A comfortable future for the British welfare state

The welfare state is not in crisis. This week's announcements by the Social Security Secretary, Peter Lilley, and his Labour counterpart, Chris Smith, on the social security front addressed an unnecessary panic about what sort of welfare system Britain can afford.

This is not to say that there is no need for a debate about the fairness of the British social security system, about how to make it more efficient, and about setting the boundaries to people's entitlements. Quite the reverse.

But the UK is one of the few industrialised countries that does not have a looming crisis in paying for welfare, according to recent research by the Organisation for Economic Co-operation and Develop- ment.* As Mr Smith emphasised this week, there is no "demographic time-bomb" threatening these islands.

Nor is there any evidence that the lack of a pension problem is just because the existing system is mean. Compared with their counterparts in some other industrial nations, relatively few British pensioners are living in poverty.

Two observations have triggered fears that the Western industrialised countries will buckle under the burden of the post-War welfare state. One is the phenomenal growth in social security spending by the governments of all industrial countries during the past two decades.

The other is the rapid ageing of their populations, increasing the number of pensioners, longer-lived and possibly ailing, who will have to be supported by taxes levied on a shrinking workforce.

Social security spending has risen sharply relative to the size of the economy in all the rich countries during the past 20 years. The UK is among them: as a percentage of GDP (excluding unemployment benefits) social security spending climbed from 8.8 per cent in 1975 to 12.2 per cent by 1993. The proportions ranged from 10.1 per cent in the US to 23.6 per cent in France in the same year. It is no surprise that governments have become concerned about the apparently inexorable upward trend.

Changes in the age structure of the populations have fed concerns that social spending will continue to rise unless the welfare state is fundamentally reformed. An ageing population could have grim implications for pressure on public spending because the amount of expenditure on citizens varies over their life cycle, rising as they get older. On top of that, age cohorts vary in size and the 1945-60 baby boom is approaching retirement.

For some OECD countries the prospects are truly alarming. The expense of keeping welfare provision at existing levels could double US government debt as a proportion of GDP (from 50 per cent to 100 per cent) between 2000 and 2030 and multiply the ratio for Japan sixfold to 300 per cent.

However, on existing policies here, the UK's net government debt to GDP ratio is likely to fall. This benign outlook is thanks to the interaction of three phenomena: a favourable starting point in terms of government finances; a less rapidly ageing population; and state pensions that are less generous than elsewhere.

By the turn of the century the British government is likely to be significantly less in debt than most other OECD countries. The government debt to GDP ratio is forecast at 46.5 per cent, lower than any other OECD country apart from Australia. Belgium, at the other end of the scale, will be staggering under a 124.8 per cent ratio.

On top of this head start, Britain will see a smaller increase in the number of dependent elderly because the baby boom here was less pronounced than in many other countries. The old-age dependency ratio - the ratio of the elderly to the working-age population - will increase a little between 2020 and 2035, but at just over 40 per cent will be lower than in most other industrial nations.

The OECD's economists have assessed the implications of the changing population structure for all the age-dependent components of government expenditure, in one of the most comprehensive attempts to put some figures on the scale of the problem. These are pensions, health spending and education.

They calculate that because of its ageing pattern and because of extremely generous state pensions elsewhere, the UK will be unique in its lack of a pensions problem, as the chart indicates. On existing policies, pension expenditure is likely to peak at about 5 per cent of GDP, compared with between 15 and 20 per cent in Japan, Germany, Italy and France.

However, the favourable British position is not the result of giving pensioners a bad deal, unless this is judged by comparison with generous Continental pension systems. A separate OECD report** shows that in 1986 the disposable income of households headed by a male pensioner averaged 66 per cent of the income of households headed by a working man of the same age, and was the same as the average income of all households. Only 4 per cent of households with a low income were headed by people over 55.

Of course, these figures ignore the significant post-1986 changes in pensions. But government transfers account for only slightly more than two-fifths of income for people over 60. Company pensions, other earnings and investment income make up the majority of income for the average pensioner. The changes to state pension provision in the UK have made public sector financing of the current position of the elderly sustainable.

Public spending on the second age-related component, health, is expected to rise significantly everywhere. Health care is most expensive for infants under one and for the elderly, rising particularly steeply in the late seventies.

Therefore, more over-65s living longer will increase the health-care bill. For the UK the cost of care for pensioners could rise from 2.6 per cent of GDP in 2000 to 3.9 per cent 30 years later.

On the other hand, spending on education is likely to fall as the school- age population shrinks, even if expenditure per pupil grows at the same pace as the economy's overall productivity growth. If higher productivity were not exploited to raise the quality of education, the fall in spending would be significant.

Combining the three, the welfare pressure on British government spending is likely to ease during the next 30 years. The OECD's authors note: "In these circumstances, the assumptions of unchanged policies for other spending and taxes may be unrealistic; policies might tend to become less restrictive." In other words, British politicians in 2020 could find themselves in the happy position of being able to increase the scope of welfare spending - especially if unemployment, the other great burden on government spending, is lower by then.

Unfortunately, the UK will still suffer the consequences of other nations' problems. High government deficits have been the main reason for falling national rates of saving and investment in the industrialised countries in the past 30 years. Extrapolating from current trends, future government deficits could be big enough to leave the OECD as a whole with a $500bn- a-year savings shortfall.

On top of that, industrialising countries will be looking for cumulative capital imports of around $1,500bn from OECD investors between 1994 and 2004. The world level of real interest rates will have to rise sharply to resolve such huge imbalances.

Future Global Capital Shortages, OECD April 1996.

The Transition from Work to Retirement, OECD Social Policy Studies No.16.