Philip Booth 2010Professor Philip Booth is the Editorial Director of the Institute of Economic Affairs.

The UK has been put on a credit-rating downgrade watch. This is not surprising, but one wonders whether Moody’s is focusing on the right issues. In particular, Moody’s cited the lack of growth and the troubles in the eurozone as being the main reasons for its decision. Moody’s fears that the lack of growth could come from further problems in the banking sector, very weak growth in Europe and continued private-sector deleveraging. Leaving aside the fact that it is rather strange to suggest that deleveraging (and the consequent increase in saving) could cause slow growth and a debt crisis in an open economy (a decent third-year undergraduate course on international financial economics would put Moody’s right here) these are relatively short-term issues. What of the long term?

George Osborne’s plan is to bring the government finances back into balance in the medium term and reduce government spending to just below 40% of national income. This is very worrying. By the Chancellor’s own admission, the UK government has never been able to tax its citizens more than 40% of national income. The limit of the ambitions of a Conservative Chancellor of the Exchequer appears to be to tax the British population at the maximum taxable capacity.

If we fast-forward to 2016 and assume that the government has been successful in reducing government spending to its target, then what? The likelihood is that the government will be locked into a 40 year battle just to keep spending at that level. Calculations from IEA authors about the true underlying size of UK debt caused alarm when they were first published four years ago. Now, using somewhat different methods of presentation, the Office for Budget Responsibility produces its own forecasts of the long-term pressure on government spending. They too make depressing reading.

Overall, the pressures from health spending, pensions, PFI costs, long-term care costs and so on are likely (on the central projection) to add to government spending over 5% of national income over the next five years.

This may not seem like very much, but it will not be easily swallowed. How much further can taxes on the young be raised? Unless we make the young pay for sixth-form education and general schooling, how much more can we levy charges on the young or their families? Yes, we can increase taxes further on working families, but, increasingly, the targeting of families is leading to reduced family formation and reduced labour-market participation. Coalition proposals to reduce pension tax relief will attack the one group of people who do still actually save a reasonable proportion of their income. The only obvious safety valves are a huge increase in the state pension age and reductions in the welfare rolls. This requires reform – real reform.

But, some might say, “we’ll be okay- we have a Conservative government that is being prudent, looking for efficiency savings in the health sector and will always have its eye on the long term”. This would be exceptionally complacent. Indeed, even since the OBR published its report late last year, there have been some alarming u-turns. The government has caved in on public sector pensions – but in such a way that the increased costs do not “kick-in” until 2017. The government is under huge pressure to pick up more of the tab for long-term care costs as proposed by the Dilnot Commission. The government looks likely to abolish contracting out from part of the state pension scheme (and, indeed, is abolishing it for individuals from this year): this means that money that was previously saved will go straight into Treasury coffers and be spent. The university funding system is being designed so that it is highly likely that the government will have to underwrite and pay off the loans of a huge proportion of university students. And, perhaps, there will be a u-turn on health reforms to come in the next few weeks. Overall, this is a very “medium-termist” government. Its time horizon is 2016 – no further.

The problems identified by the OBR can get worse – rapidly. The OBR forecast that, if health spending rises by 3% in real terms rather than 2% (a more realistic assumption, surely), then the increase in government spending over the next generation doubles to over 10% of GDP!

The situation we face is new. Systems of funding health-care, long-term care and pensions that relied not on savings, insurance and family provision have only really existed in the current comprehensive form for a generation or two. They are inherently unstable. To restore long-term sustainability to public finances, we need to restore funding, saving, insurance and the family to the heart of provision in old age – both health provision and pension provision. Nothing can be done about the current obligations. We cannot ask 60-year-olds to start saving for their pension or healthcare. Once again, I am afraid, it is the young who will have to be asked to bear the burden – though they will reap many of the benefits too.

In reflecting on the Moody’s announcement, the government needs to do two things. It needs to liberalise the supply side of the UK economy so that it can grow out of its current debt problem. It also needs to address the long-term structural problems caused by the welfare state out of which we will not grow.

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