Good times—but now the party’s over as the health and pension costs of an ageing population put increasing pressure on spending

In response to Britain’s biggest peacetime deficit, the government is embarking on an unprecedented set of spending cuts. But we should not see these cuts as either the beginning, or the end, of dramatic change in the public sector. Not the beginning because the shape of public spending has changed dramatically in the past 30 years—and there are some elements of these plans that look like a continuation of that longer run trend. And not the end, because an ageing population is going to put ever increasing pressure on spending (see Nick Carn’s piece in our investment report).

Significant decisions have already been taken to get us out of the hole we are in. But if we are to face the coming decades with sustainable policies and a robust budget we need to start a debate about how we will deal with the challenges that await us. There are rational decisions that we can make about the role of the state and the appropriate structure of the tax system which will help us through coming decades. But we can also create huge costs by cutting the wrong spending, relying on the private sector for the wrong things and increasing the wrong taxes.

Some of the most difficult choices are likely to be about how to manage the scale of health and pension costs associated with ageing. The over-65s have been the one group relatively protected during this period of spending cuts. But in future politicians will need to decide whether and how to raise more money from this group, which is vocal and votes actively, at a time when its numbers are growing. That is the political challenge of a generation.

First, the bare facts. The budget deficit is still expected to be well over 8 per cent of national income this year. There is room for argument over how fast Britain needs to act on this, but it will need to be tackled, even before we deal with the consequences of ageing. Following tax increases over the past few years, the government’s plan is to do nearly all the remaining work through spending cuts. These will come in part from social security and tax credits, but mostly from unprecedented reductions in spending on public services. Faced with a gloomy economic prognosis, the chancellor pencilled in two more years of spending squeeze for 2015-16 and 2016-17 in his autumn statement, in order to return us to a balanced budget by 2016-17.

The “good” news is that these cuts follow a period of unprecedented largesse. Between 1999-2000 and 2006-07, spending on public services grew more quickly than over any other seven-year period since the second world war. So, painful though the cuts will be, if implemented they will still leave public service spending at the same proportion of national income in 2016-17 as in 2000-01—and a third higher after economy-wide inflation.

The bad news is that not all will be rosy even if this fiscal consolidation is carried out. Net public debt will be an uncomfortably high 75 per cent of national income in 2016-17, compared with less than 40 per cent when the financial crisis hit in 2008. And both tax revenues and spending demands will be under continued pressure. Indeed, without further policy change, the deficit and total debt will surely start increasing again.

The main reason for this is simply the ageing of the population. In 2011, 17 per cent of people were aged over 65. The proportion is expected to reach 26 per cent by 2061. The rate of change for the over-85s is considerably more dramatic; their population share is expected to more than treble from 2.3 per cent to 7.3 per cent over the same period. This has direct consequences for spending on pensions and healthcare.

The Office for Budget Responsibility predicts that state pension spending will rise from 5.5 per cent to 7.9 per cent of national income between 2015 and 2060—despite a planned increase in the state pension age to 68 over that period. Health spending is less predictable. But demographic change alone is expected to push it from 7.4 per cent of national income in 2015 to 9.8 per cent by 2060. If, as may be more likely given past experience, health spending (other than that caused by the ageing of the population) rose by 1 per cent a year faster than national income, then by 2060, Britain would be spending 15 per cent of national income on health.

These projections imply some stark choices. In the best-case scenario for health costs, on present policies, spending on health and pensions would rise by 5 per cent of national income (about £80bn in today’s terms) over the next 50 years. So at a minimum we would need to find an additional £80bn of tax rises and spending cuts to cover these pressures. Arguably, more realistic assumptions about the future path for health spending could double the size of that challenge. If we accommodate these additional pressures by cutting spending elsewhere, then health and pensions alone will account for at least one pound in every two of public spending by 2060.

That’s before worrying about significant likely losses in tax revenues, notably from motorists, as vehicles continue to become more fuel-efficient. If we are to meet our (legally enshrined) carbon reduction targets we will need to replace all of the more than £30bn a year we raise from tax on road fuel. And how robust corporation tax receipts (now more than £40bn a year) will remain in the face of growing international tax competition is anyone’s guess.

So the challenge is huge. We are looking for at least £100bn a year, possibly £200bn, of spending cuts and tax increases over the next generation (over and above the more than £100bn of spending cuts and tax increases we are currently experiencing).

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Perhaps one comfort is the evidence of past flexibility in the role, size and nature of the state. That has changed more than people generally realise, even over the past 30 years. Spending on health, social care and social security has already risen from a third of total public spending in 1979 to a half. There has been no increase in the share of public spending going on education, and a shrinking of the share for defence, housing and support for industry. But that leaves less scope for taking money from them in the future. (The composition of public spending in 2010-11 is in the chart above).

It is hard to avoid the conclusion that, of the options for radical surgery on spending, most would have to come from changes to pensions, welfare, health and perhaps education. Fortunately, in principle at least, options do exist.

Pensioners are the only group largely to have escaped the cuts. Almost all their accumulated benefits and perks—winter fuel allowances, free TV licences, free bus travel—have survived, however odd the rationale. Those of working age who are dependent on benefits have seen the rules linking them to inflation—“indexation”—become less generous, moving from the old Retail Prices Index to the new Consumer Prices Index. But the inflation treatment of the basic state pension has become much more generous, moving from RPI indexation to a “triple lock” which provides indexation in line with the higher of RPI, earnings and 2.5 per cent.

However, it would be hard to make dramatic savings by changing this. Means-testing fuel allowances and TV licences would raise less than £2bn a year. Given the lack of private provision of pensions, and the need to protect the incentive to save while still providing support for low-income pensioners, the case for reverting to simple inflation indexation is perhaps not very attractive. Instead, the most important change is more likely to be to increase the state pension age at the fastest feasible rate, aiming perhaps at 70 rather than 68 by 2046.

It is harder to save money by reforming healthcare. And it is worth making clear that, whether it be pensions or health, moving from public funding to private funding will not necessarily reduce the overall burden. If there are more older people, then for any given level of incomes and services, the money must come from somewhere. However, it is worth noting that Britain is close to the top of international league tables in the proportion of total health spending that comes from the public purse. The United States, of course, is unusual in its reliance on the private sector. But Italy, France, Germany and even (by a slight margin) Sweden fund privately a greater share of health spending than Britain. The big challenge for Britain is simply having a rational debate. By international standards, our national dialogue on pension policy is relatively grown up. On health it is not—this must change, and fast.

The debate on funding long-term care for the elderly is different. In absolute terms the costs of provision are modest compared to those of health and pensions—just 1.3 per cent of national income today—but as the numbers of the very old increase, spending on long-term care will grow. This rise will be only another 0.5 per cent of national income between now and 2040, but this is a huge percentage increase. The Dilnot Commission last year recommended policies that would actually increase public spending. Currently, provision is means-tested against income and assets. The state pays only once these are all but exhausted, which requires some people to sell their homes. But Dilnot argues persuasively that the full risks of long-term care are ill-suited to self-insurance by individuals, or to insurance in private markets, in that a small minority face very high, uncertain costs. These are the sorts of cost best “insured” by the state. The individual, according to Dilnot, should have to meet the first £25,000-£50,000 of costs, and the state should pay for the minority who end up needing more.

This is interesting because it offers a possible model for thinking about the role of the state more widely—as an insurer against those risks that the private sector cannot efficiently take on. Replace “long-term care” with “hospital treatment,” and consider asking people to insure against, or save for, the first £30,000 of costs. In a less punitive direction consider the annuity market. Annuity rates are at long-term lows, in part because longevity is so high. Annuity providers have to insure themselves against the risk that people will live a very long time. How much easier would it be for the private sector to provide pensions up to, say, the age of 90, and for the state to step in thereafter?

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Of course we don’t have to keep the size of the state the same. We could decide to accommodate spending by increasing tax revenue. But if we do that, we have to do so as efficiently and equitably as possible to avoid imposing excessive costs on the economy.

This government, in common with some of its predecessors, has responded to the need for more tax by raising the main rate of VAT—now 20 per cent. While not a terrible way to raise revenue, it exacerbates the inefficiencies and inequities caused by the narrow VAT base that we have in Britain—a lower proportion of consumer spending is subject to VAT here than in most European countries. If we are to raise more money from VAT then it would be better to extend VAT to food and other zero-rated goods, increase the 5 per cent rate on domestic fuel and tackle the VAT exemption enjoyed by financial services.

To give an indication of the scale of the cost of the current zero and reduced rates of VAT, one could probably raise more than £4bn a year by increasing VAT on domestic fuel to the full 20 per cent rate, and more than £12bn by ending the zero rating of food. It would then be possible to spend some of the revenue raised on compensating, on average, poorer families who would lose out from the widening of the VAT base. This is a more efficient route, and arguably a more equitable one to raising revenue from the VAT system than simply increasing the main rate.

This government, like its predecessors, has raised national insurance (NI) contributions, but eschewed raising the basic rate of income tax. This creates numerous distortions between the treatment of income from employment and other income, for example from self-employment. Each penny on the basic rate of income tax could raise a pretty handy £4.5bn a year.

One consequence, probably unintended, has been a straight shift of the tax burden from better-off pensioners to people of working age. Retirees (or their heirs, depending on your point of view) are treated relatively generously by the tax system—perhaps most notably, their entire income is exempt from NI contributions. There is a case for any future increase in NI rates to be accompanied by an equivalent income tax surcharge on private pensions—and one could make a case for imposing a levy even now, not least because employer contributions to pensions have always been fully exempt from national insurance.

The exemption from capital gains tax of the assets of a recently deceased person is another costly distortion that should be set right. Other improvements that would raise revenue include the taxation of property, removing the many badly targeted exemptions for inheritance tax, and the taxation of carbon emissions. And over the next two decades we may also need to replace the more than £30bn a year we currently raise from road fuel duties. Revenues are actually falling gradually as a share of total tax, and of national income, as vehicles become more efficient. The OBR projects that revenues will fall from 1.8 per cent of GDP today to 1 per cent by 2030, an annual revenue loss of more than £10bn. The case for road pricing has always been strong. The fiscal case, in the face of petrol revenues that will diminish towards zero if we decarbonise transport—in line with official government plans—is becoming urgent.

If we decide we want to raise serious sums of money then we should look to the two biggest taxes—income tax and VAT.

There are two crucial lessons overall. Genuinely big decisions need to be taken about how much revenue we raise, how much we spend and how we allocate it. Given demographic pressures, there is no way to escape either increasing tax, or cutting spending on the elderly—or cutting spending elsewhere.

The second is that these decisions need to be taken in a rational, planned and well understood way or the costs will be much higher than they need to be and the effect on the poorest people harsh. Ignoring the situation is dangerous, and setting out random lists of taxes to raise or spending programmes to cut doesn’t get us very far either.

MORE FROM THIS MONTH’S COVER STORY:

Who will break the big taboos? David Goodhart says tax the elderly, reform welfare

No one dares touch the baby boomers Rachel Sylvester names the big taboo

Where politicians fear to tread Prospect asked Ruth Lea, Will Hutton and others which taboos should be broken

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