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Letwin: Avoiding Labour's Third Term Tax Rises

Speech to the Bow Group outlining the Conservatives' Medium Term Expenditure Strategy

When Britain's sea power was in its prime, Samuel Pepys ran our Navy almost single-handed.

In succeeding centuries, the gradual, and apparently inevitable establishment of a vast bureaucratic machine turned government into something that Pepys would not have recognised.

Hand in hand with this vast expansion of government, there came theory - indeed, theories: Bentham, Weber, Webb, and Marx. The practice seemed inevitable; the theories seemed modern.

Now, with the prospect of the 21st century opening up before us, we can see that the appearance of inevitability was as illusory as the appearance of modernity.

The movement towards an all-consuming, all-powerful state is not a work of nature, a great wave before which men and women must quail. The state is man-made. The size and nature of the state, as we proved in the 1980s, lie within our control.

The lesson of the 19th and 20th centuries is not that the state works better as it gets larger. On the contrary, the lesson of these centuries is that the worst things ever to have happened in the world have happened when the state has been at its largest, its most consuming, its most powerful.

21st century politics - truly modern politics - is characterised by the recognition that the dangerous disenchantment now felt by so many about our liberal democracy arises from two sources: the perception of the inefficiency of the state and the sense of powerlessness, of lack of control in the face of the state which people so often experience in their everyday lives.

People living in a liberal democracy and an open society such as ours in the 21st century, experience great power to control and determine their own ways of life. For most people, most of the time, this control is real rather than theoretical. People experience, through the functioning of an open society, a highly efficient conversion of their choices and determinations into events and outcomes.

But there is one sphere in which 21st century Britons experience a sense of powerlessness, or lack of control - a lack of efficiency in turning their choices and determinations into events and outcomes. This is the sphere of politics, the sphere of the state.

How often do we hear people lamenting that, in politics, "it doesn't make any difference what you do, or how you vote", "they are all the same", "they bind us up in red tape", "there are endless, useless forms to fill in", "nothing changes, nothing gets done", "they promise the earth, but they do not, or cannot, deliver"?

If 21st century politics is to become modern, if it is to respond to these modern concerns, politicians have to cease believing in the mythology of a ceaselessly and inevitably enlarging state, ever less accountable to the people it is meant to serve, ever less efficient in translating their choices into action. We politicians have to exert better control over the state, in order to hand control back to the people.

If we wish to engage in truly modern politics, in tune with the spirit of the times that can re-engage the enthusiasm of the electorate, we have to create a smaller, more efficient form of government, closer and more accountable to the people who are governed by it, giving people more control over their government and over their own lives.

The Conservative Party has recognised that these are the realities of modern life. We have recognised, moreover, that these modern perceptions and feelings closely accord with principles and ideas that have been long held in our Party - beliefs and ideas of independence, liberty, personal responsibility, smaller government, bigger citizens. In a speech just a few days ago, Michael Howard set out these ideas and beliefs.

The application of modern Conservative ideas to the problems of 21st century politics involves action across a wide frontier. The reinvigoration of local government, the relocalisation of control over vital aspects of the state, such as local policing, are just two examples amongst many set out in our recent policy documents, and widely recognised to constitute a new and important direction of British politics. But there are two aspects of the state that demand, in particular, the attention of the next Conservative Government if we are to fulfil our aims. These are: the fundamental reform of health care and schooling to give people more control over these parts of their lives, and the down-scaling of central government to give better value for the taxpayer and to give people more control over their own money.

No-one should be in any doubt about the radicalism of our ambitions in health care and schooling. We want to achieve nothing less than a transformation of the results by bringing about nothing less than a transformation of the methods.

The present Government has taxed and borrowed heavily to provide vast additions to the financial resources of the state. Much of this additional money has gone to health care and schooling.

Along with money has come a vast apparatus of control, not for the patient or the parent, but for ministers and civil servants and administrators: the number of senior managers, and clerical and administrative staff recorded in rather obscure DOH web-sites has risen from just over 150,000 in 1997 to around 180,000 today.

It has not worked so far: the NHS itself records that the 37% increase in NHS expenditure has so far produced only a 5% increase in treatments. The productivity gap is far too large.

In our judgement, it will never work. Top-down control conflicts with human nature. It works only in the case of a highly disciplined entity with a relatively simple and clear objective, as in an army in battle. Public services in peacetime do not fulfil any of the criteria for successful top-down control.

To create sustainable and widespread excellence, we need to place control elsewhere.

We need to create openness, competition, accountability.

We need to remove great swathes of targets and intrusive bureaucracy.

We need to let the professionals get on with the job, and make them accountable to the choices made by parents and patients.

This transformation can and will be carried out in a way that confirms our commitment to the founding principle of the NHS - namely, that healthcare should be available on the basis of need and not on the basis of the ability to pay.

We need to give patients the power to choose which NHS hospital they take the taxpayers' money to. We need to give patients the power to take the money that represents the marginal cost of an operation for which their taxes have paid, and use it towards buying health care outside the NHS.

We need to do these things to bring about a seismic cultural change in the NHS. We want NHS hospitals to be organisations on the lookout for patients, rather than organisations which have patients thrust upon them by the system. We want the NHS to compete for patients with the private and charitable sectors.

Patient power, and power for the professionals to respond to patient power, will create - as it has in so many other countries - sustainable, effective pressure for widespread excellence.

As with patients, so with parents. Parents, too, must be given effective power to choose schools for their children. And teachers, too, must be given the scope to respond to parent power, unencumbered by the bureaucracy that now impedes them.

Competition, accountability, control placed in the hands of the user and in the hands of the professional responding to the demands of the user: these are the elements of the radical reforms we will bring about.

Alongside these fundamental changes to the way Britain does business in health care and schools, we seek fundamental change in the way government does business.

I have said that, to answer 21st century concerns, 21st century government must give more control to the people, and seek less for itself. This is, in part, a remark about the nature of government and its relation to the citizen: our radical health care and school reforms, like our reinvigoration of localism, will achieve such a change in the nature of government.

But changes in the scale of central government are also important - for two reasons: down-scaling central government gives more room for the citizen to control the use of his or her own money, and it indirectly forces government to reconsider whether the bureaucracy really needs to attempt to control as much of our national life as it currently controls.

We recognise, however, that down-scaling government is not merely a matter of structures and structural policies. It is also a matter of pounds and pence. It is a matter intimately related to the management of the nation's finances.

If we are to fulfil simultaneously our twin ambitions - achieving fundamental reforms of key public services which give people more control over their own lives, and down-scaling government - then we have to formulate a comprehensive plan for public expenditure over the medium term, which accommodates these goals.

It is to that plan, to its financial implications, and to the financial and economic background against which we, as an incoming Conservative administration, would be seeking to realise our plan, that I now turn.

Let me start with the economic background and its relation to the handling of the public finances.

The present Chancellor will be leaving us with a number of structural problems. But there is one respect in which he will have left us with a significantly improved structure: the establishment of the Bank of England as the body determining short-term sterling interest rates, has provided this country with a proper framework for monetary control and has built in an appropriate way upon the systems introduced by his Conservative predecessors. This framework cannot by any means guarantee success in monetary policy: but it provides the best possible long-term prospect of avoiding repeated disasters.

The explicit role of the Bank's Monetary Policy Committee is to use one lever (the interest rate) to achieve one effect (the control of inflation within boundaries set by the Chancellor).

Implicitly, however, the existence of a target for inflation with symmetrical boundaries above and below, has rightly led the MPC to place as much emphasis on avoiding deflationary shocks as on avoiding excessive inflation. This is, I believe, evident at present in its attitude to the raising of interest rates. The MPC has been cautious, no doubt partly because of the possible effects of interest rate rises on the housing market, given current high levels of household, housing-related debt.

Where does this leave fiscal policy? What is the macro-economic role of fiscal policy against the background of monetary control exercised by the Bank?

The Treasury's 1998 Code for Fiscal Stability has provided a framework for answering this question over the last few years, and the present Chancellor, in his 2003 Pre-Budget Report, sets out clearly the Government's macro-economic fiscal policy objectives: "over the medium term to ensure sound public finances and that spending and taxation impact fairly within and between generations; and over the short term to support monetary policy and, in particular, to allow automatic stabilisers to help smooth the path of the economy" (PBR 2003 p.17).

I shall have more to say in a moment about the intra-generational and inter-generational impact of spending and tax. Let me first concentrate on the contrast between the Government's "medium term" aim "to ensure sound public finances" and its short term aim "to support monetary policy" by allowing "automatic stabilisers to help smooth the path of the economy".

Underlying these statements, there is a very sensible thought. In a financial crisis, the Bank and the Treasury would clearly need to work together - for example, to provide liquidity to the banking system through the re-purchase of long-dated government debt. But even in the absence of such a crisis, fiscal policy needs, as the Government puts it, "to support monetary policy by allowing the stabilisers to work": if there is a marked economic slow down, the natural if lagged decrease in tax receipts combined with the natural if lagged increase in social security payments or tax credits, will tend to generate short term demand, thereby reducing deflationary risks. And, as the present Chancellor rightly observes, if this automatic stabiliser is to be consistent with market confidence, it has to be based on a medium term policy of sound public finances. If money is to be injected into the economy during a slow-down, the markets need to know that the Treasury has done its housekeeping sufficiently well the rest of the time to provide that money when it is needed without throwing the public finances into disorder.

These sensible thoughts underlying the Code for Fiscal Stability, have given rise to the present Chancellor's well-known rules - the golden rule and the sustainable investment rule. Observance of these rules is meant to be a guarantee of good housekeeping sufficiently strong to ensure that, when the stabilisers are called into action, the public finances remain in good order.

Do the two rules provide such a guarantee?

My answer is that whilst they are better than nothing, they do not guarantee very much.

The golden rule, in particular, has to be treated with caution. First it appears to sanction any level of borrowing at any point in the cycle, so long as there is sufficient public sector net investment - regardless of how inefficient that investment may be. Second, it relies upon calculation of an output gap - or, if one prefers, the definition of a cycle - and hence upon an estimation of the trend rate of growth that may or may not be accurate. And third it can, under some circumstances, establish a backward-looking pseudo-justification for, or pseudo-constraint on, present behaviour based on behaviour at a previous stage of the cycle. This last point we can see rather vividly at present: if the sensible thought underlying the rule is that fiscal housekeeping should be sufficiently tight at times when the economy is growing at or above trend to permit stabilisers to act at other times without jeopardising public finances, how can it be appropriate for a Chancellor to schedule borrowing of £61 billion (incidentally, some £13 billion above net investment) in the two years 2004 to 2006 over which he is forecasting growth at well above his own estimate of the trend growth rate? Doesn't this begin to sound like a bad, old-fashioned structural deficit?

The sustainable investment rule - though inevitably somewhat arbitrary - is rather tighter. But, even here, there are questions surrounding the hidden growth of long-term off balance-sheet public sector liabilities generated by PPP and PFI projects. If one is trying to measure the robustness and flexibility of the public finances in the face of a possible future slow-down, these off-balance sheet-deficits have as much claim to be considered as the on-balance sheet variety.

There is, however, a much bigger problem relating to these two rules of thumb.

They do not to the slightest degree constrain the level of tax imposed by the Government upon the economy.

The current Chancellor has rightly addressed the need for sound public finances. It was natural that he should learn the lessons taught by the performance of previous Labour Chancellors. And it was equally natural that commentators should have been impressed by the fact that he was doing so, at least in his first incarnation. But, by impressing everyone with his rhetoric about prudence - even while that rhetoric had a claim to represent reality - Mr Brown has managed to direct attention away from the fact that maintaining sound public finances is a necessary rather than a sufficient condition for good performance by a Chancellor.

For a Chancellor, unlike a business, the maintenance of strong finances is, in principle, fairly easy. Unlike a business which can increase revenues only by persuading customers to buy more of its goods or services, a Chancellor can increase his revenues merely by threatening to put people into jail if they do not give him some more money. Chancellors, like bank-robbers, have means of getting money that most of us lack.

But the power to tax is a very different thing from the wisdom of taxing.

Over the past six years, the present Chancellor has raised tax by 50% in nominal terms, or 24% in real terms. He inherited an economy in which 34.8% of GDP was being taken in tax. In his 2003 Pre-Budget Report, he himself predicts that he will, by 2007/8, on current trends, be taking 38.0% of GDP in tax.

The engine driving taxation forward is, of course, the current Chancellor's spending. Over the course of the current economic cycle, the Chancellor plans to have raised government spending from 37.4% of GDP to 41.9% of GDP. If he were to be given the chance to do the same over the next cycle, then, to remain consistent with both the golden rule and the sustainable investment rule, he would need to raise the amounts taken in tax by something like five percentage points of GDP to about 43% of GDP. There is nothing whatsoever in any of the Chancellor's fiscal rules which would prevent him from raising tax to this level of 43% of GDP over the next cycle.

I make no predictions about the scale of tax rises in a third-term Labour Government. But respected, independent commentators - the IMF, the OECD and the IFS - have concluded that the path currently being charted by the Chancellor, albeit less rapid in its growth than over recent years, nevertheless risks causing significant tax rises in the next cycle.

But there are things in the real world that would make it unwise for the Chancellor to raise the burden of tax in this way.

The economic effects of high public spending backed by high tax, will, of course, vary with the type of spending and the type of taxation that is involved.

But there are plenty of reasons to suppose that public spending will typically be less efficient than private spending.

The current Government have, in fact, provided some text-book examples of inefficient public spending. I have already mentioned the fact that, in the NHS, the 37% increase in expenditure has produced only a 5% increase in the number of hospital treatments. More widely across the public services, the Office of National Statistics tells us that a 54% increase in expenditure on public sector goods and services has produced only a 12% increase in measured outputs - or, to put the same point in another way, public sector inflation has been running at something like five times household inflation. If these are not indications of inefficiency in public sector expenditure, it is difficult to think what could be.

There are also structural reasons for believing that public spending will typically be inefficient when the method of delivery is monopolistic, rather than competitive.

There are also structural reasons for supposing that the high levels of tax required to support high levels of public spending will typically have adverse effects on the efficiency and competitiveness of business and on the propensity of individuals to work and save.

In a democracy, electorates tend to resist overtly high taxes. This tends to drive Chancellors with a propensity for high taxes to identifying covert forms of taxation; and covert forms of taxation tend to have unfortunate characteristics. They tend to be complex; they tend to be changeable; and, as a result, they tend to absorb significant amounts of time on the part of the managers, particularly of small businesses, who cannot afford to employ armies of accountants and lawyers to disentangle them from the tax net. Moreover, where covert tax does not take the form of complex and changeable business tax, it tends to take the form of complex taxation either on work or on savings - providing disincentives to work or to save.

As with inefficient public spending, the present Government have given us text-book examples of the general rule. Amongst the 60 stealth tax increases, 35 have directly affected business, including such gems as the Climate Change Levy, Stamp Duty Land Tax, and the increase in employers' National Insurance Contribution. The CBI has calculated that the cumulative total of extra taxes on business levied by this Government will have reached £54 billion by 2005-6, and the British Chambers of Commerce have told the Chancellor that "British business has a clear consensus on how the Government could improve productivity in the UK: Simplify tax and regulation". Meanwhile, although the present Chancellor has made strenuous efforts to avoid creating unemployment traps, there have been 70% marginal effective tax rates for many people earning below the average wage and marginal effective tax rates of between 40% and 85% on savings income in retirement. Even the most fervent defender of the present Government's record would have a hard time arguing that the Government have been immune to the natural pressures exerted in a democracy to engage in economically sub-optimal forms of taxation.

Beyond these economic disadvantages of typically inefficient public spending and typically sub-optimal forms of tax, there lie what are sometimes called the moral arguments in favour of low levels of tax.

High levels of public spending, backed by high levels of tax, lead inexorably to high levels of dependency on the state - to the existence of more people, more of whose household income is derived directly from the state; more people who have more to gain by increasing their income from the state or by reducing the tax they pay to the state, rather than by engaging in productive effort in the market place. As a result, the state inevitably comes to be seen, more and more, as a vehicle whereby one part of society gains at the expense of another part of society. As levels of public expenditure, tax and dependency upon the state rise, democracy increasingly becomes a dreadful tension between warring lobby-groups, each trying to use the state to further their group-interest. Instead of a politics in which the public interest is debated, there is increasingly a debased politics in which sectional interests are foremost. We saw in the 1960s and 1970s far too clearly for comfort, these effects of high levels of tax and high levels of state dependency on civil society and on the democratic process.

In short, the moral argument and the economic argument run in the same direction.

Fiscal prudence is not enough. We also need a low-tax economy and a society that is not overly dependent on the state.

There are, of course, those who argue that fiscal prudence can be damaging as a general guide to government action. These prophets tell us that, in the search for a low-tax economy and society, fiscal rules should be jettisoned, and taxes should be reduced ahead of any spending reductions. The proponents of this thesis rest their case partly on the proposition that, where taxes are high, reductions in tax rates generate reduced avoidance, increased economic activity and hence counter-balancing increases in tax receipts. They go on to argue that, to the extent that the counter-balancing supply-side effect is imperfect or lagged, the resulting fiscal deficit will create proper political pressure for reduced public expenditure - which, they say, is unlikely to be felt in the absence of unsustainable deficits.

There is, of course, something to these arguments. Receipts are elastically related to tax rates. There is ample evidence that, and it is part of our argument that - through a combination of avoidance-reduction and increased economic activity - tax rate reduction will frequently, or even usually, lead to counter-balancing effects. For example, the reduction of top rate income tax under Lady Thatcher did undoubtedly have the effect of producing counter-balancing (indeed, more than counter-balancing) increases in receipts. But my attitude to uncovenanted bonuses is that they are precisely that - bonuses that are uncovenanted, in the sense that they cannot accurately be predicted in advance, and should, therefore, be used when they occur as a basis for further tax cuts, rather than being used speculatively as the basis for deficit-backed tax cuts.

I made a speech a few weeks ago about the balance of taxation and how I believe it should change over time. In that context, I believe supply-side theory should be given some real consideration: we should attempt to reduce the weight placed on specific types of tax which show most sign of generating avoidance and most sign of reducing levels of economic activity. But that is a very different matter from speculative, deficit-based aggregate tax cuts.

I do not believe that we should take risks with the public finances. I have seen too much of what eventually goes wrong. I believe in good housekeeping.

I shall be asked, " If you believe in fiscal prudence, and yet you also believe that high tax is bad, how are you going to make taxes come down whilst preserving sound public finances - and how are you going to do this while achieving the fundamental reform of health care and schooling, to give people more control over those part of their lives, which you say is your other great aim?"

I believe that there is an answer to this question. I believe that it lies in adopting a rigorous Medium Term Expenditure Strategy which will provide for a proper sharing of the benefits of growth between public services and private citizens.

It is often said that you can't increase spending on public services without increasing taxes. As a matter of simple arithmetic, this is untrue. Each year on average, the economy will grow. As people earn more and spend more, the Government will collect more tax revenue than it did the previous year even if it leaves tax rates unchanged. It can therefore spend more without having to put taxes up.

The choice at the next election will not be about whether Government spending should rise, but about how fast Government spending should rise and about how that money is spent. This is because what matters for taxation is how fast the Government increases spending.

If, across the economic cycle, Government spending grows more quickly than the economy as a whole, the Government will be spending a larger share of our national income and taxes will have to rise. If Government spending grows less quickly than the economy as a whole, the Government will be spending a smaller share of our national income. Once any structural fiscal deficit has been corrected, increasing government spending less quickly than the economy grows, allows taxes to come down.

I turn now to a description of our draft Medium Term Expenditure Strategy. I put it forward as a proposal. Following wide consultation, further evolution of our policies in various areas, and consideration of the James and Gershon reports, I shall set out a revised version in December 2004, when it will be accompanied by a Medium Term Fiscal Strategy that will show how we intend to deal with deficits and taxes.

Our Medium Term Expenditure Strategy covers the years, 2006-7 to 2011-12 and it consists of five baseline components. Together, they are designed to ensure that public expenditure grows, on average across the cycle, less fast than GDP, so that - once any inherited structural deficit has been eliminated - there is a sustainable basis for the tax burden to decline, on average across the cycle. In contrast to Gordon Brown, who has raised the proportion of GDP occupied by public spending by roughly 4.5 percentage points, we will reduce significantly the proportion of GDP occupied by public spending over the period of the MTES and set a course which will lead to further reductions in that proportion over future years beyond the period covered by the MTES.

The first component of the Medium Term Expenditure Strategy is the cost of running government itself. This has risen since 1997 by about £7 billion per year - some 50% in nominal terms, or 28% in real terms.

Our policy in this area will be decisively different from that of the present Government. In line both with our belief in smaller government, and our desire for cheaper government, the baseline within the Medium Term Expenditure Strategy will be a reduction of £3.4 billion a year in central government administrative overhead by the end of the period covered by the strategy. The basic mechanism for achieving this will be the gross civil service recruitment freeze that Michael and I announced last week. We will not hire civil servants to replace those who retire.

We recognise, of course, that this will impose an increasing strain on the bureaucratic machine. We welcome that strain, because we believe it will force both ministers and their senior officials to reduce the functions that the bureaucratic machine carries out. There is no point in preaching the virtues of smaller governments unless one is willing to create incentives within the machine for bureaucratic activity to diminish.

We shall, of course, study with interest the results of the current review of wasteful government expenditure being conducted, within the Cabinet Office, by Sir Peter Gershon - which may assist us in achieving the tough baseline for the administrative overhead. I have also asked David James and his team, working with my colleague, Howard Flight, and guided by the principle of taxpayer value, to identify administrative efficiency savings not investigated, or discarded by Gershon. If, through these mechanisms or otherwise, we can find, within a particular Department, other means of reducing the overhead by the amount required to match the base line we should be delighted. But the default mechanism for achieving the central government administrative cost baseline reduction will remain the gross civil service recruitment freeze.

The second component of the Medium Term Expenditure Strategy relates to the NHS and school expenditure.

Here, our Medium Term Expenditure Strategy baseline provides for growth in these key public services around 4 percentage points above the trend rate of growth of GDP during the first two years, with the rate of growth moderating gradually over the next few years to the point where, at the end of the period this baseline is growing broadly at the trend rate of growth of GDP.

We do not, however, intend to spend the money in the same way as the present Government. As I have emphasised, we are committed, as one of our prime aims in government, to fundamental reform of health care and schooling to give more people more control over these parts of their lives - to make these services more competitive and more accountable to the patients, parents and pupils that they are serving, and to free the highly skilled professionals who work in these services from the constraints and inhibitions that the present system of targets and top-down bureaucracy foists upon them.

We believe that the gradual revolution brought about by the introduction of our reforms will lead to massive improvements in the efficiency and effectiveness of these public services. As the structure of these services moves into the 21st century, as the forces of competition and control by patients and parents begin to work, we believe that we shall see the taxpayer gradually getting significantly more "bang for the buck" - just as we have seen in every other sphere in which state-managed, top-down, monopolistic provision has given way to open structures and control by the consumer.

Over the long term, as a result both of increased effectiveness and of increased independent funding (as people, for example, use their own money with help from the taxpayer to buy services outside the NHS), we expect to see a significantly better provision of health care and schooling than the present system is likely to generate for any given cost to the taxpayer.

But we know that our fundamental reforms will cause additional costs in the first few years. In due course, and well before the first likely date of the general election, my colleagues, Tim Yeo, Andrew Lansley and Tim Collins, will set out - in considerable detail - the mechanics of the passports and the additional costs that we anticipate over the course of the early years. For the purposes of the Medium Term Expenditure Strategy, we shall treat these costs as additions to the baseline for the NHS and the schools budgets.

I have asked David James and his team - in conjunction with Howard Flight and my other Shadow Cabinet colleagues and, once again, guided by the principles of taxpayer value - to seek to identify the savings in administrative overhead within the school and, in particular, the NHS system that we could hope to make alongside the introduction of our reforms. For the purposes of the Medium Term Expenditure Strategy, we shall treat such savings as reductions from the baseline for the NHS and the schools budgets.

I do not yet know how far additions to baseline expenditure caused by early year costs of the patient and pupil passports will be offset by the reductions to baseline NHS and school expenditure achieved through the dismantling of top-down administration. To a considerable degree, the additional costs will be within our control, since - for example - the speed with which we widen the scope of the patient passport to cover a gradually widening range of operations, will determine the speed with which the additional costs are incurred. I hope that we shall achieve sufficient administrative savings within these budgets to offset fully the additional costs of our reform programme.

We shall be in a better position to assess this once David James and his team have done their work.

The third component of the Medium Term Expenditure Strategy relates to transfer payments to pensioners in the form of basic state pensions, social security and pension credits. These payments are rightly described in the government's accounts as annually managed expenditure rather than cash-limited expenditure, since the amounts drawn by individual pensioners inevitably vary as a result of cyclical and demographic effects. On a cyclically adjusted basis, our baseline for such transfer payments to pensioners is that they should rise in line with GDP - broadly in accordance with the present Treasury forecasts.

Within this component, we programme the basic state pension to rise in line with average earnings. We attach great significance to this policy because it is a vital contribution towards restoring the incentive to save - since it means that, after retirement, people will not be trapped by means-tested benefits and will therefore be able to retain income from savings rather than having that income whittled away by withdrawal of benefit. The additional costs of the policy beyond the GDP growth baseline for transfer payments to pensioners, will be met, within the period covered by the Medium Term Expenditure Strategy, through reductions in the costs of means-tested benefits as pensioners are "floated off" such benefits, and through a number of other changes that will reduce spending growth below my fourth and fifth baselines - including the abolition of most of the New Deal which has been an expensive failure. My colleague, David Willetts, has recently announced our thinking on the long term financing of this commitment - which will involve further reduction of the cost of means-testing as more pensioners are "floated off" benefits, as well as redirection of contracted out rebates and the phasing out of the second state pension.

The fourth component of the Medium Term Expenditure Strategy relates to transfer payments (i.e. benefits and tax credits) paid to people other than pensioners. As with transfer payments to pensioners, these payments have to be 'managed' rather than cash limited, since they, too, are heavily affected by demographic and cyclical changes. On a cyclically adjusted basis our baseline for these payments will be growth of about 3.25% per year. This is broadly in line with growth on earnings. It is also broadly in line with the growth in these payments over the past few years, once adjustments made for the effects of recent policy changes and for the pattern of falling unemployment over the current cycle.

As with the third component, this is intended as a projection of the path of spending, assuming unchanged policies. Neither of these projections represents our last word on the subject. We remain committed to welfare reform, beyond our pensions policy, and I anticipate that, in the months ahead, David Willetts will make further announcements.

The fifth component of the Medium Term Expenditure Strategy relates to all programme expenditure covered by departmental expenditure limits outside the NHS and schools budgets

I have agreed with my Shadow Cabinet colleagues that the baseline for spending across all of these departmental budgets will be 0% growth for the first two years, followed by 2% growth per year for the remaining four years of the period covered by the strategy.

I fully accept that holding programme spending within departmental expenditure limits other than the NHS and schools to a zero increase for the first two years and to what amounts to a zero real terms increase thereafter is a tough constraint. By the end of the period, it will bring expenditure in these departments back close to real terms equivalence with 2001-2.

I recognise, moreover, that there will inevitably be cases in which particular programmes, or even the expenditure of whole departments, will need to rise at a rate faster than this. To fund such increases beyond the baseline, specific savings against the baseline will need to be found elsewhere within the non-NHS and non-schools departmental expenditure limits. A particular example is our commitment to increase police numbers by 5,000 a year - which will be funded by significant reductions in the cost of the asylum and immigration system. I have asked David James and his team to identify a range of other specific savings against the fifth baseline in advance of the general election. I have also asked him to propose to the Shadow Cabinet new machinery in Whitehall designed to improve our capacity, once in government, to identify and implement such savings. I expect to make further announcements in relation to these issues well before the likely date of the general election.

Finally I accept that - just as the third and fourth baselines apply only to cyclically adjusted expenditure and will in practice vary in any given year with the position of that year in the economic cycle, so the fifth baseline will apply to 'normal' conditions: to the extent that unforeseen events such as major wars, terrorist attack, pandemic or other acts of God cause a drain on public resources beyond what the contingency reserve can reasonably be set to accommodate, there will inevitably be deviations from this baseline. Our strategy is designed to establish an underlying path, not to create a dogma that impedes the government of the day from responding to emergencies.

Let me summarise what is inevitably a somewhat complex proposition.

The Medium Term Expenditure Strategy will set baselines for each of the five components of public expenditure.

Taken together with reasonable assumptions about the evolution of depreciation costs, interest on the national debt and other more minor items outside the five baselines, and absent any major unforeseen national emergencies, the combined effect of the draft Strategy that I have presented today is for total cyclically adjusted public spending to rise by about 4.4% in 2006-7 with the rate of growth falling gradually each year to around 3.85% per year by 2011. In other words, across the cycle, public spending will grow about 1% more slowly than the Treasury view of the trend rate of nominal GDP growth.

The Medium Term Expenditure Strategy should, therefore, enable us to reduce the proportion of GDP occupied by cyclically adjusted public expenditure from the roughly 42% which the present Government plans for 2005-6 to somewhere around 40% by 2011.

I hope to be able to cut taxes even in the early years. But I cannot be certain. That will depend on the amount of money we have to spend addressing any structural deficit we inherit from Mr Brown - and, of course, on unpredictable cyclical effects. As I have been at pains to stress today, I am absolutely determined to follow the path of fiscal conservatism to which Mr Brown was once committed, and from which he has recently been diverging.

But I can say, and I do say, that by setting government spending on a track which should gradually across the cycle reduce the share of GDP spent by the state, the Medium Term Expenditure Strategy provides a firm basis for sustainable medium term reductions in the burden of tax.

A Conservative Government, if elected at the next election, will not take risks with the public finances.

A Conservative Government, if elected at the next election, will maintain high levels of growth in spending on hospitals and schools.

But a Conservative Government, if elected at the next election, will not rely on tax rises to fund structural increases in public spending as a proportion of GDP. On the contrary, we will ensure that public spending over the cycle grows more slowly than GDP, so that the share of national income taken in taxes can gradually and substantially be reduced, because we believe that Britain needs and deserves a smaller government, a more accountable government, and a more affordable government in the 21st century.

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