Institute of Economic Affairs warns of huge tax rises and cuts due to ‘staggering indebtedness’

14th March 2014

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The Institute of Economic Affairs has warned that the UK faces huge cuts in public spending or massive tax hikes to fund future pension and social care obligations.

The right leaning thinktank says its research reveals the “staggering level of the government’s hidden indebtedness in the face of an ageing population”.

In a report The Government Debt Iceberg, Jagadeesh Gokhale, of the organisation, reveals the extent to which western governments are keeping taxpayers in the dark about true levels of debt.

The report argues that official debt figures from both EU and US governments do not take into account future pension and healthcare obligations. As populations age, tax bases will grow more slowly while government spending rises faster – a direct result of the promises made to today’s older and middle-aged generations.

The situation without reform

For EU countries to finance all future spending commitments, the IEA says consumption taxes such as VAT and fuel duty, will have to more than double or health and social spending will have to be halved.

In the UK, total spending would have to be cut by more than a quarter, or health and social care protection expenditure by 50% to avoid tax increases if current obligations are to be met from tax revenue in the long run.

If the US is to close its fiscal imbalance, federal taxes will have to double into the indefinite future, or federal spending will have to be cut by over a third.

The true extent of indebtedness

The IEA says that governments should measure indebtedness in terms of the extent to which all future spending plans cannot be financed by current taxation. Explicit debt – inherited from the past – is already enormous, equal to 85% of national income in the EU, or 2.1% of the present value of future projected GDP.

However, it says when future spending commitments are added to this, the true level of debt in the EU equals 13.5% of the present value of future projected GDP. The unfinanced implicit debt relating to future spending commitments is a staggering 11.4% of present GDP, over five times the current visible debt.

It suggests that the United States’ real level of federal debt is 9%, of which 2.2% of the present value of GDP represents the explicit debt.

The hidden debt problem in the EU is much worse than in the USA as a result of both demography and poor policy decisions. EU expenditure on social security programmes are around 30% of GDP, compared with 15% in the US. The EU’s ageing population compounds the problem as a much smaller worker-to-retiree ratio looms on the horizon.

The need for urgent reform

If countries fail to address their fiscal imbalances, the size of the necessary adjustment will increase over time, undermining investment opportunities and reducing growth potential says Gokhale. Countries cannot grow themselves out of these problems. Many of the projected expenditures would in fact increase with growth as the commitments are linked to wage growth, and most are protected against inflation in retirement.

He says that much more must be done by governments to ensure that individualss save for future pension and healthcare costs.

Professor Philip Booth, at the IEA says: “Without reform, today’s young people are likely to be disappointed, either in terms of higher tax rates or in terms of reduced future benefits provided by government. The quicker the government changes policy, the more painlessly the situation will be resolved. For too long people have voted themselves benefits to be paid for by the next generation of taxpayers, not by sacrifices that they will make themselves.”

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