With Budget day upon us tomorrow, we can expect to be told that we are almost half-way through the government’s planned fiscal consolidation. Politicians will talk about how they are eliminating the deficit and getting our debts under control. Yet the whole debate seems to assume that, when the deficit is finally gone, perhaps later this decade, we can kick back, relax and declare ‘job done’.
Nothing could be further from the truth. The immediate fiscal challenge, as defined by the government, is the tip of the iceberg. We need to grapple with the future challenges posed by an ageing population, given the commitments successive governments have made in areas like health and pensions.
The debt-to-GDP ratio is a backward looking measure, reflecting past deficits. It does not account for the future promises governments have made. No private sector firm would be able to present its accounts in this way.
This isn’t a problem specific to the UK. The pay-as-you-go nature of the provision of pensions and healthcare across many Western countries means the current working generation meets the cost of today’s elderly and retired. The current working generation then votes for policies for which future working taxpayers will be taxed. This is fine until your population ages and health care costs continually outpace economic growth. Yet now, facing these conditions, a continuation of current policies would necessitate huge increases in taxes each and every year to fully fund our promises.
To get a sense of the scale of this challenge, last week the Institute of Economic Affairs published The Government Debt Iceberg, which calculated the long-term fiscal imbalance across a range of countries given current planned policies.
The numbers are petrifying. In the US, for example, an extra 9 per cent of GDP would have to be raised in tax revenues indefinitely to close the fiscal gap. This would amount to doubling federal payroll taxes. In the UK, taxes would have to go up by a staggering and indefinite 14 per cent of GDP – equivalent to hiking consumption taxes by over 21 percentage points.
Tax rises on this scale would kill growth. And since, over the past few decades, the UK has not raised more than around 40 per cent of GDP in tax revenues in any given year, the idea it could sustainably lift tax revenues from 36 to 50 per cent of GDP looks pie-in-the-sky. The equivalent would be to halve all health and social protection spending for now and forever.
The only real way to avoid draconian cuts or growth-killing tax hikes is reform of these programmes to make them funded. But even this means one generation paying twice. Some reforms are in train, such as raising the state pension age. Other reforms – such as the triple lock on pensions and more generous state support for social care – make things even worse. There are no easy options: these are future debts that cannot be inflated away, as many commitments are index-linked. Meanwhile, those who think faster growth will bail out governments get things the wrong way round – the uncertainty of the scale of future tax rises could be one of the factors delaying private investment today.
So when the chancellor stands up at the despatch box tomorrow, let’s try to see the wood for the trees. When the government says it has a 'long-term economic plan', let’s judge it on whether its policies do anything to address our real long-term challenges.
This article was originally published in City AM.