Tax and Fiscal Policy

Defusing the debt time bomb: the challenge

Last week’s public-finance statistics were truly dreadful. They showed that despite a year of fairly robust economic growth, UK government borrowing since the start of the financial year 2014 to 2015 was actually 10 per cent higher than in the same period in 2013 to 2014. Once again, it seems, our public finances will be in deficit by more than £100 billion this year.

Running sustained deficits of this kind adds to the overall debt burden. According to the new ONS figures, public-sector net debt is currently £1.45 trillion (79.9 per cent of GDP) – meaning we are paying just over £50 billion per year in debt-interest payments. Whilst debt levels on this scale are not unprecedented historically, accumulating such large levels of debt during peacetime is more or less unknown.

The long-term challenge of keeping debts at a sustainable level is greater still. The debt figures we hear quoted in the media are backward-looking. They do not include the spending commitments that governments have made to future generations. This is especially problematic because an ageing population means that, on unchanged policies, the cost of providing age-related spending will rise substantially over the next five decades – pushing debt levels higher.

Each year the Office for Budget Responsibility (OBR) publishes its fiscal sustainability report, which highlights the scale of this long-term challenge. It always reaches the same conclusion: that the long-term path of the government’s public finances is unsustainable. This year, for example, it suggested that even if the government met its deficit reduction targets through to 2018 to 2019, by the mid-2030s net debt would begin rising again and would be back up to 84 per cent by 2063 to 2064. On unchanged policies, this would be driven by an ageing population leading to higher demands on healthcare, pensions and social-care spending.

How significant is this problem? Well, every year following the release of the report there are always people who seek to play down the challenge. That’s mainly because the OBR suggests avoiding this situation – and getting the debt-to-GDP ratio down to 20 per cent of GDP by 2063 to 2064 – necessitates fiscal tightening in 2018 to 2019 equivalent to 1.3 per cent of GDP. In other words, spending cuts or tax rises of about £22 billion relative to GDP this year. Large, but not completely unachievable.

To get to the starting point of the OBR’s projections though, it is assumed that the next government will already have delivered the 5.2 per cent fiscal adjustment planned through to 2018/19. Adding this to the further sustained tightening that will be necessary due to the demographic effects outlined, this means that to get debt to 20 per cent of GDP in the long term would require a more or less immediate and sustained reduction in government spending of 6.5 per cent of GDP, or £112 billion. This is roughly equivalent to ending all NHS spending, or all transfers to pensioners.

As if this was not a big enough challenge already, some of the other assumptions that the OBR uses to reach its figures are themselves highly questionable. For example, healthcare spending is highly sensitive to productivity growth in that sector. The lower the productivity growth, the higher the spending for a given level of demand. The OBR assumes that healthcare productivity growth will increase at the same rate it thinks the economy will grow – 2.2 per cent per year. Between 1979 and 2010 it only grew by 1 per cent, however. The OBR also assumes net inward migration of 105,000 per year – even though it is declared Conservative policy of reducing this to the ‘high tens of thousands’. And it is presumed that spending restraint is proportionate across all departments between 2015 to 2016 and 2018 to 2019, even though the parties have all declared their desire to protect healthcare.

On not unrealistic assumptions then, the equivalent, immediate and permanent spending cuts which would be necessary to get public sector net debt down to 20 per cent of GDP by 2063 to 2064 could actually be in the region of 9.6 per cent of GDP – or £168 billion. That’s equivalent to 25 per cent of all current government spending – or cutting all social-protection spending (health, welfare and pensions) by half.

Even this assumes that productivity growth in the economy will be 2.2 per cent per year – much better than our recent productivity performance. And this would leave no space for recent tax rises to be reversed.

Clearly, spending restraint on anywhere near this scale would in reality lead to governments reneging on many of their existing promises. Defusing this debt time-bomb (which has been made worse by the government in some areas) will inevitably mean that policies will not and cannot remain unchanged in the long-term.

Defusing the debt time-bomb is likely to require a combination of three different types of policy. First: changing eligibility for healthcare services, pensions and pensioner welfare. Second: supply-side policies to increase productivity growth and the size of the economy. Third: more fundamental reform of pensions and healthcare (such as moving to funded systems).

We know that an ageing population will mean more resources being diverted towards healthcare and pensions spending. To avoid a crippling and growth-killing tax burden on the working population to pay for them, these sorts of policy options are likely to be introduced in the coming decades.

Ryan Bourne is the co-author, with Philip Booth, of Defusing the Debt Time Bomb: Challenges and Solutions.

This article was originally published on the The Spectator’s Coffee House blog.

Head of Public Policy and Director, Paragon Initiative

Ryan Bourne is Head of Public Policy at the IEA and Director of The Paragon Initiative. Ryan was educated at Magdalene College, Cambridge where he achieved a double-first in Economics at undergraduate level and later an MPhil qualification. Prior to joining the IEA, Ryan worked for a year at the economic consultancy firm Frontier Economics on competition and public policy issues. After leaving Frontier in 2010, Ryan joined the Centre for Policy Studies think tank in Westminster, first as an Economics Researcher and subsequently as Head of Economic Research. There, he was responsible for writing, editing and commissioning economic reports across a broad range of areas, as well as organisation of economic-themed events and roundtables. Ryan appears regularly in the national media, including writing for The Times, the Daily Telegraph, ConservativeHome and Spectator Coffee House, and appearing on broadcast, including BBC News, Newsnight, Sky News, Jeff Randall Live, Reuters and LBC radio. He is currently a weekly columnist for CityAM.

2 thoughts on “Defusing the debt time bomb: the challenge”

  1. Posted 30/10/2014 at 12:21 | Permalink

    The UK economy is burdened by two sets of deadweight losses. One from taxation of income and capital, and the other from capitalised land rent. Some economists who have taken the trouble to calculate these losses put them together at 48% GDP. We could therefore kill two birds with one stone, by paying for State services we share, from land rent instead of income and capital. The rental value of land being a natural cap on the amount of money the State should ever spend. Our huge public and private debts are merely symptoms that our economy is not capitalist, but neo-feudal. Until we learn the difference between capitalism and freemarket dogma, this situation is unlikely to change.

  2. Posted 04/11/2014 at 21:22 | Permalink

    Ryan, please could you explain why exactly we have a ‘debt time bomb’?

    As far as I see it, yields on gilts are extremely low by historical standards, consequently the UK debt service ratio is well within sustainable limits.

    Re. your point about the deficit being higher this year, this is surely just a symptom of the demand-constrained state of the UK economy? I would draw your attention in particular to the number of people who despite being in employment, are in low paid jobs that contribute very little in the way of revenues to the Exchequer. If anything, the heightened deficit this year should go some way in generating a bit of wage inflation and (hopefully) a recovery in revenues

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