Jeremy Paxman (Interviewer), Elizabeth Truss (Reform), Philip Blond (ResPublica)

Jeremy Paxman: Public sector pay freezes, rises in the age you can get your pension and so on - this is the context isn't it, in which politics is going to be played out in the next few years?

Elizabeth Truss: Yes, absolutely. I think we are looking at the frog that is slowly being boiled on the kitchen stove.

JP: What is the frog?

ET: It's the idea that you gradually heat the frog up so that it doesn't notice what's happening in the pan. We're hearing more and more announcements of, "there's going to be a freeze in public sector pay, you're going to have to retire later and there's going to be less spent on the NHS." This is going to continue for the foreseeable future.

JP [to Philip Blond]: Feeling like a frog?

PB: No, no, no. I think, contrary to most, that this is an opportunity to develop a public service that really, really can innovate and deliver.

JP: But where is the money going to come from?

PB: Well the money can come from the savings that you generate by doing things differently. I know that sounds trite and nobody believes it, but ask anybody who works in public services and they always talk of the layers of middle management and the sheer scale of waste. I'm publishing a report tomorrow with Nesta where I argue that public services can be spun out as social enterprise, governed by frontline workers with citizens having a stake in them.

JP: And can you explain in English what that means?

PB: That means essentially giving people the right to deliver public services as social enterprises.

JP: What is a social enterprise?

PB: A social enterprise would be something that you run for the public good, rather than private profit, a non-profit vehicle.

JP: Who funds it?

PB: The funding would be from the budget, delegated from the centre and run by the frontline services themselves.

JP [to ET]: Why are you laughing?

ET: I'm laughing because these things will deliver in the longer term, or at least may deliver in the longer term. We don't have that long to wait - we've got a £175bn deficit that we need to start addressing now. And there are big issues like, for example, the level of welfare that we are currently paying to the middle classes. It's about a quarter of the total welfare budget. It's about £30 billion

PB: I agree.

ET: And I'm afraid people are going to squeal when they see their entitlements cut. It's not just about improving efficiency. There is an awful lot of money on the merry-go-round that's going through the system.

JP: You specifically mentioned the middle classes there. Middle class entitlements will have to be cut?

ET: Yes. If you look at what Ireland's done, they've means tested child benefit and they've taxed child benefit. A lot of the countries that have faced similar fiscal situations have had to take those immediate measures and that involves dealing with entitlements because the reforms that Philip is talking about only have an effect in the long term. You don't get the short term savings from those kinds of reforms.

PB: I agree with this. Short term I think we should eliminate or vastly minimise middle class welfare to help those at the very bottom. For instance I think we should means test child benefit and allow matching funds for child trust funds.

JP: But a lot of the middle class who pay the taxes to make these things possible are rather attached to some of the benefits they get. Child benefit seems to be something they get in exchange for their taxes.

PB: The middle classes benefit from the greatest largesse that they know: no tax on capital gains for their personal housing. The point is that, the lower down the economic scale, the less pay back there is from that. For instance if we cut the level of tax credits we give on the £30-50,000 scale, we could actually have, at the bottom of the scale, far more effective endowment of the poor with dynamic benefits for welfare.

JP: At the end of the first Tory term, assuming they win it, how big would the state be? How much smaller?

ET: Well Reform did a report earlier this year where we said that you need to think about reducing the level of spending by about £30 billion, so that is a good slice off the government budget. I would say it has to be in the region of 10% smaller. It all depends on the level of economic growth we are able to generate but really the alternative is to rock along the bottom with the economy stagnating. I think the choice is to make the brave decisions early on and actually drive some economic growth and not have to raise taxes (or not have to raise them much at least) or otherwise go with the stagnation option. That's the choice facing politicians.

PB: What we don't want to do is cut in an unsophisticated way, have just salami size service and leave everything in place. Then the service distorts and then public outcry means you have to refund. The key point is to do two things: start decommissioning some services (i.e. services that we don't need to provide and don't need to do) and then the other is to start innovating very radically in our public services and that will easily deliver cuts that are productive in excess of 10%.

JP: This is a really trite question and quite difficult. Gordon Brown has had this word "prudence". Is there a watchword that ought to be applied if there is a Conservative government after the next election?

ET: I'd say the word is "rigour". It's actually thinking about everything we spend and making sure that it offers value for money, is the right thing and that the people who are getting it actually need it because the alternative is for everyone to be paying higher taxes.

JP [to PB]: What's your word?

PB: I think it would be "transformation". Something that really gives you a steep change in the level and quality with your interaction with the state and I think that will really provide the savings both in the short and the medium term.