UK, we must close our deficits while avoiding tipping back into recession. We must come out of this recession by laying the foundations of long-term and sustainable growth and not, as we did in much of the world, including the UK, a decade ago, by sowing the seeds of the next bubble.

Today, in the long-term and international context I have described, I want to consider briefly three particular related issues that confront us now and which are, or should be, central to our consideration of the UK’s fiscal policy and the Finance Bill. These are first, revenue forecasting, secondly, the pace and flexibility with which we attempt to close the deficit and thirdly, tax reform.

I must declare an interest in the economics of public policy. I am currently professor of economics at the LSE and have been a professor of economics, specialising in public policy, for more than three decades. For 10 years, I was first chief economist of the European Bank for Reconstruction and Development and then chief economist and senior vice president of the World Bank, interacting with finance Ministers around the world. Closer to home, and of direct relevance to what I have to say today, I was from 2003 to 2007 head of the Government Economic Service in Her Majesty's Treasury, and for the first nine months of that time, I was Second Permanent Secretary of the Treasury with particular responsibility for the revenue side of the public finances, before I turned in my next two and a half years as a civil servant to write two major reports, the report of the Commission for Africa and the review of the economics of climate change. I was indeed fortunate in my assignments. I returned to the LSE three years ago.

On revenue forecasting, I must welcome the establishment of the Office for Budget Responsibility. My brief experience in this area at the Treasury in 2003-04 underlined very strongly the importance of independence and of transparency. In my view, in the Treasury at that time, there was a lack of clarity in setting out the assumptions, an absence of clear models of revenue and excessive use of hopeful judgment on future revenues. One result was that we went into the crisis in 2007 with inflated forecasts of structural revenues, and thus inflated expenditures which had expanded to meet the anticipated, or rather “wished for”, revenue, and with a substantial structural deficit.

There were some positive moves on the revenue front at that time. We brought Her Majesty’s Revenue and Customs together—one or two centuries too late, but better late than never—and provided much greater clarity for the formation of tax policy across the Treasury and HMRC. But in my few months working on revenue, I was not successful in bringing more rigour to revenue forecasting. Hence, my emphasis now on clarity, transparency and independence.

We must not, however, confuse independence with isolation or incoherence. It is important that the OBR is well informed about the analysis and sense of direction on policy of Her Majesty’s Treasury and the Bank of England. Independence of the OBR is perfectly consistent with discussion on analysis and policy with these two key institutions. Indeed, all three will function the better for this interaction. Bank of England independence is not compromised by constructive and detailed discussion with Her Majesty’s Treasury, which during my time was a much weaker discussion than it should have been. The reluctance to engage was not for the most part in my view on the side of the Bank of England.

I have three questions on the OBR for the Government, to which I hope that the Minister can respond. First, will he encourage the OBR to illustrate its value-added by examining how far its methods would produce different results from the less transparent methods of the past? This would be very helpful in assessing the contribution of the OBR. Secondly, will he encourage the Government to emphasise still more strongly the uncertainty surrounding all revenue forecasts and thus uncertainty in deficit forecasts? To be slightly nerdy, we should welcome the appendix on fan charts in last month’s pre-Budget forecast of the OBR. Thirdly, will he consider establishing an independent board for the OBR, advisory or otherwise, which could provide guidance to the chair of the OBR and play a role in defending its independence, as Sir Michael Scholar has so admirably done for UK statistics?

Finally, on revenue forecasting, I should like to pay tribute to the outstanding work of Sir Alan Budd in establishing the OBR so effectively and so rapidly. I have known for some months of his clear intention to serve for only a few months as its head. This was also very clear to senior Treasury officials and to Ministers, as I am sure that the noble Lord will confirm. Thus, any speculation from the press and elsewhere to the contrary is completely misplaced.

My second issue is the pace of closing the deficit. I fear that this is a subject that sometimes descends to camps and slogans. If I said that the entire structural deficit should be closed in one year, you would think that I was mad. If I said that it should be closed in a decade, you would doubt my seriousness. It is clear that we must discuss whether it should be targeted over four, five, or six years. There is nothing in the subject of economics that allows us to be very precise on this. Thus it makes no sense to denounce those who rightly draw attention to the risk of recession as narrow Keynesians who care little about budget responsibility and the future servicing of debts, just as it makes no sense to label those who rightly emphasise the dangers of large deficits and ever-increasing debt to GDP ratios as Hooverians intent on repeating the mistakes of the great depression.

Let us recognise not only that we shall have to set clear intentions on deficit reduction but also that we must feel our way on the risks of recession. These risks are very real. We will probably see strong growth in China and India, but while they are around 36 per cent or 37 per cent of the world’s population, they are around only 10 per cent of the world’s economy, although somewhat larger on a purchasing power parity basis. The US and Europe are far more important in the global economy, constituting around 45 per cent of the total. More than half our exports are to Europe where there seems to be a clear intent to go for a strong and co-ordinated fiscal consolidation with significant risks to overall demand. As Ben Bernanke said last Wednesday, the future of the US economy is “unusually uncertain”. While we have in the UK the advantage of a flexible exchange rate there can be no guarantee that rising exports and private investment will replace the demand reduction in the UK from fiscal consolidation.

It is difficult to be precise about the risks of recession in the UK, but they are not small. Let us recognise both that we will learn more in the coming months and the next year or two, and that if we fall into recession we risk not only the severe human cost of unemployment but, via the automatic stabilisers, raising the deficits we are trying to reduce. We do not know how much capacity or underlying potential have changed as a result of the crisis and recession. It is thus difficult to distinguish cyclical from structural deficits. As I have said, there are strong risks to export demand and we do not know what may happen to consumer and investor confidence. It is absurd to pretend otherwise.

Thus, while agreeing with the Government and their predecessors on the importance of cutting the deficit, I would like the Minister’s assurance that the Government will keep the risk of recession under review and stand ready to adjust their fiscal stance if necessary. While recognising that the Bank of England has a strong role to play in demand management, it cannot be left solely to the Bank. This is not lack of resolution or anticipating U-turns; it is sound economics in the face of risk and uncertainty and it is common sense.

As to tax reform, at a time when strong shorter-run decisions are necessary on the public finances, we must also recognise that tax reform is about the medium and long run. Let us not make the urgent need for extra revenue and expenditure control an excuse for yet more incremental tinkering that is not well thought through in terms of the coherence of the tax system as a whole. Tax systems suffer badly from the creeping approach to policy. Each new initiative might have had some plausibility at the time, but we now have a system with a set of major defects. These include: disincentives to work for many at the bottom end of the scale; incoherence between the various forms of personal income tax, corporate income tax and national insurance; no clear rationale on the taxation of wealth and savings; and inefficient and inconsistent ways of pursuing distributional objectives. The tax treatment of housing is a special mess. Now is the time for a strong move to correct the great market failures associated with the environment and climate change. With green taxes and other measures, including the green investment bank, we can simultaneously raise revenue, help markets work better and foster a new and cleaner source of growth. This is surely what our American friends would call a no-brainer.

There is not time to develop these points in detail. I recommend to noble Lords the work of the Mirrlees review from the Institute for Fiscal Studies which is scheduled to be published in September this year. Much of this analysis is already available and there is a clear discussion by Paul Johnson, a co-editor of the Mirrlees Review, in his lecture at the LSE last month which is available on the IFS website. Three decades after the important and influential Meade review on the tax system, it provides a most valuable analysis and sense of direction.

Let me give two examples from indirect taxation. First, the base of the VAT could be substantially broadened and the extra revenue used to more than compensate, as we should, those on low income who are most affected. Secondly, a financial activities tax, as suggested by the IMF, could be structured in a way that would be economically equivalent to a VAT on this currently exempt sector. I could go on to give examples concerned with income and other taxes and benefits.

There is also much analysis to draw upon from international institutions in other countries—for example, the expert groups of the OECD and the Fiscal Affairs Department of the IMF. At the request of an earlier Chancellor, I ran, as Second Permanent Secretary of the Treasury, a series of internal seminars on tax reform in the first half of 2004 and provided the summary paper drawing conclusions for the Chancellor in June of that year. I quite properly left my only copy with the senior management of the Treasury when I left in the summer of 2007, and I am sure they will have retained—at least, I hope they will have retained—their own copies. I hope they find the study useful.

Now is the time for a careful and considered discussion of the reform of tax and benefits in this country. I trust that the Government will play a strong, analytical and thoughtful role in this discussion and that we will see the fruits in terms of action in the coming two or three years. I seek the Minister’s assurances on this point. There is so much that we could do at this time of reform and reappraisal to move towards a system which is simpler, more equitable and more efficient. Furthermore, it could foster the entrepreneurship and creativity to drive the new forms of growth that are vital to our nation and the world in this decade of fundamental change.