On Thursday the Office for Budget Responsibility (OBR) released its report on Fiscal Risks and Sustainability. This is the third one they have produced in its current format.
The report is long and Innovation is short. It is overall quite depressing, but I will do my best. They start with a brief outline of where we are now. The UK has run a deficit of around 5% of GDP for most of the 21st century. This has led debt to triple to just under 100% of GDP.
Public spending is 45% of GDP – the highest since the 1970s. This is caused by increased spending on public services, welfare and interest payments. The previous government knew this of course, and the plan was to keep real growth in public spending below the growth rate of the economy, while also increasing tax to 37% of GDP – the highest since the late 1940s. The trouble with the plan is economic growth in 2023 was 0.1%.
The OBR believes that over the next 50 years, based on current trends, UK public finances are unsustainable. Public spending would increase from 45% to 60% of GDP, but tax revenue would only be about 40%. This scenario would see debt at 274% of GDP. Net interest spending would rise from 2.8% to 11.3% of GDP.
Even if you believe governments can borrow as much as they like, I saw a chart over the weekend showing US government debt now produces just $0.58 of GDP for each dollar borrowed – down from $9.80 per dollar in the 1960s. Debt at 90%-100% of GDP is believed to be a tipping point where the debt starts to become unproductive, although there are a number of factors which can influence the outcome.
They do stress the uncertainty of these long-term forecasts of large numbers, but these are their base case projections. They also acknowledge the projections are based on current circumstances and assumes nobody does anything about it.
The OBR identifies three key areas where the UK could improve these outcomes. All are somewhat controversial, but likely to be at the heart of government policy in the coming decades, whichever party is in power.
Firstly, climate change. The OBR believes we could reduce the 274% debt to GDP number by 10 percentage points if we get the rise in global temperature below 2%. Rising temperatures will create costs in a number of ways. It can reduce the supply of labour by increasing ill-health and mortality, it can reduce agricultural output and increase energy costs. More extreme weather also causes damage and reduces productivity.
The FCA is implementing a very large change in the regulation of ethical investment funds. A key reason it is doing this is to support the government and provide visibility on climate change targets. Much of the regulatory change relates to measuring and reporting the quantitative impact of the investments.
Secondly – improving the health of the population could reduce debt by 40% of GDP. Total spending (including private) on healthcare has increased from below 6% of GDP to over 11% and is now slightly above the median for developed economies. This increase is likely to continue as the UK population is ageing. The share of over 65s is expected to rise from 19% to 27%. Public spending on healthcare is currently just under 8% and is forecast to rise to 14.5% of GDP in 50 years.
Healthier people are more likely to be employed, earn more and live longer. This means increased tax revenue and lower welfare, pension and healthcare expense.
Thirdly – the biggest – every 0.1% increase in productivity would reduce debt by 25% of GDP. A 1% increase in productivity – which would take us back to pre-GFC levels – would keep debt to GDP below 100% for the next 50 years. Occasional reminder that productivity in the national level economic sense hasn’t got anything to do with rolling your sleeves up or working from home. It means infrastructure, technology, training, education – largely state led issues which the government can do something about if it wants to.
Productivity is also impacted by migration. The UK population is forecast to increase by 14 million to 82 million in 50 years. The birth rate is 1.59, well below the replacement rate of 2.1 needed for a stable population. The increase is due to migration. With zero migration, the UK population would decline to 60 million with a corresponding decrease in aggregate productivity.
As mentioned earlier, it is unlikely that anyone would sit and watch all this without doing anything. What kind of options might present and future governments have? If we want debt back to 75% of GDP, the OBR suggests the government could either implement a one-off permanent fiscal tightening of about 4.1% – in other words reduce spending and / or increase tax to this level. Alternatively, they could tighten by 1.5% of GDP per decade.
Either way, we will be faced with some hard choices in the coming decades. Cutting winter fuel allowances may just be the start.
Robert Fullerton – Senior Research Analyst
FPC24234
All charts and data sourced from FactSet
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