Higher debt for decades?

Date: 13 July 2011
Publisher: IFS

Much attention has focused on the damage done to the UK's public finances by the financial crisis and associated recession, and the painful tax rises and spending cuts required if borrowing is to be brought back to pre-crisis levels. A longer-term perspective is provided by the publication today of the Office for Budget Responsibility's (OBR's) first Fiscal Sustainability Report. This suggests that keeping the Government's finances in a sustainable position in the longer-term will require further uncomfortable decisions to be implemented over the medium-term, on top of delivering the fiscal retrenchment already planned for the next few years.

We know that (Figure 2.6) the increase in Government borrowing since the recent crisis began could not have been left unchecked. It would have left the UK's public finances in an unsustainable position with debt forecast to rise remorselessly throughout this century. The fiscal tightening outlined in the March 2010 Budget by then Chancellor Alistair Darling would, if it had been delivered and maintained, have been sufficient to avoid this situation. The swifter and larger fiscal tightening planned by Chancellor George Osborne will (again if delivered and maintained) see debt peaking sooner and at a lower level, and then falling faster (and therefore leading to lower debt interest payments) than under Mr Darling's plan.

However as Chart 1, taken from today's OBR report shows, even if the government manages successfully to implement the fiscal tightening it has planned for this parliament, in the longer run demographic pressures (particularly from the ageing of the population) will place upward pressure on public spending. If left unchecked these would lead to higher borrowing and, as shown in the top line in Chart 1, a rising stock of public sector net debt from the late 2020s. These are not new issues, but current and future governments will need to decide how to address these pressures if UK public finances are to become sustainable over the long run. If future Governments were able to maintain borrowing forevermore at the level currently forecast for 2015−16, debt would be on course to return to its pre-crisis level towards the end of the 2030s.

Chart 1: OBR long-term projections for public sector net debt

OBR long-term projections for public sector net debt





Assuming currently legislated policy, increasing longevity, along with changing fertility and net migration, are projected to increase public spending by 5.4% of national income between 2015−16 and 2060−61 - equivalent to £80 billion in today's terms. In other words, simple changes in population structure will require us to raise taxes or cut other spending by £80 billion (roughly 11% of the current level of annual public sector expenditure, or 14% of this year's tax receipts) just to deliver currently promised levels of pensions, healthcare and education if future Governments are to avoid an increase in borrowing.

The projected levels of spending for pensions, health, long-term care and education are illustrated in chart 2. The largest projected increases in spending are for spending on health and state pensions, which are both forecast to increase by 2.4% of national income between 2015−16 and 2060−61 on the OBR's central forecast. But one big risk to the public finances (highlighted by the OBR) is that productivity in health services could grow less quickly than in the rest of the economy. We would then need to spend an increasing share of national income in order to keep the output of the public health sector growing at the same rate as the rest of the economy. The OBR estimates that this could require health spending to increase by a further 5.3% of national income by 2060−61.

Chart 2: Age-related public spending projected to rise, if left unchecked

Age-related public spending projected to rise, if left unchecked

But the public finances will not only be under pressure on the spending side. Some taxes will also deliver less revenue in the future than they do now. In particular this will be the case for revenues derived from the extraction and consumption of oil and gas, both of which are relatively highly taxed activities. Revenues from these taxes will fall as oil resources are exhausted and motor vehicles become more fuel-efficient and eventually shift towards being electrically powered (which will also reduce receipts of vehicle excise duties). Slightly offsetting these declining trends, revenues from income tax could increase if income growth over the next few decades is skewed towards the top of the income distribution as it has been over the last few decades.

Between them these pressures lead the OBR to estimate that the ratio of tax to national income could be lower by around 2 percentage points by 2029−30, or around £29 billion in today's terms. This is not factored into the OBR's central forecast for revenues, and therefore borrowing, over the next 50 years. There are a number of ways the tax system could be reformed in light of these trends, such as a shift towards a system of national road pricing, as we have discussed in the Mirrlees Review.

The Government is undertaking radical, and painful, surgery over the course of this parliament that is intended to return the public finances to financial sustainability in the short term. But today's OBR report is a timely and salutary reminder that, all else equal, significant further fiscal retrenchment will be required over the medium term to offset the estimated detrimental impact of changing demographics, and other factors, on the public finances.