The costs of growing old
21 February 2017
The UK government continues to try and balance the books some eight years after the financial crisis. While we would disagree with the timing, speed and composition of this adjustment, there is a clear need for a credible long-term fiscal plan. In large part this reflects pressures from an ageing population. Higher life expectancies, relatively low fertility rates and the retirement of the baby-boom cohorts are set to lead to a material shift in demographics over coming decades. The European Commission has estimated that the proportion of the population of working age (15-64) will decline from 65% to 60% in 2035 and 58% in 2060. Meanwhile, the elderly population (65 and over) will increase by 7.5 percentage points over the full period (see Chart 4). This means that for every 100 people of working age in 2060 there will be 43 people at pension age, up from 27 at present. This rise in the dependency ratio poses some pretty big challenges.
Getting older is expensive. In particular the shifting demographic profile is set to trigger large increases in healthcare, state pension and long-term social care costs. In total the Office for Budget Responsibility (OBR) estimates that total government expenditure will increase by 4.8% of GDP, or £79 billion in today’s terms, by 2060. The main driver of this increase is age-related spending. Healthcare costs are expected to rise from 6.4% of GDP to 8.5% of GDP in 2060, although the OBR acknowledges the difficulty in forecasting healthcare spending. If productivity growth in this sector proves to be weaker than the rest of the economy then these costs could rise much faster. This underlines the importance of efficiency in healthcare spending. Pension costs are estimated to rise to 7.9% of GDP by 2060 (5.5% at present). This includes an assumption that the state pension age would rise to 70 by the 2060s. The government has launched a review into the state pension age which is set to be released in May this year, under the guidance that people should be eligible for state pension for on average a third of their adult life (starting at 20). Finally, the cost of age-related social care is estimated to double from 1.2% of GDP to 2.3%.
The OBR’s analysis of these trends is pretty damning. In short, the public finances are deemed to be on an unsustainable path given these headwinds. Indeed, under their central projections, the UK runs persistent deficits, which contribute to a rise in public sector net debt to 230% of GDP by 2060 (see Chart 5). What can be done to help ease the strain from demographic change? The UK faces the same tough choices as other countries. Expenditure restraint is an obvious starting place, although this is unlikely to be sufficient. Tax reform provides another avenue to try and meet these challenges, but this of course comes with political and economic hurdles. The OBR has run a number of scenarios around its central projections for the public finances. Stronger growth and higher inward migration can all help to improve the outlook for debt sustainability. Certainly this should provide food for thought over coming years as the government negotiates its new relationship with the EU. If proactive action is not taken, the risks of more malign policy choices would increase. These might include pro-cyclical bouts of austerity, financial repression and building pressure on the Bank of England to tolerate higher inflation.
James McCann, UK/Europe Economist