Ageing and long-term public finances

It is for each generation to make democratic choices about the welfare provision it wishes to pay for, albeit with the ‘path dependency’ of previous decisions, institutional arrangements and implicit promises. Nevertheless economists can make projections regarding the fiscal impact of the changing population structure, assuming no change in policy. This is the task assumed by the Office for Budget Responsibility (OBR) in its annual fiscal sustainability report (FSR), which estimates the changing cost of ‘age-related’ spending like pensions, the NHS, welfare and education, as well as considering long-term tax revenues. These estimates need to be handled with care because they are designed to assume all other things will be equal, which of course they will not.

The projections have been subject to perhaps wilful misinterpretation. In particular, some commentators have used the FSR’s ‘central projection’ to suggest that the long-term prognosis for the UK public finances is very grave. In reality the outlook is surprisingly positive, assuming we are able to close the fiscal deficit towards the end of this decade. For, although the consequences of taking no action would not be benign, the scale and urgency of the change required is modest.

The magnitude of required action is small: The OBR reports that the one-off tax rise or spending cut required to ensure that public debt is below 40 per cent in the 2060s is just 1.1 per cent of GDP (£17bn). This is a relatively small sum. For example, the current government is attempting ‘fiscal tightening’ of 10 per cent of GDP to reduce today’s deficit; indeed its plans include tightening of 1.1 per cent or more in most years from 2010 to 2017. Generally, there has been rapid oscillation in the public finances over the last 50 years (caused both by policy choices and economic conditions), with tightening of more than one per cent in a year commonplace. So, on past form, a one-off act of fiscal tightening to control for demographic change would be almost indiscernible within the noise of annual fluctuations in the public finances. Indeed there is a risk in dwelling too much on demographic pressures just because they can be predicted, when they are likely to be just one small factor in the sustainability of the UK’s fiscal position.

Taking action is important but not urgent: The impacts of ageing are gradual and predictable, which means a response can be planned, steady and slow. The OBR points out that action need not be taken in one go. It sets out an alternative strategy of fiscal tightening of 0.4 per cent of GDP (£6bn) each decade up to the 2060s – or in other words roughly 0.04 per cent of GDP (£600m) per year over the period. This would be an almost imperceptible annual squeeze considering that annual public spending exceeds £700bn. This approach would eventually cost more than a one-off tax rise or spending cut now, but it is perhaps more realistic than imagining a single moment of fiscal tightening in the late 2010s to last 50 years. To illustrate how imperceptible gradual fiscal tightening might be, it’s worth comparing it to the impact on personal taxation revenues of ‘fiscal drag’ (ie not raising tax thresholds in line with earnings). The FSR states that fiscal drag will increase revenue by around 0.17 per cent of GDP each year over the next 20 years, much more than the 0.04 per cent of annual tax rises that might be needed to achieve fiscal sustainability through to 2060. In other words it would be possible to pay for the costs of ageing simply by allowing a small proportion of ‘fiscal drag’ to continue, rather than entirely ending the practice (which is the OBR’s long-term assumption, in spite of Treasury practice under all recent governments).

Long-term spending increases are sustainable: At first glance it is surprising that fiscal tightening of only 1.1 per cent of GDP is needed to ensure low public debt in 2060, because ageing pressures are projected to push up spending by 5 per cent of GDP by that time. After all we might intuitively expect that any future spending increase must be fully offset by corresponding tax rises. But the OBR’s numbers show that, regardless of whether tightening comes in the form of tax rises or spending cuts, spending in the 2060s can be sustainable and still considerably higher than in the late 2010s. This is an important corrective to neoliberal perspectives, which use demographic arguments in aide of ideological attempts to reduce public spending. The OBR’s figures show that fiscal sustainability, modest spending rises and stable taxes are compatible. It is a matter of democratic choice whether age-related spending pressures are absorbed by tax rises or spending restraint rather than cuts being an inevitability. What’s more, even if all the costs were absorbed by tax rises, by 2060 the UK would still have a fairly small state relative to public spending today across most EU members. So analysis of the modest fiscal impact of demographic change should be kept apart from wider debates about the appropriate size of the state from the perspective of economic prosperity and social welfare.

Uncertainties in the fiscal projections: The FSR sets out a range of scenarios for future public finances, based on different demographic and economic conditions. These show that the public finances would be under much greater pressure if the structure of the future population was older than predicted – as a result of very low net migration, low fertility or high longevity. The downside risks contained in these projections should be of greater concern to policy makers than the impact of the OBR’s ‘central projection’ on the public finances. However, the positive news is that first two of these variables are amenable to government policy, although not completely under its control. There is therefore a case for public policy decisions on migration and family policy to take account of the impact on demographics and the long-term public finances. Unexpected increases in life expectancy are of course desirable rather than a risk to be contained. However, they need not be a fiscal threat, as long as they lead to corresponding increases in the duration of working life and a higher state pension age.

Demographic change sits alongside other pressures: Another key reason for caution is that demographic influences sit alongside many other upward pressures on spending. While affordable in themselves, age-related increases could leave little ‘head-room’ for other desirable areas of public spending growth. This is likely to cause political frustrations, since British politicians of all persuasions have historically been ambitious to extend public activity when they can. It is particularly important that ‘investment’ related spending is not crowded-out by age-related insurance spending. Britain’s long-term prospects would suffer if the share of public spending devoted to future-oriented activity such as education, childcare, science, infrastructure and environmental protection were to diminish as a proportion of GDP; and perhaps they should rise from today’s modest levels.

There are also upward pressures within those public services used mainly by older people which are unrelated to ageing. This means that freezing the proportion of GDP spent in these areas, except to account for population ageing, might be considered inadequate to sustain good provision. This is most obviously the case with regard to social care, where meeting today’s levels of need and also introducing a less tightly means-tested funding system requires perhaps £5bn extra in England. The FSR projections also highlight great uncertainty with respect to future spending on healthcare. The report discusses low public service productivity and also whether healthcare is a ‘superior’ good, which society will demand to consume more of as it becomes richer. Other things being equal both these would lead to the share of GDP spent on healthcare rising, which could be a far higher pressure than ageing itself.

It is important, however, to recognise that the ‘downside’ uncertainties regarding healthcare costs do not mean that public spending on health will inevitably rise out of control. Since NHS budgets are set on a one to three year timeframe and are not linked to entitlements, successive parliaments would have total discretion as to how much they wished to spend on health. The OBR’s different scenarios for health spending really relate to uncertainty regarding the quantity and quality of health outcomes that any given level of spending will buy. The upward pressure is more ‘democratic’ than ‘demographic’ – people will not tolerate standards of healthcare falling well below those in other nations. But all countries will face similar constraints on the extent to which their health systems can grow as a share of GDP (above all the USA, despite its partly private healthcare). Levels of GDP devoted to healthcare will presumably need to level-off everywhere, since developed economies are not going to become just giant health systems.

The second hearing of the Fabian Society’s  Commission on Future Spending Choices takes place on Tuesday 11th December.