Host

Bronwen Maddox, CEO, Chatham House

Guests

• David Miles, Professor of Financial Economics at Imperial College; member of the Budget Responsibility Committee at the Office for Budget Responsibility
• Carl Emmerson, Deputy Director, Institute for Fiscal Studies
• Martin Wheatcroft, adviser and Fellow, ICAEW

Transcript

Bronwen Maddox: Hello and welcome to a special episode of the Insights In Focus podcast. I’m Bronwyn Maddox, Chief Executive of Chatham House, the think tank. Today we’re discussing how demographic trends, as well as changes to the UK’s working population, are affecting the government’s finances and the policy options on hand. The numbers do not make easy reading for those in charge of the public purse. The latest census revealed that almost a quarter of the UK’s population is now aged 60 or older. Recent research claims NHS spending will need to increase yearly by 3% to meet demand, and there’s also a growing need for adult social care and trillions in unfunded state pension liabilities. And, of course, all this is converging at a time when economic conditions are particularly challenging, and the government is trying to rein back spending.

To discuss how the government can best manage these competing priorities. We’re joined by David Miles, Professor at Imperial College and member of the Budget Responsibility Committee at the Office for Budget Responsibility. Hello, David. We also have Carl Emmerson, Deputy Director at the Institute for Fiscal Studies. Welcome Carl. And finally, we have Martin Wheatcroft, ICAEW adviser and Fellow. Very good to have you all here today. Before we plunge into the policy questions, let’s start with the key changes and trends in UK demographics that listeners should be aware of. Martin, perhaps we can start with you. You’ve been doing a lot of thinking about the effects of the ageing population, haven’t you?

Martin Wheatcroft: Yes, more people are living longer. Over the next 20 years we’re expecting about 25% more pensioners, that’s going to increase from 12 million to 15 million people. At the same time, the working age population is only going to go up by about 5%, or potentially 7% with higher migration, which I know other people will want to talk about. And then the number of children under 18 is going to fall by 11% over the next 20 years. So, we’ve got quite a different change in the profile of the demographic. We’ve also got slower population growth. Over the last 20 years, the population has increased by about 20%, but over the next 50 years, it’s going to go up closer to 5% to 10%.

BM: So, these are really quite big shifts. David, I wonder if you could take us into the implications. I should say that these are not in themselves bad things, are they? People are living longer, many of them living healthy, longer lives, and slower population growth is something that many governments have wanted. But they do have real effects on the public finances, don’t they?

David Miles: They do, because they have an impact on the age structure of the population, what proportion of the population is working, what proportion of the population are in those parts of their life when they make the greatest demands on the health system, and on the payment of state pensions. So, the net effect of all those things is to almost certainly increase pressure on the public finances in a way that will get worse almost certainly year on year. As you say, though, the underlying drivers of what’s changing the demographics are in themselves not negative things. Increasing life expectancy, many of the extra years that people will live are good years in decent health, is on balance a good thing, and a lower rate of growth of the population in a densely populated country like the UK that’s trying to hit net zero targets is also not in itself a bad thing, but it generates major fiscal problems.

BM: And what about immigration, which Martin mentioned?

DM: That’s an offset to what would otherwise be an even sharper increase in the proportion of people over 65, relative to the rest of the population, at least it is in the short term. Immigrants when they arrive in the UK, on average, are a lower age than the domestic population, and they can be expected to, on average, work for the next 20-30 years or more. That’s of some fiscal help in the short term, but of course those people grow old themselves. So, unless you have immigration at quite high levels, possibly even accelerating levels, it’s not going to stop the ageing of the population in the UK.

BM: Carl, there was a lot of emphasis in the 2023 Budget on getting people back into the labour market after coronavirus, and after many seem to have just left the workforce. Can you tell us about that?

Carl Emmerson: Absolutely. If the challenge we have is that people are living longer at older ages, as David says, and some of those years are in good health, that’s a good news story. But if you think about the effects on the public finances, if you think about the effects on people’s own private finances, actually a neat solution to the challenge of how you deal with the fact that you’re going to have more years of life at older ages, well retiring a bit later looks like quite a smart solution. You can be encouraged by a higher state pension age, you can be encouraged by other policy levers. The government in particular has been looking at incapacity benefits and how they work, and other ways of supporting older individuals either to get back into the labour market, or perhaps more likely to stay in the labour market for a bit longer. And in terms of their own private finances, if you’re saving privately for retirement, if you spend more years in working life, that’s more years paying into a pension, perhaps don’t have quite so many years drawing out, that’s fewer years that pension has got to finance. So, it can be a neat solution to the challenge of having an adequate retirement income privately, as well as a neat solution of how to keep up tax revenues, and how to limit some of the demands on the state.

BM: Not an uncontroversial one, as we can see from the streets of France at the moment, with the protests there about pension age. But we’re talking mainly about the UK. Martin, just take us a bit more into the pressures that these trends we’ve just been describing are exerting on the public, on public spending and public finances.

MW: As David said, more pensioners equals more spending on pensions, health and social care. And we’ve had that added to by government policies such as a triple lock, social care reform – if it happens – welfare expansion, such as childcare in March’s Budget, that all adds to the pressure on the public finances. So there tends to be not only a demographic pressure, but also a political pressure to expand the social protection that the state provides. And we don’t have any more the ability to raid the defence budget that we have. That’s contributed a lot of money towards the health service in particular over the last 50 years or so.

BM: Let’s explain this a little bit. Basically by squeezing the defence budget, governments have found more and more money to go into health, but they can’t, with war in Ukraine, do that any more.

MW: Correct. We’ve now hit the 2%, NATO minimum, and defence spending looks like it’s going to be going up over the next 10 to 20 years, not down. By being able to raid the defence budget in that way, governments have been able to avoid putting up taxes in the way that we’ve seen in some other countries.

BM: Target NATO minimum, I think I should say for those in search of wiggle room, but as you absolutely rightly say, the UK is not going to be looking there for extra money right at the moment. Let’s turn to the politics of it, which we cannot ignore. These things are immensely controversial. And Martin, again, could you take us to where you think public expectations have got to about the level of public services?

MW: Well, I hesitate to use the phrase ‘cake and eat it’, but I will. There is a tendency to believe that we can have European-style levels of public spending, public services, a comprehensive health service, etc, without European-style levels of taxation. And that dichotomy over the last few decades is now coming to more of a severe point, particularly exacerbated by low economic growth.

BM: David, do you think people are right to feel betrayed, as I think some do, that they had a contract with the state for all kinds of things like pensions, health care, education, and somehow that contract is being rewritten, not in their favour? And then the politicians say, but please vote for us again.

DM: Well they may feel that, but I think if people do expect that the level of services they get will just keep getting better, and they’ll be protected from more and more economic shocks, whilst at the same time not seeing any increase in the burden of tax, then I’m afraid that’s a pretty an unrealistic set of expectations. I guess you could see why they may be there. The government did a great deal to protect people from some of the worst damage of the two big shocks we’ve had in recent years, that is COVID, followed shortly after by the huge increase in energy prices, which came on the back of the Russian invasion of Ukraine. And the government spent an enormous amount of money in cushioning households in the UK from at least some of the enormous damage those two shocks brought. And I think people need to be realistic about the scope that the state has to protect against things like that, which were unpredictable shocks. And also against more predictable things such as demographic change, whilst doing that without increasing taxes. Taxes are going to go up in the UK, they’re scheduled to go up fairly significantly as a proportion of GDP. But to preserve the level of support that the state has been able to give households into the distant future, that tax may need to go even higher.

BM: It’s a very important point you’ve made that people’s expectations may have changed – risen in a way – during coronavirus. And indeed the energy protections the government brought in, though those were not immediate and not to be taken for granted. You could say they were extracted from the government. Carl, what is your view of this? The IFS has done a lot of work on expectations of the health service, of social care and so on?

CE: Well, I think one of the lessons from the last few years is that when these bad, nasty shocks come along, for very good reasons the government steps in and provides a lot of support to public services, to businesses and directly to households to help them through those shocks. And what happens in those periods of time is government debt increases pretty substantially as a share of national income, and for good reasons. I think the challenge that means is that, unfortunately, at some point, another adverse shock will come along, and it will be right for the government to step in and right for the government probably to increase debt again.

What that means is, we really need to be aiming to get debt down in the years when we’re not anticipating those kinds of bad shocks coming along, just in case they do. We can’t have debt rising in both the good years and the bad years too. So, it does mean that we need to be ambitious in terms of creating what’s known technically as fiscal space, for when those bad events come along. And history teaches us, the OBR has shown that, unfortunately, the next recession is usually at most a decade away. The shocks the UK has experienced – the financial crisis, the pandemic and now the energy shock – have been pretty big and pretty adverse shocks. And we want to have the space for government to step in and help us in those periods, which I think means we need the government to repair the damage it does to its balance sheets in the other years.

BM: Martin, do you think there’s a risk of short termism because of politics?

MW: I think we do suffer from short termism, and there’s many reasons for that, the electoral cycle being one of them. But it is very difficult. You’ve got a fiscal strategy, in effect, that’s been based on a pay-as-you-go system. And that really requires a steady state population with similar demographics, and we’ve not got that. And it also relies on strong economic growth, which we haven’t got either. And finally, it relies on the willingness of future generations to pay the taxes that are needed to pay the bills. And we’ve discovered politically that it’s quite difficult to put up taxes and make other adjustments that that are needed. So that makes it challenging for people to make long-term decisions that you would ideally like to see, in terms of a long-term fiscal strategy, to fix the roof while the sun is shining.

BM: And just spell out for us the difficulty in putting up taxes – is it political opposition, people are going to vote you out, or they’re going to leave the country, they’re very mobile?

MW: I think the concern is about your ability to get votes. Going into an election saying you’re going to raise taxes, for example, is not a comfortable place to be. Although having said that, there is no surprise that the first Budget after a general election tends to be a tax-raising budget, because that’s the best time to raise taxes. But we do have this ratchet effect where pressures on spending gradually increase over time. The politicians, the Chancellor and the Treasury tried to hold the line, and then every so often they need to relax the waistband and raise taxes. And so you get this ratchet effect going on.

BM: David, Martin was referring to growth, and that has been stalling in the UK. Can you describe for us how this is complicated, these kinds of choices?

DM: It certainly has. If you go back to before the financial crisis of 2008 and look at the two decades leading up to that, the gross of productivity, average output per hour worked in the UK was running at probably around about 2%, maybe a bit more than 2%. Since the financial crisis 15 years ago, it’s barely been positive, probably nearer half a percent than the slightly more than 2% that preceded it. Fifteen years of that means that relative to the trajectory you might have hoped the UK was on, output or incomes per person in the UK is probably 25%, maybe even 30% below that previous trend. That generates an enormous hole in the available resources there are in the UK, and it means that standards of living have stagnated rather than increased as they had in most of the period since the Second World War. And when expectations of what the state can do don’t diminish in line with those diminished resources, there is an enormous pressure on the fiscal position. And that’s where we are right now.

BM: Carl, we’ve heard a lot over the years – decades even – about the UK’s productivity problems, and also about regional imbalances. How much of these are a factor in the lack of growth we’re seeing?

CE: There’s lots of reasons why the UK economy is not growing as fast as it used to, and lots of reasons why the UK economy is not as productive as some other countries that we’d like to be as productive as. And I think it points to the fact that if we want to solve those problems, there’s not going to be one easy solution to that, there’s a lot of complicated policies that interact. There’s lots of policies that economists would point to and say, well, you should do this, this and this, but actually, politically, they’re not that easy. So relaxing planning laws, changing competition policy, thinking about your trade policy, your immigration policy, getting your education policy right, in particular for the half of people that don’t go on to higher education, all of those things are the kinds of things that economists would point to. And indeed, colleagues at IFS have got lots of examples of how we can improve the functioning of our tax system. But a lot of those things create losers, they can be a difficult sell, and there’s reasons why politicians have shied away from doing them in the past.

BM: So at this point, we’ve talked about the demographic, the economic, and some of the political pressures on public spending, all coming together at once. Let’s now turn to this question of what policymakers can and should do to manage all these competing objections. I want to start with this word – tax – that has indeed made it into this podcast already. Martin, you’re saying that higher taxation is inevitable, and lasting austerity, in a sense, is likely,

MW: I don’t think it’s inevitable, but it’s going to take some good luck, I think, to try and help. We are in a Catch-22 fiscal position at the moment. The Chancellor can’t find enough money to invest in the economy because economic growth isn’t strong enough to be able to afford it. So we need to break out of that cycle somehow, and a good run of the economy would provide that bit more room for manoeuvre that the current Chancellor doesn’t have. The other thing is to say that this is a long game, and the good news is that we do have quite a long time if we want to make changes for them to have an effect. So small changes now over a period of 25 years or 50 years can make a big difference. And we’ve seen that in some other countries, for example, Australia, with their Future Fund, a sovereign wealth fund that they’ve set up. They’ve moved their federal staff on to a defined contribution pension arrangement, for example, and that’s gradually helping their public finances and putting them into a better place. And there are opportunities to do small changes that build up over time. So hope is not lost, I would say.

BM: What about more dramatic changes? We’ve heard quite a bit from Labour – at the moment ahead in the polls – about property taxes, and indeed wealth taxes. How live do you think that debate is?

MW: Well, I think all tax policy is always live. I think as Carl says, the challenge with tax changes is that the losers do tend to squawk much more loudly than the winners. There are opportunities to improve things like how wealth is taxed, and how businesses are taxed, for example, but we do have a challenge that quite often what tax policy tends to focus is on is playing around with the small taxes. But two thirds of our taxes come from five taxes, and there’s a resistance there to tinker with them. The fifth of those is corporation tax, and that has been tinkered with, with the big rises from April. But other taxes like income tax and National Insurance, there tends to be a lot more political resistance because they do affect a much wider group of people, but they are the ones that produce the money.

BM: Carl, I’m not going to use the word inevitable again, but you were making a case that increases in state pension age are often seen as a way to go about this.

CE: I think they’re seen as a natural way forward when people are living longer, and at older ages living healthier lives. It seems appropriate for not all of that extra life to be spent in retirement, not all of that extra life to be spent receiving a state pension, but it’s not inevitable. We could choose to have a lower state pension age, we could choose to have a more generous state pension, but these things come with a price tag. It’s about getting those trade-offs right. And I think that the principle now, if it is the case that people are living longer at older ages, that we should push up the state pension age is a coherent one. But it does point as well, probably, to requiring tax rises alongside that – it’s not going to fix all of the demographic challenges we face. And I think there, we might want to look at where other countries get their extra tax revenue from. Martin spoke earlier about how Western European countries, Scandinavian countries, often have higher tax burdens than the UK. How do they do that? It’s not by taxing the top 1% or the top 5% more, it’s about taxing the top half more. They often have higher rates of their equivalent of National Insurance contributions on middle and just above middle earners. Now, that’s not necessarily politically easy, but it’s where they get the extra revenue from.

BM: David, what do you make of this debate and the sheer amounts of money that Carl, for example, is talking about? Is that reflected in the British debate?

DM: Well, I think it’s becoming better recognised that taxes have to – and are likely to – rise, certainly in the near term. If you go back just a few years before COVID, total amount of tax raised In the UK out of total incomes or GDP in the UK was about a third, it was about 33%. Projections are that on the current trajectories of government policy four or five years down the road, that 33% number will be 38. So that’s five percentage points of GDP, and of GDP which is not growing very fast, with more going to the state. We’re already seeing this happening, and it will continue over the near term. And if it didn’t happen, the stock or government debt, which has been rising very dramatically in recent years, would continue going up without end in sight, and that’s not sustainable. How far you can push the tax take-out of GDP without doing significant damage to people’s incentives to save, to work, to invest is a deep and difficult question. The easy answer, of course, is well, you just have to have a more effective and efficient tax system.

That’s easy to say, it’s quite difficult to achieve. The best answer, of course, is can we get back to growth rates that were normal in the 1950s, 60s, 70s, 80s, 90s? And if that were to happen, then there’s nothing inevitable about the tax take-out of people’s incomes and GDP rising. The question then is what is the power of the state as opposed to entrepreneurial drive of individuals and companies? What is the power of the state itself to raise the rate of growth of the UK economy?

BM: As we’re coming to the end of this, let’s just take closing thoughts on that last point, which is a more optimistic point in a way. And it’s obviously where politicians would like the debate to be about what they can do to increase growth – every government for decades has come in with plans for industrial improvement, whether or not they call that a policy for further education for regional development. And just on that point that David put so well, let’s take last thoughts on what a government is capable of doing to change these factors?

MW: There’s a huge amount that government can do. The question at the moment is that there’s a lack of fiscal firepower, if you want to call it that, available to the Chancellor, because he’s right up against his self-imposed fiscal rules. So, a lack of money, in other words. And as David said, debt is now at 2.5trn and heading up towards 3trn fairly shortly. So, we’ve got a challenge about how you control that rise in debt, invest in growing the economy, the infrastructure, whether that’s in skills, in technology, and to do things. The other thing, just on public services themselves, we’ve got a quality problem in public services at the moment. They need investment. You need new technology to improve the quality of public services. And again, because of the need to conserve resources at the moment given the current fiscal situation, the investment that you need, and ideally would go into public services, isn’t happening. And of course, that’s a Catch-22 again, that you’re not being able to improve the quality of public services in the way you’d like, and in fact, many areas of public services are deteriorating at the moment.

BM: Carl, your last thoughts on this?

CE: Well, there are certainly lots of policies that we could do that would help contribute to more growth. And actually, if we are putting up taxes, yes, it’s important that we reform those taxes, it’d be less damaging to put up well-designed taxes than to put up the ones that we currently have. But even if we weren’t going to push up taxes, there’s a strong case for tax reform, to have a smarter tax system that can achieve the redistribution that we want to have without doing as much damage to the economy. So, to take one specific example, calls for a new wealth tax. Well, I think my starting point would be to say, let’s look at the taxes we currently have on wealth – let’s look at capital gains tax, let’s look at stamp duty, let’s look at council tax, they really don’t work as well as they should. Let’s reform them regardless of whether we want to push up the taxes, or whether we want to keep them roughly at their current level. By doing so we could have a fairer tax system and one that does less harm to our economy.

BM: David?

DM: There’s one area where I’m optimistic that we could do better and one area where people make proposals and I’m very sceptical about them. The optimistic thing: I think we manage to get resources allocated in not the best way in supporting people when they leave schools. So those people that go to university, which is still probably a bit less than 50% of the people coming out of schools, get quite a lot of resources from the state. But there’s really very little – relatively anyway – that goes to those people who would benefit greatly from vocational training, apprenticeships, those kinds of things, who get much less support from the state than people who go to university. So I say this as someone who works at a university, I think the allocation of resources has gone a bit wrong there.

And can I tell you one thing about an area where I’m kind of sceptical? Quite often people say that one of the problems with the direction of economic strategy in the UK from the government is we’re far too centralised, it’d be much better if power was decentralised across the country. I’m kind of sceptical for two reasons. Firstly, it’s quite a small country. I mean, there are probably 12 or 13 individual states in the US that are bigger geographically than the whole of the UK. But more than that, when we have devolved power to the Welsh government, the Scottish government, it’s not obvious in the period since that happened that it has improved relatively the economic performance of those areas. So, I’m sceptical that that’s the answer to the question.

BM: David, you’re sketching out there a tantalising whole new subject that could be the subject of a whole different podcast. We can’t go there today. This does sound with those closing thoughts, though, like a great place to end things. So, my thanks to David, Carl and Martin for sharing all your thoughts on what the years ahead may and should look like. You can learn more about the issues discussed today by visiting the Future of Tax and Public Spending hub on the ICAEW website, and you’ll find the link in the show notes for this episode. Regular host Philippa Lamb will be back next episode. In the meantime, please rate, review and share this episode, and remember to subscribe to ICAEW Insights wherever you get your podcasts.