The Government Debt Iceberg


Government and Institutions

2014 Budget should be the last in its current format

Monetary Policy

A book about the compatibility of free-market reforms and electoral popularity

UK faces crippling tax rises to pay for ageing population
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·       Europe and the United States will soon begin to encounter fiscal constraints the like of which we have never seen before. Federal debt as a percentage of GDP more than doubled between 2000 and 2012. According to the US Congressional Budget Office, total national debt is expected to remain close to 100 per cent of GDP during the next decade and begin to increase thereafter as the baby-boomers fully enter retirement.

·       Debt levels in European Union countries have surged similarly, from 60 per cent of national income during the mid 2000s to 85 per cent of national income today. 
• An ageing population alone does not create greater government indebtedness as long as each generation sets aside adequate funds to meet their own future pensions and health-care costs. Instead of adopting such pre-funded retirement support systems, however, Western governments have developed unfunded social insurance programmes where retiree benefits are paid for from the taxes of the working-age population. This means that an ageing population leads to 
rising expenditures that cannot be covered without increasing taxes on the young. Politicians have known about population ageing for around 50 years but ignored the problems it will create for public finances.

·       Figures for accumulated debt are backward looking, reflecting past deficits; they do not take into accountthe promises that governments have made in relation to future commitments. No private sector firm would be able to present accounts in this way.

·       If we include commitments that have been made under Social Security and health-care programmes, the US fiscal imbalance is 9 per cent of the estimated present value of future US GDP. This means that an additional 9 per cent of GDP in tax revenues, over and above existing taxes, would have to be levied each year to ensure that all US government spending commitments could be met from taxation. Closing the fiscal gap between expected tax revenues and spending would involve more than doubling federal payroll taxes, assuming that such a rise is economically feasible.

·       Under the most realistic assumptions regarding future policy, the US fiscal imbalance is about seven times the total national debt held by the public. In other words, if current unfunded spending commitments 
to future generations of older people are included, the underlying national indebtedness of the US government is seven times the published figure.

·       Over two-thirds of government spending commitments not covered by current tax plans is attributable to two major programmes: Social Security and Medicare. These programmes have been hugely expanded in recent years.

·      All the fiscal metrics used by EU countries, for example, in the euro zone’s stability and growth pact, are backward-looking measures of accumulated debt; as such, published debt measures understate trueindebtedness.

·       The underlying fiscal situation in the EU is worse than that in the US. In EU countries, the ratio of workers
to retirees currently stands at between three and four but, for most EU countries, this ratio is projected to decline to below two workers per retiree by the middle of this century. The ratio of workers to retirees will also decline for the US, but will remain considerably above the ratios in the major EU nations.

·       This demographic situation, combined with future pension and health-care commitments, is at the heart of the unsustainable budget positions in the EU. The use of explicit debt measures to judge policy leads to bad long-term decision making, especially in areas such as pension provision. For example, in the UK, Poland and Hungary, action has been taken to reduce short-term debt measures in ways that increase long- term state pension liabilities.

·       The average fiscal imbalance in the EU is 13.5 per cent of the present value of GDP. Ireland has the highest fiscal imbalance; at 31.6 per cent, the UK’s fiscal imbalance is a little above the EU average; and four countries (Sweden, Cyprus, Luxembourg and Estonia) have fiscal imbalances less than 8 per cent.

·       A 13.5 per cent fiscal imbalance as a share of GDP
in EU nations translates, on average, into a 23.2 percentage point increase in the consumption tax rate if taxes are going to fully finance spending – again assuming that such a rise is feasible. Alternatively, the fiscal imbalance could be closed by reducing health and social protection expenditure by about one half.

·       In the UK, total spending would have to be cut by more than one quarter or health and social protection expenditure by around one half compared with the level implied by current policy if the UK is to avoid tax increases and all spending is to be met out of tax revenue in the long run. Some measures have been planned in the UK which will address the situation, such as a proposed rise in state pension age, but these measures are being implemented slowly and are inadequate on their own.

·       Faster economic growth than already incorporated into fiscal imbalance estimates is unlikely to resolve governments’ long-term fiscal problems. Many of the projected expenditures could increase if there 
is economic growth because the commitments on pension and health benefits are designed to keep
pace with overall economic growth. Furthermore, if countries do not address their fiscal imbalances now, the size of the necessary adjustment will increase over time, undermining investor confidence and generally worsening the conditions for maintaining economic growth. Instead, appropriate and timely structural changes to bring the finances of public programmes into balance would be likely to spur economic growth.

The publication featured in The FT Adviser, CityAM, The Daily Mail, The Guardian and The Telegraph.

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2014, IEA Research Monograph 68

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