How Britain Can Grow Old Without Going Broke

Last week the Dilnot Commission on long-term care produced its findings and recommendations. On Wednesday the Office for Budget Responsibility (OBR) will publish its first report on Britain’s long-term fiscal sustainability, in other words the ability of the public finances to withstand the pressures of an ageing population.

Alongside it the Treasury will produce what are known in the jargon as whole of government accounts, essentially the balance sheet of the public sector. This will provide new official estimates of government liabilities on public sector pensions, the private finance initiative, and so on.

Of all the pressures on the public finances in the coming decades, easily the most important relate to demographics. Currently there are 3.6 working-age people for every person of retirement age in Britain. By 2050 that will be just 2.4.

Over the next two decades the percentage of the population aged 65 or over will rise from 16% to 23%, while numbers aged 85 or over will double from 1.5m to 3m.

It is, of course, excellent news that so many of us are liviung longer. It is also a challenge. John Hawksworth of PriceWaterhouseCoopers (PWC), in a detailed preview of tomorrow’s OBR report, projects an increase in age-related spending from 22.6% of gross domestic product in 2009-10 to 27.5% in 2049-50.

Of that 4.9 percentage point increase most, 3.4 percentage points, is health; 1.3 points is state pensions and 1 point is long-term care. It is offset by a reduction in spending on public sector pensions, down from 1.9% to 1.4% of GDP, and education, down from 6% to 5.7%. An ageing population requires less education spending.

You might ask why we should be worried about this. Four decades is a long time. In the short-term, according to the National Institute of Economic and Social Research, growth is the problem.

On the back of the latest industrial production figures it reckons GDP will have risen only 0.1% in the second quarter. Some City economists are even gloomier. Knowing the Office for National Statistics, this at least raises the possibility of a negative second quarter.

Weak growth may not end there. The CEBR (Centre for Economics and Business Research), in a new forecast tomorrow, says without the contribution of a strong consumer and rising government spending, growth will average only 1.8% between now and the end of 2015.

That is about two-thirds of the pre-crisis growth rate and will mean annual government borrowing will be about £20 billion higher at the end of the parliament than forecast at the time of the March budget.

But, as Doug McWilliams of the CEBR points out, this is no reason to relax the fiscal tightening. Indeed, if Britain’s trend growth has permanently dropped, the public spending that can be afforded in the future will be less than was thought.

This is the essential point made by PWC’s Hawksworth, in his preview of tomorrow’s official report on fiscal sustainability. Left unchecked, the path for Britain’s debt in future can be mapped out with reasonably accuracy.

It will rise for the next few years, dip back temporarily as the current fiscal tightening takes effect, but from around 2020 begin to rise again as age-related spending kicks in. The debt will never get below 60% of GDP and by the middle of the century be 90% and rising. Age-related spending and debt interest will be huge burdens on a diminishing proportion of working age people. It is not a bright future.

The Treasury will use such projections to underline the need not to let up on tax hikes and spending cuts now. It may need to go further Hawksworth suggests additional fiscal tightening by 2020 worth 1.3% of GDP, around £20 billion, and a more aggressive increase in the state pension age so it reaches 70 by the 2040s, to put the public finances oln a sustainable path.

That way public sector debt will be 40% of GDP and trending gently lower by the middle of the century, rather than 90% and rising. The dynamics of debt mean a stitch in time really does save rather a lot.

Why, going back to the debate of a week or so ago, does the government need to clamp down further on public sector pensions when the OBR is likely to confirm that, as a result of action already taken, their cost will fall as a percentage of GDP?

It is a good question. The answer, I think, is that it would be politically untenable to make the state pension far less generous – by increasing the age of elibibility (particularly for women) – while not further reforming public sector pensions.

Finally, what about Andrew Dilnot’s proposals for long-term care for the elderly? His proposals, setting a £35,000 cap on individuals’ contributions to their care costs, and raising from £23,250 to £100,000 the means-tested assets’ threshold at which people will have to make a full contribution to these costs, are appealing. An insurance market for these £35,000 of costs could be established.

Their drawback is the cost; £1.7 billion now, rising to £3.6 billion a year by the mid-2020s. George Osborne wants to save money, not spend more.

Geoffrey Dicks of Novus Capital Markets, formerly with the OBR, suggests one way of squaring the circle. Why not, to establish a sustainable system for long-term care, scrap some of the handouts Gordon Brown lavished on pensioners?

These handouts, partly to atone for the infamous 75p state pension rise, include for some or all pensioners free TV licences, bus passes and the winter fuel allowance. Their annual cost is around £3.5 billion, twice what it would take to put long-term care on a sound footing. It should be done.

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This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.