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Diego Zuluaga

Diego Zuluaga is Financial Services Research Fellow at the Institute of Economic Affairs.

Most Western countries today offer extensive pension and healthcare entitlements which are predicated on inter-generational transfers: those of working age pay the benefits of the old in exchange for the promise to receive payments and public services commensurate with their lifetime contributions in retirement.

Yet increasingly lavish benefits, rising life expectancy with which the statutory retirement age has not caught up, and the imminence of demographic decline, all jeopardise the pay-as-you-go system.

In a 2014 paper for the IEA, economist Jagadeesh Gokhale – an expert in modelling the long-term sustainability of old-age entitlements – estimated that the average EU country would have to raise personal income taxes by 27 percentage points, or cut all government expenditures by 26 per cent. Either of these would have to take place immediately and in perpetuity to make current welfare commitments sustainable.

Neither of the options, nor a combination of the two, is especially attractive. Fiscal pressure on workers is at historic highs, and dangerously tilted towards the most productive members of society.

Whilst the hike estimated by Gokhale is a theoretical possibility, the fact that the UK has never – whether at times of high or low tax rates, and high or low growth – been able to raise more than 37 per cent of national income in tax should give policymakers pause. Moreover, increasing marginal tax rates on middle and high earners risks inducing them to cut their labour supply, thereby compromising not only the Exchequer’s revenue in the present but the future dynamism of the economy as well.

The rationale for maintaining welfare spending whilst slashing expenditures on everything else is also dubious. Modern governments spend taxpayers’ money on, broadly defined, three functions: the provision of public goods such as national defence; spending on income-multiplying physical and social infrastructure such as roads and education; and redistribution through the pension system, social security, and healthcare.

Whilst there is a strong case for bringing down overall spending, especially as it has consistently exceeded tax inflows, there is to my knowledge no sound argument for massive reductions in expenditure on the first two areas of activity so as to prop up the third.

 

Zuluaga Table

The safer alternative – though by no means more politically attractive – is to fundamentally reform public pensions and healthcare with a view to providing freedom from destitution and ill health, but no more.

Redistribution ought to rescue the poorest from their poverty, but there is no prima facie case for transferring resources across age groups regardless of socioeconomic status. Such inter-generational redistribution has ushered in the paradox that the average British pensioner – a net transfer recipient – is today better off than the average young worker – a net welfare contributor.

These reforms would involve an implicit default on the promise to provide benefits in exchange for earlier contributions, but it is fair to say that most young people see through this “social contract” justification for the welfare state and are sceptical that they will ever receive a state pension.

Furthermore, the alternative is not no reform, but one of the avenues outlined by Gokhale, and both would adversely affect the long-term economic welfare of those in or about to enter the workforce. Better to give them the certainty that the welfare state will change, and allow them to plan accordingly whilst they are still young.

It is remarkable, and disappointing, that politicians are not spending more time pondering the transitional arrangements to a more rational welfare state. An equally pressing question, however, is how to ensure that the sort of grossly unbudgeted-for promises made in previous decades will not re-occur.

It has been said that, if the Government were a private firm, it would doubtless be charged with fraud for the way in which in it accounts for its welfare state commitments.

Any company making similar promises, no matter how long-term, would have to list them on its balance sheet and promptly react to any asset-liability mismatch. Yet, the implicit debt from welfare state promises is wholly absent from the headline figure for the national debt, which in no small part contributes to the public’s lack of awareness of the problem, and to politicians’ ability to eschew the issue.

The parallels with corporate governance do not stop here. The modern welfare state is like a firm whose management had over the years racked up debts in order to give itself and employees perquisites beyond any reasonable estimate of the future cash flows from the firm’s activity. The shareholders are not just current taxpayers, but future generations of taxpayers whose equity value is being eroded by the management’s recklessness.

Yet future taxpayers get no vote in company decisions – think about them as minors whose shares were held in a trust also under the custody of the firm’s management.

The comparison is naturally imperfect, not least because corporate governance in private firms is so superior as to make the above scenario unfathomable. But it offers some lessons about what is needed to secure inter-generational justice in the management of a nation’s wealth.

Namely, what future generations of taxpayers lack is adequate representation of their interests in the Government’s financial decisions. We need a Board of Trustees that will work to ensure that those who cannot vote today are not short-changed by the present management.

So, here is a modest reform proposal: create an Office for Intergenerational Responsibility alongside the Office for Budget Responsibility, whose sole function would be to scrutinise the long-term sustainability of spending programmes involving large payoffs in the present and large outlays in the future.

Because of the pressing nature of the problem, and the profound political challenge of persuading politicians to care for the welfare of people whose voices do not count, this new Office should be given legislative teeth, for example, in the form of veto power over spending promises exceeding £100 billion in present value whose cost was found not to be accounted for.

We spend very little time discussing the enormous implicit debts incurred by the welfare state and the need for long-standing reform. Even less attention is devoted to the perverse incentives of politicians to bribe voters whilst compromising the prospects of future generations. That needs to change.

47 comments for: Diego Zuluaga: We must face the realities of funding the welfare state

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